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JPM Beats but Credit Is Red Flag (Update 3)

During the third quarter, the company released $967 million in reserves. A year earlier, JPMorgan released only $170 million in reserves.

The smaller reserve release coincided with a sharp increase in nonperforming loans. Nonaccrual loans - loans for which the company no longer books interest, for it does not expect to recover principal balances - grew to 1.57% of total loans as of Sept. 30, increasing from 1.38% the previous quarter, although they were down slightly from 1.58% a year earlier.

Wholesale credit quality continued to improve, but within JPMorgan Chase's consumer portfolio, nonaccrual loans made up 3.21% of total loans as of Sept. 30, increasing from 2.69% in June, and 2.52% in September 2011.

The company's total nonperforming assets increased by $1.1 billion, or 10%, during the third quarter, to $12.48 billion, as of Sept. 30. A year earlier, the company had $12.47 billion in nonperforming assets.

Third-quarter net charge-offs -- loan losses less recoveries -- totaled $2.8 billion, or an annualized 1.53% of average retained loans. The net charge-off ratio increased from 1.27% the previous quarter, and 1.44% a year earlier, however, reserve coverage was very much "ahead of the pace" of charge-offs, covering 2.61% of total loans as of Sept. 30.

During JPMorgan's conference call with analysts, CFO Douglas Braunstein explained that regulatory guidance required that loans whose borrowers had gone through Chapter 7 bankruptcy and were in early stages of delinquency, with payments less than 60 days late, "be written down to collateral value," resulting in $825 million in third-quarter charge-offs. Braunstein went on to say that"97% of those loans are current, 85% actually paying principal," and "if these loans perform the way we expect them to, we would expect to recover a significant amount of the charge-offs over time."

The CFO said that the regulatory guidance "impacted our nonaccrual loan balances." Excluding the effect of the regulatory guidance, and also excluding "performing junior liens that are subordinate to nonaccrual senior liens," total nonaccrual loans were $5.1 billion as of Sept. 30, declining slightly from the previous quarter.

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