JPM Beats but Credit Is Red Flag (Update 3)

  • JPMorgan Chase reports third-quarter EPS of $1.40, soundly beating the consensus estimate of $1.24.
  • Net revenue also beats, at $25.1 billion.
  • Significant decline in credit quality, as nonperforming assets grow by 10%
  • CIO "effectively closed out the index credit derivative positions."

Updated with detailed information on JPMorgan's net interest margin, credit quality information, including comments from CFO Douglas Braunstein, CIO Update, and conference call comments from CEO James Dimon. Also updated to include comments from Stifel Nicolaus analyst Christopher Mutascio, and from KBW, tying JPM's strong mortgage results to expectations for Bank of America.

NEW YORK ( TheStreet) -- JPMorgan Chase ( JPM) on Friday announced a very strong third-quarter bottom line, but also a significant increase in problem loans.

The company reported third-quarter earnings of $5.7 billion, or $1.40 a share, beating the consensus estimate of $1.24, among analysts polled by Thomson Reuters.

In comparison, JPMorgan earned $5.0 billion, or $1.21 a share, during the second quarter, despite booking a $4.4 billion trading loss, from the hedging activity of the company's Chief Investment Office (CIO). During the third quarter of 2011, the company earned $4.3 billion, or $1.02 a share.

Third-quarter revenue totaled $25.1 billion, beating the consensus estimate of $24.5 billion, and increasing from $22.9 billion the previous quarter, and $24.4 billion a year earlier.

The company reported a third-quarter return on assets (ROA) of 1.01%, improving from 0.88% in the second quarter, and 0.76% during the third quarter of 2011. JPMorgan's third-quarter return on tangible common equity (ROTCE) was 16%, increasing from 15% the previous quarter, and 13% a year earlier.

The company estimated a Basel III Tier 1 common equity ratio of 8.4% as of Sept. 30, increasing from 7.9% the previous quarter.

The company said that "during the third quarter, the CIO effectively closed out the index credit derivative positions that were retained following the transfer of the synthetic credit portfolio to the IB on July 2, 2012." The CIO results included $449 million of losses on this portfolio reflecting credit spread tightening during the quarter," and "net revenue also included securities gains of $459 million from sales of available-for-sale investment securities." Net interest income within CIO "was negative, reflecting the impact of lower portfolio yields and higher deposit balances across the Firm."

When asked about the CIO losses during a conference call with reporters, Dimon said "synthetic credit is a sideshow."

One of the reasons JPMorgan Chase had such a good bottom line during the second quarter was that the company released $2.1 billion in loan loss reserves. A reserve release takes place when a bank's provision for loan loss reserves -- the amount set aside each quarter to cover expected loan losses -- is less than the amount of problem loan balances charged off. Most large banks have seen a significant earnings boost over the past two years through reserve releases, as the economy and credit quality have improved, but analysts expect this trend to subside.

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.

Dimon said that "the Firm reported strong performance across all our businesses in the third quarter of 2012. Revenue for the quarter was $25.9 billion, up 6% compared with the prior year, or 16% before the impact of debit valuation adjustments."

Dimon added that "business Banking loan balances grew for the eighth consecutive quarter to a record $19 billion, up 8% compared with the prior year," while "Mortgage Banking originations were $47 billion, up 29% compared with the prior year," credit card sales volume increased by 11% year-over-year, and "Commercial Banking reported record revenue and grew loan balances for the ninth consecutive quarter to a record $124 billion, up 15% compared with the prior year."

When discussing credit trends, the CEO said that " housing has turned the corner."

Following Dimon's announcement in May of the hedge trading losses, JPMorgan suspended its share buyback program. The company later applied for Federal Reserve permission to resume its buybacks, even before the regulator conducts its next round of stress tests next year. Dimon said in September that JPM hoped buybacks would "start sometime in the first quarter."

During the media call on Friday morning, Dimon said that if the company were to resume share buybacks during the first quarter it would be "immaterial," because the buybacks would only total $3 billion.

JPMorgan reported third-quarter net interest income of $10.976 billion declining from $11.146 billion the previous quarter and $11.817 billion a year earlier, as the company's core net yield on interest-earning assets narrowed to 2.92% during the third quarter, from 3.00% during the second quarter, and 3.14% during the third quarter of 2011.

The margin decline was in-line with expectations for most -- but not all -- large banks in the prolonged low-rate environment, with the Federal Reserve's target short-term rate in a range of zero to 0.25% since late 2008, while the central bank recently expanded its purchasing of long-term mortgage-backed securities, in an effort to push long-term rates even lower, or at least keep them at their historically low levels.

JPMorgan Chase reported that the average rate for its securities investments during the third quarter was 2.11%, declining from 2.42% the previous quarter, and 2.66% a year earlier.

JPMorgan Chase's shares closed at $42.10 Thursday, returning 30% year-to-date, following a 20% decline during 2011. Based on a quarterly payout of 30 cents, the shares have a dividend yield of 2.85%.

The shares trade for eight times the consensus 2013 EPS estimate of $5.23.

Stifel Nicolaus analyst Christopher Mutascio -- who rates JPMorgan a "Hold," said that "if we back out sizable gains from the redemption of trust preferred securities ($88 million pre-tax), investment securities gains ($458 million), DVA losses ($211 million) and a one-time hit to the loan loss provision expense ($825 million) attributable to regulatory guidance on certain residential real estate loan portfolios, we put core operating EPS closer to $1.34," which would still be a convincing beat of the consensus estimate.

Mutascio's third-quarter operating estimate for JPMorgan was $1.38, which "did not incorporate the DVA loss, the trust preferred redemption gains or the higher loan loss provisioning due to regulatory guidance." Excluding "the securities gains embedded in our estimate, our core EPS estimate would have been $1.15," he said," which would be "a better apples-to-apples comparison to the core EPS of $1.34 the company reported in 3Q12," making the operating earnings beat even more solid.

The analyst said that the earnings beat mainly reflected "mortgage banking revenues came in $450 million higher than we anticipated due to strong origination volume ($0.08 per share)," investment banking fees at $260 million higher than his estimate, for five cents a share, and "a slightly lower tax rate than we expected ($0.03 per share)."

In its "Read-Across for Financial Sub-sectors," KBW said that based on JPMorgan's "strong quarter of mortgage originations (up 8% QoQ) of $47.3B, while retail channel originations declined 2%" sequentially, "we expect the upside potential to BAC's mortgage numbers to be on the small side at $100-$200M, given that JPM's positive results in 2Q12 did not seem to translate into significant upside to BAC's quarterly results, which we believe is representative of BAC's recent market share declines."

KBW analyst David Konrad rates JPMorgan "Outperform," with a $49 price target, while KBW analyst Jefferson Harralson rates Bank of America "Market Perform," with a $10 price target.

Commenting about mortgage repurchase demands, KBW said that JPMorgan's mortgage putback "reserve was up from 2Q's $36M number, and while still well below trends of the previous year, it does seem to somewhat contrast last quarter's statement that it was substantially compete with reserving. This increase gives us slight pause as we extrapolate to BAC's likely reserve but we feel that it is more likely that we see BAC's rep and warranty reserve come in below our $400M estimate in the quarter given JPM's low overall reserve level."

JPM Chart JPM data by YCharts

-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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