Will New Derivative Trading Regulation Cost JPM $3 Billion? According To Bernstein Analysts It Very Well Might

John McDonald at Bernstein is concerned that the impact from upcoming derivative reform on JPMorgan may be substantial - to the tune of $0.20/share. McDonald points out that based on a conversation with Steve Black, the Exec. Chairman of JPM's Investment Bank, JPM's blockbuster FICC revenues "will be difficult to repeat in 2010" and that the firm could be on the hook for up to a $3 billion revenue drop once derivatives move to exchange-based trading, as proposed by the current regulatory overhaul bill. It is likely that the impact on another derivative Fixed Income trading powerhouse, Goldman Sachs, will also be material as a result of comparable analyses.

Some highlights from the Bernstein report:

The stars aligned for FICC in '09; will be difficult to repeat in '10. Wide spreads, high volumes, the flight to quality, and the retrenchment of peer firms all helped JPM achieve record FICC revenues in '09. Management acknowledges that this will be difficult to repeat in '10, as credit spreads have come down and the environment has gotten more competitive due to newer upstarts, government supported domestic banks, and foreign banks looking to protect home turf and gain market share. We model for FICC revenues to decline 12.5% y/y in '10, but note that the company looks for earnings levers from improved y/y comps in core IB fees, better performance from select businesses it is investing in, and reduced provision expense.

4Q activity levels may be lower than the typical q/q seasonal decline. Nearer term, Black noted that the seasonal 4Q slowdown in trading volumes affecting all brokers may be exacerbated this year, citing the preservation of investor-gains after a volatile year (closing up the books early) and the fiscal year-end shift from November to December at the standalone brokers as two potential drivers.

Reduced provision expense and potential excess reserves remain material earnings levers. While NCOs continue to rise, provision expense in the investment bank has been on the decline throughout '09. JPM got an early start on reserve build in the IB (3Q09 LLR ratio of 8.4% vs. NCO ratio of 4.9%) and released close to $400m of reserves last quarter. Assuming that JPM brings its LLR ratio down to a more normal level of 3.0%-4.0%, it could imply over $2.0b of excess reserves in the investment bank alone.

Walking the tightrope on compensation. Management acknowledged the difficult challenges it faces related to employee compensation within the investment bank. JPM wants to balance retaining talent, paying competitively and rewarding employees for a record year, with the need to remain sensitive to increased public and regulatory scrutiny. All the while, the company (and all financial services firms) continues to wait for clarity on guidelines surrounding the level, mix (cash vs. stock), and required vesting period for compensation.

The investment bank is in the process of juggling a multitude of headwinds related to compensation and the potential for increased regulation of a number of its businesses. In terms of comp, JPM wants to balance retaining talent, paying competitively and rewarding employees for a good year, with the need to remain sensitive to increased public and regulatory scrutiny. All the while, the company (and all financial services firms) continues to wait for clarity on guidelines surrounding the level, mix (cash vs. stock), and required vesting period for compensation. From '05 –'07, JPM's compensation expense averaged ~41% of total IB revenues, and is on pace to average ~38% in '09.

And most notable to the topic at hand:

Aside from compensation, the investment bank faces a number of other potential regulatory headwinds including increased derivative regulation from the CFTC, and higher capital requirements for certain trading assets. Management acknowledged the potential challenges of increased regulation and emphasized that the IB is positioned to quickly adapt its business model to the new regulatory environment, once the new guidelines become clear. While it is very difficult to handicap and quantify regulatory related risks, increased derivative regulation could be a material negative for JPM, as derivatives accounted for ~8% of all of JPM's revenues from '06 – '08 (~$6b a year). JPM sees the largest risk from legislation mandating that all derivatives be traded on an exchange as opposed to through the OTC market, limiting the company's ability to create customized products. However, the company's rough estimate of a worst case scenario (assuming the vast majority of transactions are moved to standardized exchanges) is that derivative legislation could reduce revenues by up to ~$2b - $3b. While this represents ~6%-10% of our estimated '10 (and normalized) total revenues for the IB, we estimate that after factoring in expenses, reserving costs, and taxes, the net impact would only be a ~$0.13 to $0.20 reduction in EPS (Exhibit 11). Again this is viewed as a worst case scenario, and assumes the most severe regulatory changes take place. It also presumes JPM realizes no offsets from increased volumes and from the capital relief that would likely come from a scenario where virtually all transactions were standardized and cleared on exchanges.

h/t C-Mac

Comments

[TraderMark]

Welcome Back

David Kotok of Cumberland Advisors just returned from Asia and tells what is really being said behind closed doors

http://www.fundmymutualfund.com/2009/12/david-kotok-of-cumberland-adviso...

We will be going back to Shanghai and Hong Kong in January for another look at the region and to examine how US policy is playing out there. Or should I say, how US policy is failing miserably to play out there.

