As I sit in the car, surrounded by thick NYC traffic, on my way to the highly anticipated CNBC interview (the Squawk on the Street show) on JP Morgan, banks, real estate and related issues, guess what I happen to drive by... MORE construction - causing me to ponder what additional damage  will be done to banks that backed these deals. Then, less than an hour later I read from CNBC and Bloomberg that JP Morgan's analysts predict that forced repurchases of soured U.S. mortgages may be the “biggest issue facing banks”. Bloomberg goes on to state:

Future losses from repurchases of home loans whose quality failed to meet sellers’ promises will likely total $55 billion to $120 billion, or potentially $10 billion to $25 billion for the next five years, the New York-based mortgage-bond analysts led by John Sim and Ed Reardon wrote in a Oct. 15 report.

I immediately blurt out, "Now hold the hell on a minuted!!!" That report of the 15th sounds an awful lot like the article I published on the 12th, “The Robo-Signing Mess Is Just the Tip of the Iceberg, Mortgage Putbacks Will Be the Harbinger of the Collapse of Big Banks that Will Dwarf 2008!” (Hey, no peeking, no copying, fellas!) which, among many other things, reiterated what I said in the 4th quarter of LAST YEAR!!!.

To be fair, the JP Morgan report is very similar to mine in content, scope and gist - JUST A YEAR OR SO TOO LATE! I quote (again) "Reggie Middleton on JP Morgan’s “Blowout” Q4-09 Results":

Note: I will be on CNBC's Squawk on the Street Monday Morning, Oct 18th to discuss my (probably controversial) opinions on banking, technology and real estate. It should be interesting for I believe I am a very "different" type of pundit. Be sure to tune in and write CNBC with your opinions and comments

This is my opinion and analysis of  JP Morgan's 3rd quarter 2010 operating results. I have included the hefty sidebar to the right to give my readers and subscribers historical perspective into the possibility of management being,,, ah,, well, optimistic at times when confronting investors and the public about what I see as potentially devastating macro and/or fundamental developments. I also included the sidebar to illustrate and remind all that just because certain big, brand name pundits, Wall Street banks and analysts may claim the coast is clear and all is just fine, it may not necessarily be the case - particularly when your favorite, most handsome and humble blogger claims otherwise. Please take careful note of the dates next to each entry and video. The time line aids significantly in giving the reader perspective. For those who are new to BoomBustBlog or are not familiar with me and my work, please visit Who is Reggie Middleton!!! before you move on.

As for those who may consider it blasphemous to mention the enshrined, the exalted JP Morgan and Bear Stearns or Lehman in the same sentence - I query "Who bought Bear Stearns?". Whatever Bear had, JPM now has - of course along with some very convenient government guarantees. But, then again...

Click any graphic below to expand... _{(there is a typo in the graphic below, it should read "t"rillion, not "b"billion)}

Excerpted from An Independent Look into JP Morgan (subscription content free preview!):

Cute graphic above, eh? There is plenty of this in the public preview. 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 35.4% 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???

Now, on to JP Morgan's 3rd quarter 2010 results...

In a Nutshell, JPM's quarterly results were downright horrible - as we expected and warned of in our previous quarterly analyses (see notes at bottom of page)...

JP Morgan’s Q3 net revenue declined 11% y/y (-5% q/q) to $24.8bn as investment banking revenue declined 18% y/y (-9% q/q) to $12.6bn from $13.9bn in the previous year and net interest income declined 2% y/y (-2% q/q, off of a combination of ZIRP victimization and a rapidly shrinking asset base and loan book) to $12.5bn versus $12.7bn in the previous year. Non-interest expense increased 7% y/y (-2% q/q) to $14.4bn as compensation expenses to net revenues remained broadly flat (28% vs 27.5%) while non-compensation expenses to net revenues jumped to 33% vs 23% in the corresponding period last year. As a result of "Fraudclosure" we expect this number to skyrocket next quarter. Overall, the efficiency ratio (total expenses-to-net revenues) increased to 60% vs 51% and we expect this ratio to spike next quarter as well as the banking business becomes even more expensive.

