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The Perils of J.P. Morgan


When Chase Manhattan swooped in to bid $33 billion for white-shoe investment bank J.P. Morgan in September, 2000, Chief Executive William B. Harrison Jr. claimed that the new behemoth would provide "huge" growth. The idea was simple: Thousands of Chase's corporate customers would be pushed into J.P. Morgan's arms and pay fat fees for takeover deals, securities issues, and the like. Nor was the strategy far-fetched. After all, Citibank and Travelers Group had successfully combined in 1998 to produce a bull-market juggernaut that was leaving rivals, including Chase, in the dust.

The reality has turned out to be a lot different. Instead of striking the new gusher of profits promised by Harrison, the merged J.P. Morgan Chase & Co. (JPM) has tapped into a seemingly endless well of red ink. As a result, the new bank is ending its first full year by taking huge write-downs and making expensive additions to loan loss reserves. Analysts figure anything from $800 million to over $2 billion will be sliced off the fourth-quarter operating earnings to be announced on Jan. 16. Piled on top of second-quarter charges of about $1 billion, net income for 2001 could drop as low as $3.5 billion, down from the $5.7 billion that J.P. Morgan and Chase Manhattan together earned in 2000.

Admittedly, 2001 was the worst year for investment banking in nearly a decade. Mergers and acquisitions dried up, as did stock offerings and syndicated lending. Moreover, as the global economy worsened and the bear market dragged on, corporate lending and private equity took major hits as well.

More than bad luck with the timing of its merger could be dogging J.P. Morgan, however. Some analysts argue that the bank regularly runs much bigger risks than its rivals and is now paying the price. The bank's exposure to bankrupt energy trader Enron Corp.'s loans, and energy and derivatives contracts, has grown to $2.6 billion. It has $900 million in exposure to Argentina and its $117 billion commercial loan portfolio is facing a series of high-profile losses--thanks to bankruptcies among its telecom customers, as well as Enron. The value of its private equity portfolio, the largest of any U.S. bank, has been a major drag on earnings since the Nasdaq crash in March, 2000. And analysts have started to worry that the bank's off-balance-sheet assets could be a future source of losses. "I think their risk profile is greatly understated," says Charles Peabody, an analyst with independent researcher Ventana Capital.

J.P. Morgan executives balk at any suggestion they deliberately court more risks than their peers. They argue that investors and analysts are punishing the bank because it has been more scrupulous about reporting potential losses. The company's stock has sunk 22% since the merger was announced in 2000. "We're a lightning rod for credit issues because we've been more up-front than other participants in the market," says Chief Financial Officer Dina Dublon. Indeed, J.P. Morgan has been more open than others in some matters. It posts its private equity portfolio online. And it told analysts about its Argentina exposure when the country careened toward default. Citigroup (C), by contrast, doesn't detail its private equity holdings. Nor has it given details on its exposure to Argentina, which analysts estimate at $4 billion, beyond saying that country contributes less than 2% of earnings.

Still, it's unnerving how the bad news keeps piling up at J.P. Morgan. Because the bank was one of the largest lenders to Enron, as well as an adviser in the aborted Dynegy Inc. takeover bid, analysts weren't surprised when it announced on Nov. 28 that it had $900 million in exposure to the energy company. The real shocker was the disclosure on Dec. 19 that the bank's unsecured exposure to Enron (ENE) had tripled, to $1.6 billion, after insurers failed to make good on nearly $1 billion in guarantees on Enron gas contracts. Called surety bonds, the guarantees were issued to Mahonia Natural Gas, a J.P. Morgan "special purpose vehicle" created to handle commodity contracts with Enron. The bank is suing the nine insurers to force them to pay up, but they are fighting back. Meantime, analysts say the belated disclosure has hurt the bank's reputation.

Corporate lending problems don't end there. J.P. Morgan and Citi assembled a group of banks that lent telecom company Global Crossing Ltd.--now deeply troubled--more than $2.2 billion in its palmier days. Normally, banks take precedence over other lenders in a bankruptcy, but that may not be so with Global Crossing, says Aryeh B. Bourkoff, a distressed-debt analyst at UBS Warburg. Because of the way the loan is structured, he says, other creditors could be paid first if Global Crossing goes under. The point isn't academic: Global Crossing lost $1.9 billion on revenues of $2.4 billion in the first nine months of last year, and its bank debt sells for 20 cents on the dollar, far below that of other distressed telecom companies. J.P. Morgan and the other banks have been negotiating to stretch out the loan and cut the interest rates charged on it in exchange for new collateral. In late December, the bankers gave the company until Feb. 13 to reach an agreement. J.P. Morgan insists that its loan is, in fact, secured. CFO Dublon says analysts should look beyond these black marks. "We're still going to be profitable," she says.

Indeed the market may be exaggerating some of J.P. Morgan's risks. For example, its Argentina exposure is smaller than the likes of Citi or FleetBoston Financial (FBF). And Brian O'Neill, J.P. Morgan's chairman of Latin America, says the loans are predominantly to large commercial and industrial enterprises, many of them subsidiaries of foreign companies and therefore less likely to be affected by the peso devaluation.

Still, there's more bad news ahead. J.P. Morgan Partners, the bank's private equity unit, will need to write down $100 million on its investment in telecom outfit Triton PCS Inc. And losses could be even more severe in its $8 billion portfolio of privately held companies. Fox-Pitt Kelton analyst E. Reilly Tierney expects the unit will have to take $600 million in write-downs for the last quarter of 2001. Further losses are likely from the bank's off-balance-sheet dealings. It founded, and is by far the largest market maker in, the $1 trillion market for credit derivatives, a form of loan insurance. Issuers of these derivatives lose money if insured borrowers don't repay their loans. In the third quarter, banks lost $99 million in derivatives, says the Office of the Comptroller of the Currency. Nearly all of that--$95 million--was borne by J.P. Morgan alone, says Ventana's Peabody, who expects more losses to come. J.P. Morgan's head of credit derivatives, Andy Brindle, says the bank made substantial profits on its overall derivatives portfolio in the first nine months of 2001, while losses are on credit derivatives were "insignificant."

The litany of woes at J.P. Morgan seems endless. Bank executives remain philosophical that times are bound to be tough when the economy tanks. "Extending credit is the business we're in, and we're at the point that credit losses are going higher," says Dublon. There's no arguing with that. But sooner or later, the brass are going to have to make good on their boss's promises of future growth to placate critics. By Heather Timmons in New York, with Christopher Palmeri in Los Angeles


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