JPMorgan Investment Bank Avoids Crisis, for Now (Update 2)

Story updated to include qoute from CEO Dimon and closing stock prices starting in fourth paragraph.

NEW YORK ( TheStreet) -- After doing its best to prepare the entire world for the worst quarterly revenue result at its investment bank since the depths of the financial crisis, JPMorgan Chase's ( JPM) investment banking unit did better than expected.

The unit earned $6.37 billion in revenue and $1.64 billion in profits during the third quarter. Its trading division drove investment banking results, posting revenue gains that countered estimates of a 30% fall tied to a trading and deal making environment that snowballed worse as the third quarter wore on.

Overall, JPMorgan reported Thursday that third quarter profit was $1.02 to a share on revenue of $24.4 billion, beating estimates of 91 cents a share and revenue of $23.40 according to Thomson Reuters.

The earnings beat; however was a result of a $1.9 billion debt valuation gain -earnings that are not related to the underlying operations of the investment bank. In its press release announcing earnings, JPMorgan said, "the DVA gain reflects an adjustment for the widening of the Firm's credit spreads which could reverse in future periods." According to a Barclays ( BCS) report, JPMorgan's CDS spreads nearly doubled from 83-to-162bps during the quarter.

Its investment bank would have posted the lowest net earnings and revenue result since the worst of the financial crisis without the debt-valuation adjustment. Of the investment bank earnings, JPMorgan CEO Jamie Dimon said in a press release, "The Investment Bank's revenue, excluding the DVA gain, was down substantially; however, we are gratified that the business maintained its #1 ranking in Global Investment Banking Fees." Dimon pessimistically added in a later analyst call that, "its not unreasonable to expect that the fourth quarter is going to look very similar to the third quarter."

Shares fell as much as 6% in early trading after earnings were announced and closed down nearly 5% at $31.60.

Net income from JPMorgan's investment banking operations dropped 20% to $1.64 billion from $2.05 billion in the second quarter of 2011. The result was better than the third quarter results a year ago, when the investment banking unit brought in a profit of $1.29 billion.

Revenue at the investment bank fell 13%, to $6.37 billion from $7.31 billion in the second quarter, beating company forecasts. It was also more than revenue of $5.35 billion this time a year ago. The beat came from an unexpected gain in its fixed income and equity trading businesses.

Expectations were for JPMorgan to earn $1 billion in investment banking fees and roughly $3.77 billion in trading revenue, making overall investment banking revenue forecasts of roughly $4.8 billion the weakest quarterly figure since the 2008 financial crisis when the bank reported an overall loss in the fourth. Without the debt valuation gain, JPMorgan's underlying investment bank revenue of $4.48 billion was slightly lower than pessimistic estimates.

DVA gains aside, which the company said "could reverse in future periods" the third-quarter results casts doubt on whether the investment bank will grow for the year compared with 2010. The results also show that while revenue contracts, earnings may stay strong. Nine months into the year, revenue is now on track to rise 10% and net income is set to rise 18% compared with last year -without the DVA gain, revenue would be close to flat for the year.

In a September Barclays Capital ( BCS) financial services conference, JPMorgan investment banking head Jes Staley said that the bank's trading business would fall 30% from the second quarter, when it registered a total of $5.39 billion in revenue, and that investment banking revenue would plummet roughly 50% to $1 billion.

The grim forecast proved to be overly pessimistic for now --and it was a reflection of a quarter when markets and deal volumes deteriorated as the possibility of a return to crisis grew with concerns over government indebtedness and the health of U.S. and European banks. In a research note after Staley's forecast, Barclays Capital analyst Jason Goldberg wrote, "we expect all major capital markets revenue categories to decline amid the U.S. debt-ceiling debate/credit downgrade, European financial concerns, falling global equity markets and heightened volatility."

