The full 3rd quarter forensic analysis and valuation update for JP Morgan is now available for all subscribers: JPM 3Q 2010 Forensic Update. The download is a much more detailed version of the (not so) quick overview I posted the day after earnings that reveals some very interesting points. All in all, the JPM quarter was quite bad, considerably worse than the media appears to be making it out to be. I have taken the liberty to include some of the highlights of interest in this blog post. While the hardcore actionable stuff is reserved for clients, I feel there are a few topics of discussion that demand public attention. I would like anybody who reads this to go to their local broker (or prime broker) and get a copy of their JP Morgan quarterly research opinion and update – regardless of the source(s). If the four issues that I have discussed in this blog post are NOT PRESENT in your (prime) broker’s report(s), I respectfully request that you do yourself a favor – subscribe to BoomBustBlog.com and download the report linked above, which includes valuation as well. I will be offering an extra download for professional and institutional subscribers interested in granular, detailed loan, charge-off and derivative holdings in the near future.
FACT ONE: First and Foremost, JP Morgan has been DESTROYING Shareholder Value for TWO Years Running, and I Don’t See It Getting Much Better Any Time Soon! That Two Years Is Exclusive Of The Devastating 2008 Market Crash!
Getting back to the issue of Wall Street’s sell side analysis, the biggest problem I have with them (outside of rampant conflicts of interest, which is probably not the fault of the individual analysts) is the abject reliance on accounting figures to measure and value an economic entity such as a business as an ongoing concern. Let’ be frank here, accountants, albeit probably quite smart, don’t necessarily make the world’s best investors. As a matter of fact, practically every accountant I know comes to me for my investment opinion and I make a horrible accountant. Try and try as I might, I can only think of one accountant that has ever excelled at investing over time (not to disparage accountants, of course, with all respect due). Granted, this man is probably a damn genius, and he knows how to identify quality when he sees it – having created Canada’s largest independent brokerage and independently its premier asset management firm with ~$6 billion under management – including the innovative physical gold trust. He has said, and I quote from Crain’s New York:
“His work is so detailed, so accurate, it’s among the best in the world,” says Eric Sprott, CEO of Sprott Asset Management, a Toronto firm that manages about $5 billion and subscribes to Mr. Middleton’s research.
Yeah, I know that was cheesy, but I couldn’t help myself . Back to the matter at hand, accountants have not been – and currently are not, trained in the economic realities of corporate valuation. They are trained to tabulate business operations data. There is a marked and distinct difference. That difference is as stark as night and day for investors, yet despite this stark difference, Wall Street still reports corporate performance metrics strictly in accounting terms, and the media (both mainstream and the more specialized financial media) simply follow suit. Hence we hear much about easily manipulable and manageable accounting earnings, revenues, operating margins, earnings per share, etc. These measures are highly flawed in a variety of ways, with the primary flaw being that they do not account for the efforts both required and undertaken to achieve them. Basically, they measure JUST HALF (and coincidentally, the positive half may I add) of the risk/reward equation that should be at the root of every investors move. Long story short, they do not account for, nor do they EVEN RESPECT, the cost of capital. This concept ties in closely with Chairman Bernanke’s current course of action as well as the ZIRP discussion later on this missive demonstrates (capital offered at zero cost causes reckless abandonment of risk management principles which eventually causes crashes – yes, more crashes). Acknowledgment of the cost of capital enforces a certain discipline on both corporate management and investors/traders. Without respect for such, it is much too easy to create and portray a scenario that is all too rosy, since we are only looking at rewards but never bother to glance at the risks taken to achieve said rewards. I reviewed this concept in detail as it relates to bonuses and compensation on Wall Street in The Solution to the Goldman (and by Extension, the Securities Industry) Compensation Dilemma.
Net revenues, net profits, and earnings per share are totally oblivious to what took to generate them. As a result, anyone who adheres solely to these metrics is probably oblivious as well to what it takes to generate these measures. It’s really simple, put more money into the machine to get more money out – damn the risks taken, or the cost of the monies used. This has been the bane of Wall Street for well over a decade, is the direct and sole reason for this current crisis, and is the reason why bonuses based upon revenue generation alone engender systemic risk. Just sell more, do more, to get a bigger bonus. It doesn’t matter what you sell or who you sell it to, as long as it blows up AFTER the bonus is paid. This short term-ism is now so deeply ingrained within the investor psyche as to allow companies’ to rampantly destroy economic shareholder value with the abject blessing of the shareholders, with cheer leading by the analysts – as long as those accounting earnings per share keep rolling in higher and higher!
Ignoring the cost of capital inflates returns by default, because those returns were never costed in the first place. The problem is, ignoring something does not make it go away. Capital does have a cost whether you acknowledge it or not, and if you ignore that cost you may skate for awhile but eventually it will come back to reassert itself, and often with a vengeance towards the wayward investor. On that note, here is JPM’s return on average equity – and here’s JPM’s return on average equity less the cost of said equity. It’s negative, very, very negative!!!