We believe that few trust the United States. This is obvious in private conversation. And it is clear to all that confidence in the dollar is low. This is mostly mentioned only in private. In public there is quiet response when the Treasury Secretary of the United States utters words about a strong dollar. Asians have heard that for years and with the many different accents of the various Treasury Secretaries. Geithner would serve the country better by ceasing to mouth the same words that his predecessor Snow and others used. He is not believed.

• The American federal budget deficits are worrisome everywhere. Policy promises from Washington to reduce them are greeted with great skepticism. Often they are privately described as American arrogance.

Publicly, Asians are very polite and do not often subject their guests to embarrassing criticism. Privately they are quite candid. In my view they are correct: America is arrogant and seems to pretend that it is still the best and most trustworthy financial and capital market in the world. There is no basis for the US to have such a view of itself. We have squandered our reputational capital as a financial center leader. 

[Anonymous]

not that I disagree with much of this, but Kotok is an ass that thinks Benny is doing a great job. His commentary is politically tainted, and he thinks we need these TBTF banks as they are.

[assumptionblindness]

I'm curious...how much money would you continue to lend someone who repeatedly violates your trust?  Maybe the next "shock" to world markets will come when these private conversations morph into public statements or ACTIONS.

[Screwball]

A couple of failed autions should do it.

[order6102]

i feel pain for JPM and GS... so, sorry... bonuses will be down.. so sad...

[Anonymous]

does this mean the "customers" will pay $3b less so instead of remaining in JP & IB pockets it will be elsehwere or will product choice be reduced ??

[deadhead]

so what if it costs them 3 billion?

the phucking insaniacs at the Fed will just give them 5 billion for some shit cdo's.

Thank you for the article, Tyler, it is important and appreciated.  I'm cranky because I'm just so tired of the incessant insanity, the lies, the fraud, the confidence game, etc exhibited by the fed, treasury, wall st, the banks, the politicians.

[SDRII]

Situation looks increasingly like Dinon will make his escape sooner rather than later. he obviosuly knows the game is up. The BS report states the obviosu abvout the artificial FICC revenue (wash) that occured over th past few quarters. They go on to talk about declining provisioning and massive reserves as firepower for the future? The assumption of course being that the stranded loss on the balance sheets has worked its way through (GS says 2/3 of the way, under courrent accoutning rules of course).

The second greatest myth behind trade barriers caused the great depression (Smoot/Free Trade jihadists) is that an increase in bank lending will solve this problem. next time some shill gets on TV and says this, perhaps chesty over at the ministry of CNBC can ask how exactly lending on overvalued assets or into a dearth of proiftable opporutnities solves anything.

[geopol]

deadhead,

Hang in there,

Behind every successful man is a woman, behind her is his wife.”

[Anonymous]

Please add this to your signature

http://instantrimshot.com

[geopol]

Perfecto..

[Anonymous]

My sentiments exactly. Tired, nay exhausted from the obvious leeching of productive society, accompanied by willful MSM lemmings who apologize for the status quo or worse yet wax nationalistic. My "most viable third party" voting is about all the energy I have left to extend to the cold war, that and preparations for when things heat up.

[Anonymous]

ah, do they plan to exempt the galactic sized shorts in gold and silver? i mean, they are completely underwater now, and ... come on, you know that the taxpayers are going to end up with the losses....

i think we should talk about this upfront, don't you all?

[JohnKing]

Placing reserve requirements on derivatives holdings sounds deadly for JPM and other TBTF, the current reserve requirement for failed derivative contracts is called "the fed window". I have a hard time seeing the day when these guys have to cover their own bets and doubt seriously that any oversight will be meaningful.

[Anonymous]

Team Tyler, I know what you are doing. Yesterday we had Marla encouraging us to be kinder and gentler with The Squid and today you march out your new whipping boy JPM!!?

How much did The Squid pay you?

[Anonymous]

a couple of questions: (1) which one is "chesty" at CNBC? (2) what do we think about the prospects for a major disruption in the functioning of the comex? a lot of scenarios are going around: a sudden 100% margin requirement; a run on the warehouses (apparently not shaping up in december); a default by the big shorts; deliveries of ETF shares rather than metal; and so on. up to now, comex seems to be hanging in there. thanks in advance.

[Anonymous]

I am probably the dumbest guy in the room... But has anyone ever asked why Goldman is still considered a commercial bank? If Goldman never loses and these new derivative regulations will ultimately hurt profitability for the investment bank then I wonder what new form of revenue stream will be created by Goldman, eh em Government, going forward being a commercial bank. Things that make you go hmmmm. I am thinking it will revolve around CRE and lending, maybe throw in a few government backed programs as well.

[Anonymous]

No. They'll make $3 billion from it.

How?

By reversing the negative sign.