Note to readers: a formatting issue caused the 2nd half of this article to get cut off. I urge interested parties to reread the article to get the full message.
Since I write for a diverse audience, I will start this off with an overview of securitization. If you are in the industry or are just a smart ass dude, feel free to skip down to the JP Morgan specific section below. I also have a 30 part series on this Asset Securitization Crisis for those who are interested in my take on this from the beginning. It is a lot of reading, but it tells it like it is.
Securitization is still a very significant source of leverage and opacity in the US and European economies, in spite of its predominant role in the most recent global financial turbulence. It is a practice where loans and other debt instruments are aggregated in a pool and thereby used to issue new securities. Banks and financial institutions started establishing Special Purpose Vehicles (SPV) and Qualifying Special Purpose Entity (QSPE) under the FASB rules to securitized loans and thereby reducing, from an accounting perspective (but more accurately put), or transferring from an economic perspective, financial risks on their balance sheets. Although these new founded QSPE's were rated by rating agencies (Moody's, Fitch, S&P among the few) prior to the issuance of securities, the underlying ratings failed to capture the actual economic value of the underlying collateral. Furthermore, the ratings established by the rating agencies are an assurance of performance.
According to analysis conducted by Ann Rutledge of RR Consulting, subordinate tranches have performed more predictably than senior tranches since subordinate tranches had already built in high default rates and prepayment assumptions. The mezzanine tranches during downturn tends to be relatively stable. Quoting Ms. Rutledge, "Paradoxically, because the underlying collateral experienced such high rates of default and prepayments early on, the risky tranches now tend to be very stable because they were only really ever worth 20 cents on the dollar when the deals went out!". Further, since most of the deals are not done on DCF analysis on the underlying collateral, they were heavily mispriced at inception. According to Ann Rutledge if a risk is analyzed correctly, most ABS deals will converge to "AAA" rating regardless of the initial rating of the security. For instance, securitization from Countrywide did not converged to AAA suggesting that the deal was heavily mispriced at inception. For those interested in hearing more about what Ms. Rutlege had to say, see "If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It?" and scroll down to the second half.
JP Morgan securitization activities and QSPE exposure
JPMorgan securitizes and sells a variety of loans, including residential mortgage, credit card, automobile, student, and commercial loans through Special-Purpose Entities (SPEs) as a part of the securitization process. These SPEs are structured to meet the definition of a Qualifying Special-Purpose Entity (QSPE) and accordingly, the assets and liabilities of securitization-related QSPEs are not reflected on the Company's consolidated balance sheets.
As of June 30, 2009 total assets held by these QSPEs stood at $574.4 bn while assets held by QSPEs with continuing involvement stood at $424.0 bn. Of the total assets held by QSPEs, prime mortgages, commercial mortgages and credit card receivables formed majority of investment portfolio with total assets of $211 bn, $160 bn and $102 bn, respectively.
As of June 30, 2009 total interest held by JPM in these securitized assets stood at $37.4 bn, or 39.5% of tangible equity with credit card leading the pack with an 89% contribution. The table below details QSPE's exposure for JPM as of June 30, 2009.
JPM provides servicing for mortgages and certain commercial lending products on both a recourse and nonrecourse basis. In nonrecourse servicing, the principal credit risk to the company is the cost of temporary servicing advances of funds while in case of recourse servicing, the servicer agrees to share the credit risk.
Although JPMs loan sale transactions have primarily been executed on a nonrecourse basis, the company still has a substantial credit risk from recourse transactions as well. As of December 31, 2008 the unpaid principal balance of loans sold with recourse was at $15.0 bn, or 15.8% of tangible equity compared with only $557 mn as of December 31, 2007. You have read that correctly, a 270% increase in full recourse risk in a year and a half. The increase in loans sold with recourse basis was driven by none other than the Washington Mutual acquisition ((i,e) substantial portion of loans acquired from WaMu were principally on recourse loans). If you recall from the previous forensic reports:
- JPM Public Excerpt of Forensic Analysis (free)
You will realize that JPM's loan portfolio is performing horribly, and although they purchased the WaMu portfolio at a very deep discount after restructuring, they are still under water and the deflationary phase of the underlying is only 50% or so along its cycle. This is surely a widely unrecognized problem for JPM!
Credit card securitizations
At the time of the acquisition of the Washington Mutual banking operations, the assets of the WMM Trust were comprised of Washington Mutual subprime credit card receivables which had a much lower quality of assets relative to that of JP Morgan's. In order to closely conform WMM Trust's quality to the overall quality of a typical JPM credit card securitization master trust, during 4Q08 JPM randomly removed $6.2 bn of credit card loans from the WMM Trust and replaced them with $5.8 bn of higher-quality receivables from the JPM's portfolio.
However, during 2009 the credit quality of the WaMu portfolio deteriorated so sharply that it could have led to an early amortization event unless additional actions were taken. On May 19, 2009, JPM removed all remaining credit card receivables originated by Washington Mutual. Following this removal, the WMM Trust collateral was entirely comprised of receivables originated by JPMorgan Chase. As a result of the actions taken by the company, the assets and liabilities of the WMM Trust were consolidated on the balance sheet of JPMorgan. Consequently, during the 2Q09 JPM had recorded additional assets with an initial fair value of $6.0 bn, additional liabilities with an initial fair value of $6.1 bn, and a pre-tax loss of approximately $64 mn. This was the VIE consolidation referenced in the forensic research reports linked above.
During 2Q09 JPM securitized $12.5 bn of credit card receivables. The expected loss rate built into these credit card receivables is at 8.7%. The Company's assumption regarding expected loss rate build seems highly optimistic, rosy and reminiscent of that of a Goldilocks fairy tale considering the current charge-off rate for JPM's credit card loan portfolio stands at 12.5%.
Of the $23.2 billion securitized interests held by JPM, 25% is classified as noninvestment grade. Interest in noninvestment grade securities form 6.0% of tangible equity while interest in investment grade securities form 18.5% of tangible equity.
Next up is Bank of America...