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.