In the third quarter, the S&P 500 index fell 14% and the MSCI World Index dropped 17%. Meanwhile, the VIX, a gauge of general risk aversion averaged 31 during the quarter, reflecting an almost doubling of fear from the second quarter's average level of 17. Currently the VIX is above 40, indicating that since the quarter ended, worries of a crisis haven't subsided entirely. The market's volatility has been even worse for banks. In the third quarter the KBW Bank Index ( BKX) fell over 25%.

JPMorgan's earnings also rebut analyst's forecasts that the investment bank would contribute the smallest share of revenue to the overall bank since the fourth quarter of 2008, a time when global capital markets were nearly frozen. According to median estimates compiled by Thomson Reuters analysts expected JPMorgan to earn $23.40 billion in revenue, making managements forecast of $4.77 billion in investment banking revenue, roughly 20% of overall forecasted revenue the smallest revenue contribution by the investment bank since it nearly pushed the overall bank to a loss in the 4th quarter of 2008.

For now, the DVA boosted earnings reverses a trend of falling investment banking revenue, which accounts for between a quarter and a third of JPMorgan Chase's overall revenue and has, in post-crisis quarters, supplied up to 75% of overall profits to the second largest bank in the U.S. For JPMorgan's investment bank, which has shown quarter-over-quarter declines in revenue in 6 of the last 8 quarters, today's earnings still jeopordize expectations earlier in the year that 2011 would be better than 2010. In the first two quarters of the year revenue increased 16% and net income increased 49%.

Falling revenue and an increase in profits were driven by expense savings, mainly pay. Compensation expense as a percentage of revenue fell to 29%, from 35% in the second quarter and 38% a year earlier --overall the investment bank paid employees $1.85 billion. In the quarter, it reduced headcount by about 1,100 employees, or 4% of total workers. Barclays Capital's Goldberg wrote in his note, "as revenues decline, we would expect a commensurate decrease in expenses." Expense reductions may continue to come via a shrinking staff. After earnings were announced Dimon said that while the bank does not have a formal layoff program, he expects the investment bank to reduce headcount by about 1,000 over the next 18 months.

Investment banking fee revenue fell 46% to $1.04 billion, after growing 23% and 37% in the first and second quarters respectively when compared with 2010. In the second quarter, the investment bank posted its best quarter since earning $2.24 billion in that period two years prior. According to Dealogic, global investment banking revenue was $13.5 billion in the third quarter, the lowest level since the first quarter of 2009 and down nearly 40% from second quarter levels of $21.4 billion. The third quarter results still showed that JPMorgan led all banks in investment banking fees, taking an 8.4% overall market share. Results showed that through the first 9 months of the year, it led all banks in fees earned from debt issuance and was second in equity capital market, M&A and Loan fees earned.

Total fixed income, currency, and commodity trading revenue fell to $3.33 billion below $4.28 billion earned in the prior quarter -but more than $3.12 billion this time last year. Meanwhile, equity trading increased to $1.42 billion from $1.22 billion in the second quarter and $1.14 billion at this point in 2010. Overall FICC trading revenue is up 6% and equity trading is up 11% 9 months into the year, when compared to 2010.

JPMorgan's shaky investment banking earnings numbers may be a harbinger of things to come as Morgan Stanley ( MS), Goldman Sachs ( GS), Citigroup ( C) and Bank of America ( BAC) all report earnings in coming weeks. For other investment banking divisions, falling revenue from operations may be erased by gains from widening credit spreads.

"Third-quarter 2011 has been a very difficult quarter for market making across the Street, particularly in FICC trading... We are currently forecasting the median bank's FICC revenues to decline 14% and equity trading revenues to increase 17% from 2Q11," wrote analysts at KBW ( KBW) in a September 26th note.

In a separate note written following JPMorgan's muted outlook for investment banking, Mike Mayo of CLSA wrote, "We think these lower activity levels will carry forward until the global economic and market outlooks improve."

If debt valuation gains based on widening bank credit spreads are readjusted to losses in coming quarters, management and analyst pessimism for investment banking revenue may actually be reflected in coming quarters.

-- Written by Antoine Gara in New York