JPMorgan Creates Illusion Of Profits

While reports of profits by JPMorgan Chase may have boosted the mood on Wall Street, the so called "profits" are merely an illusion created by an accounting loophole and does not mark the beginning of a banking recovery. To find out how the mega bank was able to conceal their massive losses with accounting slight of hand, see the following article from Money Morning.

It takes more than two to make a trend.

JPMorgan Chase & Co. (NYSE: JPM) yesterday (Thursday) became the second major U.S. investment bank – following Goldman Sachs Group Inc. (NYSE: GS) – to this week report windfall profits for the second-quarter. That’s helped fuel a four-day advance in U.S. stocks that’s seen the Dow Jones Industrial Average surge 7%.

Unfortunately, these two decidedly positive developments don’t necessarily indicate that better days have arrived for the U.S. banking sector.

To the contrary, many analysts – including Money Morning Investment Director Keith Fitz-Gerald – say these profits are merely a mirage created by an obscure accounting rule that allows banks to transform “toxic debt” on their balance sheets into income.

JPMorgan, the second-largest U.S. bank, said that that second-quarter profits were $2.7 billion, a jump of 36% from a year ago and 27% from the previous quarter.

A $1.1 billion, one-time reduction that resulted from the decision to repay $25 billion in Troubled Asset Relief Program (TARP) funds was offset by strong gains at the firm’s investment banking division.

Profit at JPMorgan’s investment banking division more than tripled as a result of record investment-banking fees and the strong performance in the fixed-income market. The investment-banking operations generated $1.47 billion of profit, almost quadruple the amount earned in last year’s second quarter.

Investment-banking fees – which zoomed 29% from a year ago and 62% from the first quarter – totaled $2.2 billion, and were a "record for any investment bank in any quarter," according to JPMorgan Chief Financial Officer Michael J. Cavanagh.

JPMorgan’s earnings in the first half of 2009 grew 11% to $4.86 billion, or 68 cents a share, from $4.38 billion, or $1.20 a share, in the first six months of 2008. Revenue jumped 43%, reaching $50.6 billion, from $35.3 billion last year.

JPMorgan’s announcement follows an equally impressive earnings report by rival Goldman Sachs, the largest investment bank in the country. Goldman said Tuesday that its revenue in the three months ended June 26 was $13.8 billion, compared with $9.43 billion in the first quarter and $9.42 billion in the second quarter a year earlier. Net income rose to $3.44 billion, or $4.93 a share.

Still, despite these banks’ stellar results, analysts are hesitant to say that the U.S. financial sector has bottomed, meaning that a rebound is under way.

Fitz-Gerald said last month that large investment banks like Goldman Sachs and JPMorgan would almost certainly generate record profits in the first half of the year as a result of less competition, favorable interest rates, and relaxed accounting standards.

Indeed, the Financial Accounting Standards Board has made it possible for the biggest U.S. banks to book profits on loans that have not been fully repaid.

“Called ‘accretable yield,’ these mega banks will book income on loans that have ‘reduced credit quality’ by recognizing the value of the bonds on their balance sheets and the cash flow those securities are expected to earn,” Fitz-Gerald said. “Please understand, we’re not talking about cash that’s already been earned, and not cash in the bank … we’re talking about cash flow those banks are expected to earn.”

In JPMorgan’s case, the firm took on $118.2 billion in toxic debt when it acquired Washington Mutual Inc. last year. As a receiver of that debt, JPMorgan was allowed to mark that debt down to “fair value,” or $88.65 billion. But now, the bank says that those same debts may appreciate by some $29.1 billion over the life of the loans. And as those loans are paid back, that money is booked as profit.

Of course, this distorts banks’ earnings and camouflages the deterioration in other banking segments.

For instance, consumer-loan losses continued to rise, as did losses on businesses loans. Retail banking earnings of $15 million were down sharply from earnings of $474 million in the first quarter, and $503 million in the second quarter of 2008. The consumer lending division reported a net loss of $955 million, compared with a net loss of $171 million in the prior year and $389 million in the prior quarter.

Home equity charge-offs jumped 4.61% to $1.3 billion. The bank warned that prime mortgage losses may be $600 million “over the next several quarters,” and that subprime losses may be $500 million.

Credit cards lost $672 million, compared to income of $250 million in the second-quarter last year. The bank warned that losses in its Chase credit-card portfolio may be 10% next quarter and will be “highly dependent” on unemployment after that. The unemployment rate rose to 9.5% in June, its highest level in two decades.

The managed charge-off rate, which generally tracks unemployment, climbed to 10.03% from 7.72% in the first quarter and 4.98% in the year-earlier period.

“For JPMorgan Chase, the challenge going forward is going to continue to be deterioration of credit,” Gerard Cassidy, a banking analyst at RBC Capital Markets, said in a Bloomberg Radio interview.

This article has been republished from Money Morning.

What We Should Make Of Goldman Sachs Record Quarter

Despite a $3.4 billion profit by Goldman Sachs in the second quarter, analysts are warning that Goldman's results are not representative of the larger market. But how could Goldman make a record profit if the banking sector is as bad as it is claimed? The following post from Money Morning examines this question.

Goldman Sachs Group Inc. (NYSE: GS) said yesterday (Tuesday) that it posted record earnings in the second quarter, but that’s not necessarily an indication that better days have arrived for the U.S. banking sector.

Goldman’s revenue in the three months ended June 26 was $13.8 billion, compared with $9.43 billion in the first quarter and $9.42 billion in the second quarter a year earlier. Net income rose to $3.44 billion, or $4.93 a share.

