DBRS Comments on 2Q12 Earnings of JPMorgan – Senior at A (high), Trend Remains Stable

DBRS, Inc. (DBRS) has today commented that its ratings for JPMorgan Chase & Co. (JPMorgan or the Company), including its A (high) Issuer & Senior Debt rating are unchanged following the release of the Company’s 2Q12 results. For the quarter, JPMorgan reported earnings of $5.0 billion, up from restated 1Q12 earnings of $4.9 billion.

Second quarter results included $4.4 billion of pre-tax trading losses related to the Chief Investment Office’s (CIO) structured credit portfolio that were partially offset by $1.0 billion of pre-tax securities gains. The Company also restated 1Q12 results to reflect new marks on certain structured credit positions. This lowered 1Q12 net income by $459 million (after tax). While well above initial guidance, the CIO trading loss did not exceed expectations given market movements, and in light of the Company’s significant earnings power, JPMorgan was able to absorb the losses relatively easily. The remaining synthetic credit portfolio has been transferred to the Investment Bank (IB) to manage and JPMorgan estimates that in an extreme scenario further losses could be between $800 million and $1.6 billion.

That said, and as noted when JPMorgan’s trend was revised to Stable from Positive, of greater concern to DBRS than the trading losses is the risk management failures that the loss highlights. On that front, JPMorgan enumerated the key failures that its investigation into the CIO has brought to light. Among these were insufficiently granular risk limits and a poor understanding by both traders and risk managers of the risks in these positions, which when combined, allowed the portfolio to grow significantly over a relatively short period of time. The review also revealed weakness in the Company’s model review and implementation processes, and highlighted problems associated with the insular nature of the CIO, which hindered the escalation of concerns and contributed to inadequate scrutiny relative to client-facing businesses. DBRS takes a degree of comfort from the swiftness and thoroughness of the Company’s investigation (both at the management and Board level) and notes that many of these failures are already being addressed. Nonetheless, further work remains and combined, these issues underscore the significant challenges associated with managing and monitoring the myriad risks across large, complex institutions.

Outside of the CIO, DBRS views JPMorgan’s second quarter results favorably. For the quarter, adjusted net revenues were $25.0 billion (excluding the CIO trading losses and securities gains, $755 million of DVA gains and a $545 million gain on its Bear Stearns-related first-loss note), down from 1Q12’s $26.5 billion. First quarter adjusted revenues exclude CIO mark-to-market losses, $907 million of DVA losses and the $1.1 billion WaMu bankruptcy settlement. Adjusted income before provisions and taxes (IBPT) increased approximately $1.8 billion from 1Q12 to $10.0 billion, driven by lower litigation expenses, which declined $2.4 billion from the first quarter to $0.3 billion.

In the quarter, the Company benefited from continued improvement in credit, notably in its home lending portfolios and in cards, and underlying business trends were mostly positive. Across the firm, JPMorgan reduced its allowance by $2.1 billion from the end of 1Q12, with $1.25 billion of that reduction in its Real Estate Portfolios and $750 million in Card Services. In 1Q12, reserves were reduced by $1.7 billion. Also noteworthy from DBRS’s perspective was the reduction of the mortgage repurchase reserve (to $3.3 billion from $3.5 billion at the end of 1Q12) in the quarter and an outlook for further reductions in coming quarters. While litigation expenses did decline materially from 1Q12, DBRS expects the ongoing LIBOR investigation to remain an overhang for JPMorgan and the industry.

JPMorgan reported a strong quarter for mortgage banking which along with the noted reserve release drove a 29% q-o-q increase in net income for Retail Financial Services to $2.3 billion. Second quarter results also displayed continued loan growth across commercial and business banking, while Treasury & Securities Services showed solid positive operating leverage. IB results, while down from the strong first quarter, were, in DBRS’s view, reflective of the more challenging market conditions rather than Company-specific weakness and should be comparable to (if not better than) 2Q12 peer results. IB revenues (ex-DVA) declined 27% q-o-q to $6.0 though the IB reported net income of $1.9 billion that was up 14% from 1Q12 due to the $1.7 billion pre-tax swing in DVA.

The Company’s asset quality remains sound and most indicators continue to improve. Despite reserve releases, JPMorgan’s loan loss reserves remain solid in DBRS’s view. The Company reported lower levels of charge-offs for most wholesale and consumer lending portfolios and delinquencies declined further for its card and mortgage portfolios supporting the noted reserve releases. Nonperforming assets declined 5% q-o-q to $11.4 billion. At quarter end, the Company’s allowance for loan losses was $23.8 billion and represented 2.74% of total loans and 183% of NPLs excluding purchased credit-impaired balances.

In DBRS’s view, JPMorgan’s sound funding and liquidity profile and solid capital levels afford it greater flexibility, relative to many banks, to cope with the challenging market conditions and manage through the evolving regulatory environment. It also enabled the Company to absorb the losses from its CIO. Total deposits declined about 1% from March 31 to $1.1 trillion and the Company’s global liquidity reserves exceeded $414 billion as of June 30. With respect to capital, JPMorgan maintains a comfortable cushion and ample loss absorption capacity. The Company reported an estimated Basel I Tier 1 common ratio of 10.3%, unchanged from the prior quarter. JPMorgan also reported an estimated Basel III Tier 1 Common ratio of 7.9% that reflects Basel 2.5 as well as the recent Notice of Proposed Rulemaking. Post-mitigants this ratio would improve to an estimated 9.1%. DBRS notes that the Company is aiming to restart its stock repurchase program (perhaps as soon as 4Q12), once the Board completes its review of the CIO and JPMorgan submits a new capital plan to regulators and receives a “no objection” response.

Note:
All figures are in U.S. dollars unless otherwise noted.

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organizations. Other methodologies used include the DBRS Criteria – Intrinsic and Support Assessments. Both can be found on the DBRS website under Methodologies.

The sources of information used for this rating include the issuer, the Federal Deposit Insurance Corporation and SNL Financial. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

This is an unsolicited rating. This rating did not include participation by the rated entity or any third party, and is based solely on publicly available information.

Lead Analyst: William Schwartz
Approver: Alan G. Reid
Initial Rating Date: 22 June 2001
Most Recent Rating Update: 15 May 2012

For additional information on this rating, please refer to the linking document under Related Research.