As JPMorgan Goes So Goes The Market

JPMorgan Chase is a metaphor for the stock market in the sense that while still paying mightily for the financial world's sins of commission it will share in a zippy economic setting likely to unfold.

Morgan weathered the storm better than Citigroup, while the likes of Bear Stearns, American International Group, Merrill Lynch and a host of mortgage insurers and packagers of housing paper like Washington Mutual were merged out for a song or required massive cash infusions from the Federal Reserve and U.S. Treasury.

As financial assets rebounded from their panic lows early in 2009, regulators like the Justice Department, SEC and a host of state attorneys general sharpened knives, sued for tens of billions and won court cases or settled with their defendants.  The bill for Morgan could reach $30 billion by year end 2014.  This is over 1½ year's earnings, and we shareholders will have experienced a haircut to book value near $8 a share.

But, TARP assistance funds largely have been repaid with interest. The federal government may lose some capital on the General Motors bailout, but GM is hearty, profitable and a solid world player with a respected line of new model trucks and cars. I don't fully understand why regulators demand and get tens of billions from JPMorgan Chase and its ilk. After all, no senior bankers were indicted for criminal fraud and then jailed.

Awaiting JPM's September quarter's report, I mused over the sheer size and scope of Morgan. It reminded me of the old Standard Oil of New Jersey which bestrided the oil sector like a colossus; finally it was broken up by the Justice Department. Talk about too big to fail! Rockefeller's domain was a cornucopia of asset values – oil reserves in the ground, cash flow, earnings power and dividend paying capacity.

Ma Bell was dismantled in the sixties but kept its long lines franchise.  Today, both AT&T and ExxonMobil are polite investments but are structurally incapable of outperforming. AT&T has too much landline business, slowly withering away and XOM is troubled replacing oil reserves year over year.

I can imagine how you break up JPM, but is it worth the government's efforts? The best control is indirect control. You keep raising reserve requirements against earnings assets, keeping leverage to a respectable ratio. Below 15:1 rather than 25:1 makes sense.

The enormity of this colossus shouldn't go unremarked:  Shareholder equity of $196 billion, headcount of 255,000 and total assets of $2.46 trillion. The stock, like many other banks, sells at book value before intangibles, but there's not much free capital left for buybacks.

JPMorgan Chase's 16-page quarterly report is chock-full of statistics, ratios and year-over-year comparisons as well as sequential quarterly results. The numbers come fast and furious, complicated by releases of loss reserves in almost every segment of the bank's operations. The initial reading left me nonplussed.

Could I rely on management's pronouncement that "real" earnings were $1.42 a share, excluding litigation expenses and reserve releases? Maybe yes, maybe no. What was eerily missing from the density of the report was any feed-out on how each sector of the bank's business might fare going forward, quarterly, annually, whatever. How was capital going to be allocated to each major earnings sector? In short, what were areas of strength or softness? The silent message is do your own your homework.

OK. I dug in, amazed at the runoff in assets in the mortgage sector, largely from the peaking of mortgage refinancing and some sloughing off currently of home mortgage writing. The numbers are enormous, but are squeegeed out by loss reserve reversals in the billions.

Mortgage banking revenues declined $1.7 billion to $2 billion. Non-interest revenue declined $1.6 billion to $877 million. Loss provisions dropped by $1.5 billion. Mortgage production pretax income was minimal, dropping almost a billion, year-over-year. These are enormous shrinkages in the face of mortgage application volume dropping 45% year-over-year and 38% sequentially.  Prime home mortgages are tagged near 4.5%, not the 3% over 6 months ago.

In the bank's real estate portfolio, again, credit loss provisions swung by $1.5 billion.  Allowance for loan losses in mortgage banking dropped from $11.3 billion to $7.7 billion or from 4.6% to 2.4% of loans. I'm untroubled by such earnings management just so long as the country doesn't lapse into a no-growth setting next year or two.  It's hard to see the loan loss ratio cut much more.

Likewise, in the credit card and autos sector, Morgan experienced spread compression and flattish revenues offset by loss reserve flowbacks. Another major profit center, consumer banking, also showed lower revenues, spread compression and loss reserve flowbacks of over $2 billion, year-over-year.