JPMorgan: Hold the Champagne


The bank's earnings are impressive, but they're built upon some businesses, such as mortgage refinancing, that may prove temporary

JPMorgan Chase's (JPM) first-quarter earnings results are a bright spot amid all the gloomy financial news. The bank announced on Apr. 16 that its first-quarter profit came to $2.14 billion, on 50% higher revenues from a year earlier—$25 billion vs. $16.9 billion. The stock market response was kind, as shares opened up 4%.

But this latest report doesn't necessarily point to a broader economic rebound, or a banishment of toxic assets, which still fester on bank balance sheets.

JPMorgan's buoyant results come on the heels of two other major banks—Goldman Sachs (GS) and Well Fargo (WFC)—that startled Wall Street by posting better returns than expected. Wells Fargo, the San Francisco bank that bought Wachovia in a shotgun marriage late last year, announced a first-quarter profit of $3 billion. Following suit, Goldman reported a $1.7 billion profit this week after a disheartening $2.3 billion loss last quarter. Rival Citigroup (C) will announce earnings on Friday, and Bank of America (BAC) on Monday.

In all the reports from the big banks, analysts say, the positive results may be distracting from problems that could emerge over the next year.

Temporary Gains

Although JPMorgan's first-quarter earnings did exceed analyst's expectations, profits still fell 10% from the first quarter of 2008, to $2.1 billion. Like its banking cousins, Goldman and Wells Fargo, a big portion of JPMorgan's earnings gains are temporary, analysts suspect, based on finite streams that will peter out soon.

Also, favorable accounting rules may have helped massage the results: Starting in April, banks were allowed to value their own assets, ignoring the price that an increasingly depressed market might assign them. Such an optimistic treatment of assets could artificially boost earnings. Analysts don't know whether JPMorgan overinflated any of its asset values, but the concern is there.

Still, during JPMorgan's investor conference call, management exhibited a realistic attitude toward losses. That suggests the company has prudently assessed the possibility of future losses, and is girding its balance sheet to absorb those. JPMorgan set aside $28 billion to insure against future loan losses. On a conference call with reporters, Chief Executive Jamie Dimon indicated that he would be willing to add "a bit more" to those reserves if the economy continues to deteriorate.

Michael Cavanagh, JPMorgan's chief financial officer, assured skittish investors that the souring assets are "getting to be much less noteworthy." Even though increasing capital for loan losses currently dampens profits, JPMorgan Chase's caution might benefit it in future quarters.

JPMorgan's investment banking division saw solid gains from its bond-trading, notching earnings of $3.6 billion. JPMorgan Chase also benefit this quarter from its acquisition of failed thrift Washington Mutual. It told investors that integration was "on track" and that retail banking deposits jumped up 62%.

Mortgage Refinancing

One bright spot for the bank was its mortgage-lending division. But this profit stream might dry up in the future. Much of the activity was fueled by refinancings, as borrowers look to seize upon plummeting interest rates. That business has a finite lifespan since there is a limited number of homeowners eligible for refinancing. Mortgage activity will level off if new-home mortgage applications don't pick up soon; the bank's new-mortgage originations are down 20% from last year.

A further potential trouble spot for the bank is its commercial real-estate loans. They could turn problematic if developers continue to see a mass exodus of retailers from properties and if surviving businesses are unable to make regular lease payments. The total value of commercial real-estate loans held by JPMorgan is $6.5 billion, down from $7.7 billion last year. But the bank reports that 46% of those commercial loans are AAA-rated.

Another potentially explosive area for JPMorgan: its credit card portfolio. Default rates on the company's credit card portfolio could grow. This quarter, net charge-offs for credit cards—that is, card accounts that are so delinquent they are deemed uncollectible by the bank—grew to 4.9% from 2.68%. If unemployment continues to rise through the rest of this year, reaching 10% as some economists predict, more card-holders will struggle to pay their bills. That could mean much higher charge-off rates for the bank.

In that case, WaMu's credit-card portfolio could become a liability for JPMorgan. WaMu, like so many other credit-card companies, lent generously through the boom years. Losses from WaMu's card-services division are expected to reach 18%, according to the bank's investor presentation.

Silver-Greenberg is a reporter for BusinessWeek.com.

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