But analysts say investors should consider those results to be uniquely Goldman’s and not indicative of what we’ll be seeing from the greater financial sector. Traders said Goldman made several key moves during the quarter. The bank:

• Played the whipsaw volatility in the global credit markets by trading bonds to generate part of its quarterly fortune.

• Properly played a similar pattern in U.S. stocks this year, profiting as an early-year plunge reversed course and turned into one of the most-powerful short-term.

• Capitalized on such commodities as oil, while also trading volatile currencies.

• And made the most of its position as one of the few remaining heavyweight-investment-banking firms willing and able to service the deal-making market. It reaped lucrative fees from the high-margin business of underwriting stock offerings, which have surged anew this year as other more-troubled financial institutions raced to raise capital.

“What’s so intriguing about Goldman Sachs is that there are all these levers there,” says David Wintergreen of the Wintergreen Fund, which owns Goldman shares told BusinessWeek. “There are so many ways this company can win.”

A look at a common risk-taking measure - so-called “value at risk,” or VAR - shows that while other investment banks were playing it conservative, Goldman was clearly game to take risks. VAR, an estimate of what an institution could lose in a single day, zoomed by more than 20% in the first quarter and jumped 33% during the second quarter, hitting another record high.

Fixed-income trading remained strong, with second-quarter revenue rising to $6.8 billion from $6.6 billion for the first three months of the year. It was up 186% from the second quarter of 2008.

The bank also saw a massive bump in equity trading where revenue jumped 110% over the past quarter, to $2.2 billion.

However, there is a question about whether or not these profit-making opportunities will disappear in the year’s second half - which looks much more challenging. Part of that challenge will be for the company to deal with the heightened group of regulations it is now subject to after having converted from an investment bank to the more-heavily regulated bank-holding company.
This post was republished from Money Morning.

Who Should Be Blamed For Big Bonuses

Many Americans are outraged right now of the report that Goldman Sachs is planning to pay out record bonuses. Although Goldman Sachs denies the report, many are asking how this could possibly happen. Martin Hutchinson from Money Morning explains who deserves the blame.

It’s been in the news the last couple of days. Goldman Sachs Group Inc. (NYSE: GS) bankers are headed for record bonuses. The Financial Times reports that bankers’ pay in the London market is already right back to 2007 levels and going higher. Banks are poaching each others’ best staff, and are offering huge pay packages to staffers willing to make the leap.

It’s enough to make you succumb to the Two Minutes’ Hate.

But let’s face the truth. As egregious as salary escalation seems - coming as it does on the tail of the worst U.S. banking crisis since the Great Depression - the reality is that this is the U.S. government’s fault. After all, it was the U.S. Federal Reserve and the Obama administration that created all the bailouts and the special-loan-subsidy schemes for banks that would otherwise have been on their last legs.

In a truly free market, ex-Citibankers (NYSE: C) would be on every street corner of Manhattan - selling apples - and that would properly hold down the pay of those bankers still lucky enough to have a job.

The sudden rebound in demand for bankers is a symptom of overall market conditions right now. The U.S. stock market is way up from its lows, there are three Chinese initial public offerings (IPOs) due to come to market this week (one of them for a company with no earnings), the volume of home mortgage refinancing has been running at record levels, the FHA index of home prices has dropped only 0.3% this year and the volume of new corporate debt issuance is also high. Commodity prices are well off their lows, and oil prices are again close to $70 a barrel, which would have been considered an excessively high level only three years ago. That’s not a picture of a financial market - or a global economy - in deep recession.

Far from it.

To some extent, this is good news. A revival of the financial system and its ability to finance businesses and home purchases is exactly what the huge monetary and fiscal stimulus was meant to produce. A modest revival in world trade, as inventories cease being wound down and Chinese production ramps up again, is also a necessary precondition for economic recovery.

As the banking bonus news suggests, however, much of the activity is coming in some pretty funny places, where the excesses of the past decade were concentrated and where you wouldn’t expect to see such a quick revival.

That gives us a clear indication of just what the problem is. Because bankruptcies weren’t allowed to happen back in September and October - as they would have in a free market - there are more institutions in the market than there should be, Citigroup and Merrill Lynch most notable among them.

Moreover, in a true free market, the entire credit-default-swap (CDS) business - a product that caused $180 billion of losses to the financial system through American International Group Inc. (NYSE: AIG) - would be nothing but a smoking ruin. But in the market we are living in, those $180 billion worth of losses have been transferred to the tab of the taxpayers of America.

With Citigroup and Merrill Lynch bankers mooching around on street corners, financial sector salaries would be forced down to a more reasonable level. As it is, the few unemployed unfortunates who worked at Lehman Brothers are not enough to depress the market. Likewise, credit default swaps have caused huge pain to the unfortunate employees of Abitibi-Bowater Inc. (NYSE: ABH), General Growth Properties (OTC: GGWPQ), and Six Flags Inc. (OTC: SIXFQ), each of which went bust partly because their creditors were playing in the CDS market and had no incentive to find an alternative to bankruptcy. Had CDS caused the pain they should have to financiers, the product would no longer exist, to the considerable benefit of the rest of us.

Inevitably, we are going to have to pay the price for all the bailouts. The financial sector will eventually shrink to its proper size, as will its members’ earnings. CDS will eventually be sharply restricted, to prevent their holders from forcing random companies into Chapter 11. Interest rates will have to rise, to accommodate the huge debt-funding needs the government has incurred. Money will have to be kept tight, to pay for the indulgences that Fed Chairman Ben S. Bernanke granted during the bubble, as well as for the even greater-indulgences of the bust.

Which is probably why you don’t want to hold U.S. stocks right now.

This article was reposted from Money Morning. You can also view this article at Money Morning's investment news site.