Click to enlarge...

However, despite a decline in net revenue and increase in non-interest expenses (both of which appear to be part of an obvious trend), profit before taxes was up 22% y/y as provisions for credit losses were slashed by 60%. JPM decreased its provision for credit losses despite no evidence of a substantial, sustainable improvement in credit metrics (please reference As Earnings Season is Here, I Reiterate My Warning That Big Banks Will Pay for Optimism Driven Reduction of Reserves). Provisions have lagged charge-offs for two consecutive quarters in a row.

As a result, banks allowances for loan losses have decreased to 4.9% in Q3 from 5.1% in Q2 and 4.7% in previous year.  Although under provisioning has helped the bank to mask its dearth in profits it has also materially undermined its ability to absorb losses if economic conditions worsen. The Eyles test, a measure of banks ability to absorb losses, has consequently worsened to 1.9% in Q3 from 3.7% in Q2 and 5.9% in Q3 09.

JPM also increased its mortgage repurchase reserves increased $1.0 billion pretax in anticipation of pressures from GSE’s for repurchase of troubled mortgages and made a provision of $1.3bn for litigation reserves. I explicitly outlined this risk this time last year (Reggie Middleton on JP Morgan’s “Blowout” Q4-09 Results) and reiterated it days before JPM’s earnings release (The Robo-Signing Mess Is Just the Tip of the Iceberg, Mortgage Putbacks Will Be the Harbinger of the Collapse of Big Banks that Will Dwarf 2008!) wherein I told BoomBustBlog readers to carefully follow the “warranties and representations” numbers, which is nearly guaranteed to spike – and spiked it has.

I would like to note that I don’t recall anyone making a big deal about this topic when it first reared its head last year, although the trend was quite obvious. Now, it is one of the biggest issues of discussion in the earnings call Q&A. Was it potentially my advice on watching the spike in the repurchase requests? I do hope somebody was paying attention!

If you haven't noticed, despite the fact JPM is pulling provisions to, IMO, pad accounting earnings ahead of what I feel to be a tsunami of macro and fundamental issues, they are at the same time going to the capital markets for a re-up, and willing to pay a premium to do so...

Here Comes The Scramble For Capital: JPM To Raise $4 Billion

BN  *JPMORGAN $1.25 BLN 30-YR DEBT MAY PAY 165 BASIS-POINT SPREAD
BN  *JPMORGAN $2.75 BLN 10-YR DEBT MAY PAY 180 BASIS-POINT SPREAD

I suggest readers brush up on reading between the lines... I will be factoring a lot of this into the updated valuation for JPM for my subscribers next week.

As quoted from “Reggie Middleton on JP Morgan’s “Blowout” Q4-09 Results” almost a year ago:

“Warranties of representation, and forced repurchase of loans

JP Morgan has increased its reserves with regards to repurchase of sold securities but the information surround these actions are very limited as the company does not separately report the repurchase reserves created to meet contingencies. However, the Company’s income from mortgage servicing was severely impacted by increase in repurchase reserves. Mortgage production revenue was negative $192 million against negative $70 million in 3Q09 and positive $62 million in 4Q08.”

Counterparties who are accruing losses from bad loans, (ex. monoline insurers such as Ambac and MBIA, see A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton circa November 2007,) are stepping up their aggression in pushing loans that appear to breach certain warranties or smack of fraud. I expect this activity to pick up significantly, and those banks that made significant use of brokers and third parties to place mortgages will be at material risk – much more so than the primarily direct writers. I’ll give you two guesses at which two banks are suspect. If you need a hint, take a look at who is increasing reserves for repurchases! JP Morgan and their not so profitable acquisition, WaMu!