FACT TWO: ZIRP is Literally Starving JP Morgan
Even as the Fed tries to reduce the cost of debt capital to damn near zero, bad things are still happening to those this exercise was meant to save. Why??? Because the responsible world wants capital to have a cost, for if it does, it enforces discipline upon those who use it – whether they acknowledge that cost or not (here’s to you Wall Street).
In regards to JP Morgan and despite zero interest rate policy (ZIRP), fed funds as a proportion of interest bearing assets have increased due to lower risk appetite. The proportion of fed funds to interest bearing assets have increased to 12% as of end September 2010 from 7.7% as of end March 2009 while proportion of loans have declined to 35.8% from 38.9% in the corresponding period. Lower interest rates together with a higher proportion of lower interest bearing assets have taken a toll on banks spreads and net interest margin.
ZIRP, low demand, plus the slow investment banking environment is what forced a disgorging of reserves and provisions by management. In a catch 22, ZIRP is not so slowly starving the patient it was intended to save. This is analogous to the use of chemotherapy in treating cancer. The treatment needs to eradicate the disease in confined period of time or the patience is at risk at succumbing to the treatment, itself.
FACT THREE: The JP Morgan Foreclosure Pipeline is Not Only Packed Tight, It Is Progressively Getting Much Worse As The Time To Foreclosure Extends AND the Delinquency Rate Continues to Climb At The Same Time That Real Economic Housing Sales Value Is At An All Time Low As Well – and Getting Worse!!!
Future Losses Are Mounting at an Incredible Pace Yet JPM is reducing provisions due to improving credit metrics. See JP Morgan’s 3rd Quarter Earnigns Analysis and a Chronological Reminder of Just How Wrong Brand Name Banks, Analysts, CEOs & Pundits Can Be When They Say XYZ Bank Can Never Go Out of Business!!! and JP Morgan’s Analysts Agree with BoomBustBlog Research on the State of JPM (a Year Too Late) but Contradict CEO Jamie Dimon’s Conference Call Statements
JP Morgan’s average delinquency at foreclosure is 448 days (with Florida and New York having a record 678 days and 792 days of delinquency at foreclosure). Average delinquency for the industry is about 478 days and is increasing consistently since the start of the crisis. During 2009 the average days from delinquent to foreclosure process was 223 days while as of August 2010 average days from delinquent to foreclosure process is 478 days. A very important, yet often under appreciated fact is that although serious delinquencies are still climbing, the lengthening of foreclosure process has resulted in these loans still being classified as delinquent. The difference between delinquency rates and foreclosure rates has increased to 5.3% (9.8% delinquency rate vs 4.6% foreclosure rate) in August 2010 from 3.6% in March 2002 (5.1% delinquency rate vs 1.5% foreclosure rate). As the difference between delinquencies and foreclosure rates normalizes, and shadow inventory overhang moves to further depress real estate prices, real estate related write-downs could further balloon. So, you see, the marginal improvements in credit metrics that JP Morgan’s management has used to justify the releasing of provisions (which also just so happened to have padded a weak quarter of accounting earnings) is really kicking the can of reckoning down the road…
Add to this the difficulty in getting rid of the properties once they are foreclosed upon and you will find that the big banks such as JP Morgan (or after looking at these numbers, particularly JPM (although I suspect BAC and certain others are worse off) will become the nations largest distressed residential housing REITs!!!
FACT FOUR: JP Morgan’s Derivatives Portfolio Is STILL VASTLY Inferior To That of Bear Stearns AND Lehman Brothers Just Before They Collapsed!!!
The oft used chart below was created in the 4th quarter of last year.
Click graph to enlarge
Here is an update as of Q2 2010 regarding JPM’s net derivative exposure…
As you can see, the AAA holdings have been trending down significantly, replaced by materially lower rated assets.
Cute graphics above, eh? When considering the staggering level of derivatives employed by JPM, it is frightening to even consider the fact that the quality of JPM’s derivative exposure is even worse than Bear Stearns and Lehman‘s derivative portfolio just prior to their fall. Total net derivative exposure rated below BBB and below for JP Morgan currently stands at 36.9% while the same stood at 17.0% for Bear Stearns (February 2008) and 9.2% for Lehman (May 2008). We all know what happened to Bear Stearns and Lehman Brothers, don’t we??? I warned all about Bear Stearns (Is this the Breaking of the Bear?: On Sunday, 27 January 2008) and Lehman (“Is Lehman really a lemming in disguise?“: On February 20th, 2008) months before their collapse by taking a close, unbiased look at their balance sheet. Both of these companies were rated investment grade at the time, just like “you know who”. Now, I am not saying JPM is about to collapse, since it is one of the anointed ones chosen by the government and guaranteed not to fail – unlike Bear Stearns and Lehman Brothers, and it is (after all) investment grade rated – and we all know how prescient those rating have been. Then again, who would you put your faith in, the big ratings agencies or your favorite blogger? Hey, if it acts like a duck, walks like a duck, and quacks like a duck, is it a Swan??? I’ll leave the rest up for my readers to decide. On that note, for those that don't remember the sequence of events, here is refresher: A Chronological Reminder of Just How Wrong Brand Name Banks, Analysts, CEOs & Pundits Can Be When They Say XYZ Bank Can Never Go Out of Business!!!