JPMorgan CFO Expects Mortgage Production Loss, Higher Legal Expenses in Q3

NEW YORK ( TheStreet) -- JPMorgan Chase ( JPM) expects to make a loss in its mortgage origination business in the second half of 2013, CFO Marianne Lake said in a presentation to investors Monday.

The sharp increase in interest rates since May has resulted in a 60% reduction in refinancing applications relative to the peak.

Sticking to earlier guidance, Lake said the refinance market is likely to shrink by 30% to 40% in the second half of 2013.

While purchase volumes are growing -- Chase's share of the purchase market has increased from 7.2% in 2011 to 10.7% as of the first half of 2013 -- it is unlikely to make up for the revenue loss from the decline in refinancing activity, she said.

And although rising home prices are lifting more borrowers out of water and increasing the pool of borrowers eligible to refinance, that, too, is likely to take time.

Moreover, revenue margins are compressing, due to "competitive pressures, changes in mix and higher secondary market rates." And while banks are slashing mortgage jobs and reining in costs, expenses will adjust with a lag to the changing landscape.

As a result, pretax margins in the third and fourth quarter are likely to be "slightly negative."

Wells Fargo ( WFC) CFO Tim Sloan gave a similarly dim outlook for the business in a presentation Monday morning. Mortgage originations at the San Francisco-based bank are expected to come in at about $80 billion in the third quarter, down from $112 billion in the second quarter

Still, while the rate impact on the business has happened "sooner than expected," JPMorgan maintains its long term target of mortgage production pre-tax income at $1.5 billion.

Also, while the mortgage production business is clearly hurting from rising rates, the overall business is poised to benefit.

A normalized rate environment in the backdrop of an improving economy is "what we have been waiting for," the CFO said. Assuming a 200 basis point (100 basis points equals one percentage point) increase across the curve, the bank's net interest income could rise by $3.7 billion, by the bank's estimate.

And while a 200 basis point increase could cause unrealized losses in its bond portfolio to climb by $15 billion, which would affect its capital, it would also generate $17 billion in incremental income over the next three years, the CFO noted.

In short, the capital impact from rising rates is "very manageable" and the incremental earnings impact is "significant," said Lake.

Credit quality continues to improve significantly in the mortgages and credit card businesses. Issuing guidance for the third quarter, the executive said investors can expect the bank to release reserves totaling $1.2 billion in the mortgage business. The Cards business could see an additional $500 million reserve release in the second half of 2013.

But the gains from improving credit quality might be more than offset by an increase in litigation reserves.

The firm has seen a "crescendo of activity" in the last few weeks, with multiple regulatory agencies pursuing legal action against it.

Lake did not offer any fresh details. "We are reacting where it makes sense to do it and where it is in the interest of our shareholders. We are still finalizing the number."

The CFO said the bank intends to be appropriately reserved for all possible legal losses based on the information it has at this time.

The bank is making instituting controls its number one priority and has added 3,000 workers across control functions, according to the presentation.

Guidance for markets revenues was also weak, as a unusually strong September in the previous year, makes for tough comparison.

The bank expects its trading revenues to be flat or lower by 5% in the third quarter.

JPMorgan also set new targets for capital.

While it is on track to finish the year with a Basel III Tier I Common Ratio of 10% by the end of next year, nearly double the level it had when it entered the crisis, the bank plans to maintain an additional buffer of 50 basis points above the minimum capital and supplementary leverage ratio levels.

But, the bank is not giving up on its return targets despite the higher capital, the CFO said.

Overall, it was somewhat of a mixed outlook from the bank. While the long-term outlook was positive, it looks like the third quarter is going to be lackluster.

-- Written by Shanthi Bharatwaj New York.

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Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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