Now, let’s fast forward to the Q3 2010 conference call:

On outlook, what we said is for 2010 I think our outlook was plus or minus $1.2 billion of expense. Obviously you'll take a look at our third quarter numbers are a little higher. And so we're likely to come in at the high end of that range. For 2011 what we've said is $1 billion of realized repurchase losses. And what we've done is we've taken, based on what we know, we've gone back and increased our reserves by $1 billion based on the higher file requests as well as higher settlement demands. And where we are today we believe we're adequately reserved based on what we know and we'll go back periodically and review that.

Reggie Middleton (not invited nor present at the conference call, but throwing his 22 cents (2 cents levered 11x) in anyway: But why are you raising these reserves "based on the higher file requests as well as higher settlement demands" now when it was obvious this was coming down the pike anyway? Hey, I called it in Q4 of last year, and I have much, much less access to info than you guys. It seriously looks as if you were more interested in padding the quarter than in preparing for this issue - although I could always be wrong. Is next quarter gonna be an "unexpected jump" in "higher file requests as well as higher settlement demands" as well or are you guys gonna come clean and realize that the insurers, investors and borrowers are officially lawyered up and comin' after 'ya? Again, if you haven't read it, peruse The Robo-Signing Mess Is Just the Tip of the Iceberg, Mortgage Putbacks Will Be the Harbinger of the Collapse of Big Banks that Will Dwarf 2008! in its entirety!

Oh well, back to the people who were invited, welcome, and present at the conference call...

Matt O’Connor – Deutsche Bank

I realize you guys don't want to talk in too much detail on the litigation reserve, but just conceptually, you've taken a little bit greater than $4 billion reserves for litigation so far this year and I guess a lot of us are just having a hard time understanding what it might be for and are you getting ahead of it or are still trying to catch up and -

Jamie Dimon

You know our society, right? You know how many lawsuits go on, and class action suits, and stock drop suits, and [unintelligible] suits and WaMu suits and Morgan suits and it ain't going away. It's becoming a cost of doing business.

…In repurchase reserves and litigation, it's unclear exactly how or where it's going to show up, but we do think there will be some of that. And when we make the statement that some of these costs may go on for a while it relates also to that. That while we're burning through the vintages or the GSEs there are other vintages where there may have been more of a time lag than that. And I think it's also important to note that they're fundamentally different, because a lot of the private label stuff didn't have the same rules, requirements, disclosures. So they're all different, but loan by loan it's going to have some of the same characteristics that people are right. You're going to have to make them [unintelligible]. Hopefully if they're going to sue just to win they're making a huge mistake.

Jim Mitchell

Right, but you're already contemplating some of those issues in your current reserving?

Jamie Dimon

To the extent we can, you know? Reserves are - you can't guess and put up numbers, but to the extent we can. I think the question is, between the reserves we have is how long losses relating to repurchase, whether it's GSE or private label, and whether it shows up on the litigation or repurchase, how long they go on for. We don't expect it to be a blowup kind of number. We expect it will be they'll just drag out these losses as these things play themselves out.

Nancy Bush - NAB Research

Two questions. The first related to the foreclosure issues, and whether there are going to be any extraordinary expenses associated with that. And is the level of expense in that whole activity now going to be higher going forward?

Jamie Dimon

I think I already mentioned that the way I look at it we're bearing $5 billion of charge-offs a year, $1 billion in repurchase reserves a year, a lot of re-owned foreclosure, which I forget off hand, but it's big numbers. Those numbers may bounce up and down and probably will go up a little bit because of this, but I'm not sure they're going to materially change because of this. And there will be litigation, I put to the side, I don't know how it's all going to be sorted out.

… I think the way you should look at this topic is that we're bearing today $7 billion of charge-offs, foreclosure, repurchase costs - this affects reserves. That $7 billion will go up or down based upon the economy and stuff like this. I'm not sure stuff like this is going to dramatically change that number. It may extend it a little bit longer and stuff like that but - and remember we have in total, between repurchase reserves and the $11 billion, we have $14 billion of reserves for repurchases or loan losses. And look, the mortgage thing is - we're halfway through all this. We think we should continue and get done and make sure we do the right things for the consumers, the investors, and the country. And so obviously it will increase our costs a little bit and maybe we'll have to pay penalties eventually to some of the AGs, but we really think we should just continue.

