JPMorgan Earnings Won't Be Business as Usual (Update 1)

Updated from 7:26 a.m. with latest estimates and share price information.

NEW YORK (TheStreet) -- JPMorgan Chase (JPM) will be the first Dow component and the first bank to report third-quarter results on Friday, formally kicking off earnings season.

As the nation's largest bank, it usually sets the bar for its competitors. Management views on the economy, housing and other concerns such as the government shutdown often move more shares than just JPMorgan.

This time around investors will be on heightened lookout for how the bank is handling its mounting legal tab as well as a raft of new regulations and enforcement actions.

According to consensus estimates polled by Thomsom Reuters as of Thursday afternoon, JPMorgan is expected to report a third-quarter earnings per share of $1.19 per share, down 25% from $1.60 per share in the previous quarter and down 15% from $1.40 per share reported a year earlier.

Total revenues are expected to come in at $23.94 billion, down from $25.21 billion in the second quarter and $25.14 billion a year earlier.

Shares of JPMorgan ended Thursday up 3.5% at $52.52.

But the big news would be the bank announcing an expected settlement with the Department of Justice and other regulators over the sale of faulty mortgage-backed securities in the run up to the crisis.

Press reports suggest the settlement could be as high as $11 billion, though at least $4 billion of that could be in the form of consumer relief.

While the tab is high, most analysts believe that such a settlement would broadly put to rest concerns about the bank's legal woes.

JPMorgan, which sailed through the financial crisis, has hit a rough patch in the past year or so, after a set of disastrous derivative trades in 2012 exposed a lapse in risk management and controls at the bank.

Since then the bank has been a target of a number of investigations and enforcement actions on a variety of charges that ranges from the London Whale, to claims of faulty mortgage-backed securities sold in the run-up to the crisis and charges of bribery relating to its hiring practices in Hong Kong.

The bank said in its second quarter 10-Q that the reasonably possible legal losses in excess of reserves it has already set aside could total $6.8 billion. <story_page_break>

In an investor presentation in September, CFO Marianne Lake said additions to legal reserves in the third quarter would likely more than offset loan loss reserve releases of approximately $1.5 billion.

Since then, the bank has already entered into a $920 million settlement with four regulators over its "London Whale" losses and into a $369 million settlement related to credit card practices.

It remains to be seen if the bank sets aside even more reserves for the expected settlement. The bank has not disclosed the actual amount set aside for legal reserves so far. Most analysts expect about $1.7 to $2 billion will be added to reserves, although Oppenheimer analyst Chris Kotowski estimates an addition as high as $5 billion.

A settlement would provide much certainty for investors. Despite the multiple legal charges facing the bank, a universal residential mortgage-backed securities (RMBS) settlement is still the "big nut" according to KBW analyst Chris Mutascio. "If you look at the major legal costs for banks since the crisis -- litigation, putback claims . . . it is all related to mortgages," he pointed out, in telephone interview. There could still be other lawsuits after the mortgage settlement related to bribery or manipulation of energy prices or derivatives, but they are not going to be anywhere near the size of the RMBS claims, he said.

With the bulk of the legal troubles behind the bank, investors could finally start refocusing on the fundamentals. When they do, argues Mutascio, they are likely to find an extremely attractively valued bank that is still capable of delivering return on equity in the low teens, despite having to build significantly more capital.

Plus, while shareholders have to endure large legal losses, Mutascio notes that the $7 billion reported cash settlement, when adjusted for reserves already set aside and for tax, could pose only a modest hit to tangible book value of about 2%.

Of course, if the bank fails to reach a settlement by Friday, then questions will abound during the analyst conference call about the bank's legal problems. But it is quite likely that the bank would avoid commenting on the issue given ongoing negotiations. So there are likely to be more questions than answers.

Still, investors would like to know what has changed within the bank given its recent troubles.

The bank has said it is making compliance its number one priority and plans to spend $4 billion and hire 5,000 employees to fix its compliance problems. <story_page_break>

JPMorgan is also exiting businesses it views as unprofitable in a new regulatory environment such as student lending and the physical commodities business. The bank is also evaluating its relationships with commercial lending clients such as pawn shops, payday lenders, check cashers and car dealerships, relationships that could expose the bank to more reputational damage and legal liability.

Shareholders have so far shrugged off JPMorgan's legal problems. Shares are still up 19% year-to-date, underperforming its peers Wells Fargo (WFC) and Bank of America (BAC) by a slight margin.

That's testimony to the health of JPMorgan, which still remains among the best capitalized banks. "No one believes that JPMorgan is insolvent or cannot afford its legal bills," says Mutascio.

But Rafferty Capital Markets analyst Richard Bove worries that JPMorgan's troubles are more long lasting.

"The predominant view is that once the bank makes a large settlement with the government all business activity returns to normal and the bank earns at least $20 billion net," Bove wrote in a recent report. "While I have not adjusted my earnings estimates as yet, I do not share this view. I believe that the short-term and secular earnings of the company have been negatively impacted by the changes being forced upon the company."

There are also concerns about Dimon's future role in the company, as critics call for his exit. Supporters worry that the chairman and CEO might leave the company, tired from the constant attacks.

"It would be a bit of a shame," said Mutascio. "Maybe Dimon wasn't as great as people thought he was, but he is not as bad as people make him out to be today."

He believes the chances of Dimon leaving are low.

Outside of the legal problems, the results have been pretty well telegraphed and the market should expect few surprises.

But the results are likely to be disappointing, with almost every avenue for growth suffering. Based on management guidance and analyst estimates, loan growth is likely to have been tepid, margins probably flat to lower, fixed income trading is expected to be sharply lower and the mortgage business is expected to post a loss.

So ironically the announcement of a multi-billion dollar legal settlement might actually be good news and give investors something else to focus on.

-- Written by Shanthi Bharatwaj in 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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