…And the big one is the $200 billion runoff of stuff, a lot of which was acquired from WaMu. That will be running off for years.

I will be releasing the balance of this review to subscribers, including an updated valuation, more on the (by now probably fully disintegrated) discount on the WaMu purchase and any other issues we uncover.

As a matter of fact, the quarter ended before the “robo signing” scandal really started making waves, thus the numbers reported are only the tip of the iceberg. We contend that the “robo-signing’ subject will actually open the door to a much more critical issue for the banks (refer to our upcoming Foreclosure Crisis subscriber research for details) as RMBS securities tied to residential mortgages will experience higher loss due to longer liquidation time lines, negative ratings and potential losses arising from the repurchase of loans from GSE’s due to mortgages not meeting the investor underwriting standards – or put more directly, fraud during the underwriting process will come to the forefront and cause many an investor to attempt to disgorge these loans and derivative loan products. With GSE’s already vying for more repurchases of troubled securities, the outrage caused from falsified documents would further escalate the repurchase demands.  When combined with the issues of foreclosures, weakening pricing, and legal issues with foreclosures which materially exacerbate the economic sales and pricing situation, combined with the deluge of repurchase demands, the banks will be facing one of the toughest periods of this century.

Let's not forget about CRE!

JP Morgan's (like many other banks) real estate related issues are woefully underestimated, yet JP Morgan can get away with under-provisioning without being punished by the markets. Hmmm!!! How long will that last?

Even visitors from Amsterdam, never having been here (area in the video below) before, can see there is something fundamentally wrong with the mortgage landscape (still) in many parts of the US. The clincher, "But how do all of these people [developers] get all of this money to put up all of these [empty] buildings? [as they are still building new buildings around the empty buildings that they cannot sell or rent!]"  I reply, "Those people over there! The banks!" As I point to the local JP Morgan Chase branch in downtown Brooklyn.

[youtube WsTdV86nAGw]

For all of you CRE bulls, that clip is the same area photo-toured more than one year ago - tell me if the situation has changed in accordance with the 100%+ spike in REIT and bank share prices - “Who are ya gonna believe, the pundits or your lying eyes?”. Download my free research on the topic - CRE 2010 Overview 2009-12-15 02:39:04 2.72 Mb. Tuesday, December 15th, 2009, then subscribe to get the juicy stuff.

The clip above is from the October 4, 2010 VPRO Backlight (Dutch public television) featuring the issues facing JP Morgan, as well as the European banking sector. This special was very well done and I look forward to the US public television stations doing similar investigative work. See the entire video (43 minutes) on the VPRO site (in Italian, Dutch and some English with Dutch Subtitles).

Teaser to our upcoming foreclosure research

More Reggie Middleton on JP Morgan

The full JPM Q2 review can be downloaded by subscribers (click here to subscribe) here: JPM 2Q10 review

Subscribers should also review our forensic valuation reports, which have (thus far) proven to be right on the money in terms of JP Morgan:

The JP Morgan Professional Level Forensic Report (subscription only)

The JP Morgan Retail Level Forensic Report (subscription only)

Those that don’t subscribe still have a lot of BoomBustBlog JPM opinion and analysis to chew on, including a free, condensed (but still about 15 pages) version of the forensic analysis above. You can find it below this pretty graphic from “An Unbiased Review of JP Morgan’s Q1 2010 Results Yields Less Roses Than the Maintream Media Presents“…

1. An Independent Look into JP Morgan (subscription content free preview!)
2. If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It?: Pt 2 – JP Morgan
3. Is JP Morgan Taking Realistic Marks On Its WaMu Portfolio Purchase? Doubtful!
4. Anecdotal observations from the JP Morgan Q2-09 conference call
5. Reggie Middleton on JP Morgan’s Q309 results
6. Reggie Middleton on JP Morgan’s “Blowout” Q4-09 Results