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.

Watchout: The Bankers May Be Let Loose

With several banks getting permission to buy their way out of the TARP program, will it mean these institutions will be back to their old ways of doing business? Will the executives at JP Morgan and Goldman Sachs have too much power now that there is less competition? Tim Iacono from The Mess That Greenspan Made discusses why the executives at these banks are looking forward to the day when they can get out of "time out" and be free to spend half a million on a "company retreat" without everyone finding out and questioning their ethics.

Jonathan Weil at Bloomberg examines the implications of "life as we knew it" being restored to at least some portions of Wall Street and comes away wanting.

Lock up the booze, and hide your wallet. America’s most powerful, too-big-to-fail banks are turning in their TARP money. And you know what that means: It’s party time again on Wall Street.

Ten U.S. banks gained permission this week to buy back $68 billion of shares they issued to the government under the Troubled Asset Relief Program. And thank goodness for that. For eight months, they endured the twin nuisances of mass hysteria and populist scorn for blowing taxpayer money on employee bonuses and junkets. Now they can tell the rest of the country to kiss off. There’s nothing Barney Frank can do about it.

Finally, the richest bankers and traders at Goldman Sachs, Morgan Stanley and JPMorgan Chase can stop asking what their country can do for them, and start dreaming again about what they can do for themselves with their banks’ money. Biking to work is out. Helicopter commutes to the Hamptons will be back in. The opportunities are limitless. They’re free at last.

If the government succeeds in somehow restoring the "normal" operation of our pre-2008 financial system, then, we will all have truly failed.

Yet, that has clearly been the goal and, sadly, it looks increasingly as though it just might work, the prospect of even more power and influence being concentrated in fewer and fewer companies such as JP Morgan and Goldman Sachs perhaps being the desired result all along.

Mr. Weil continues...

What these masters of the government rescue need now is a shopping list -- a 10-step program to restore their remorseless, reptilian souls and help them rediscover the unique thrill that can come only from being paid millions of dollars to provide services that are of no value to greater mankind. This brings us to our first agenda item:

No. 1: Reinstate the bonuses. Start with the top guys. That means you, Lloyd Blankfein, John Mack and Jamie Dimon. America is back. All we need is a little confidence. And there can be no confidence without the hope, however faint, that one day the son of some unemployed auto worker can grow up to make millions advising his dad’s old company on its next Chapter 11 filing. Just keep repeating this line: We need to retain our best talent, or else we’ll wind up the next AIG.

No. 2: Raise the bonuses. Because you can. Don’t worry that Timothy Geithner at Treasury might unveil some new, vague “best practices” for banker compensation. They’ll never stick. Your lobbyists can fix that.

No. 3: Relax your rules on corporate expense accounts. Scores, which I’m told is Manhattan’s finest adult-entertainment hot spot, has re-opened after a two-year hiatus. A happy customer is a loyal customer. Tell your bank’s traders to say Howard Stern sent them.

It goes on from there - office decorating, private jets, junkets, etc. - all thoroughly depressing, unless of course you work at JP Morgan or Goldman Sachs.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

Should Private Equity Groups Be Allowed To Own Banks?

With several banks in disparate need of capital, could the government change regulations to allow private equity groups to own banks? Despite long-standing regulations that separated the banking industry from higher-risk companies, a series of events have been set in motion that could lead to a change in the near future. Shah Gilani from Money Morning discusses how the stage is being set for such a change to occur.

U.S. banking-industry regulators have long understood that there needed to be a carefully delineated separation between such low-risk activities as deposit-based banking, and much higher-risk activities as investment banking.

But the regulatory walls that separated the two have been steadily dismantled through the years, an intentional act that had the unintentional consequence of helping spawn the worst financial crisis since the Great Depression.

Not unlike the Depression era Glass-Steagall Act, which was enacted to keep FDIC-insured commercial banks separate from the riskier businesses of investment banks and securities broker-dealers, regulators determined that bank ownership should be limited to bank holding companies. The Bank Holding Company Act of 1956 further ensured separation of commerce and banking by prohibiting bank holding companies from engaging in non-financial activities. The essence of the regulations was to prevent banks from failing by not allowing owners to deplete bank resources by diverting them to prop up other businesses they owned or controlled.

Setting the Table for Trouble?

In 1998, in what many experts agree was the starting line in the race to worldwide financial collapse, Citibank Inc. merged with Travelers Group, which owned the Solomon Smith Barney and Shearson investment-banking and securities broker-dealer businesses, to create what is now Citigroup Inc. (NYSE: C). It was a move marked by extraordinary bravado that was made in direct contravention of the existing Glass-Steagall and Bank Holding Company acts.

The flaunted marriage was subsequently blessed a year later when an ocean of lobbying money floated the Gramm-Leach-Bliley Financial Modernization Act, which repealed parts of Glass-Steagall and circumscribed regulations in the Bank Holding Company Act.

The merger that created Citigroup was touted as necessary to compete with other universal banks. Now private equity is touting its burgeoning coffers and the distressed state of undercapitalized banks as a marriage whose time has come – as well as one that will benefit the U.S. economy. Not unlike Citibank and Travelers forcing legislative changes after the fact, private equity is pushing hard against every law and regulation standing in the way of its ultimate prize. The push began more than a year ago and under the weight of last summer’s devastating events finally succeeded in getting a first foot in the door last Sept. 22.

That day, according to a series of memos prepared by powerhouse law firm Simpson, Thacher & Bartlett LLP, the U.S. Federal Reserve issued a long-awaited policy statement that details the new terms under which investors can take stakes in bank holding companies without having been deemed to have acquired actual “control” – which would force the investor to become a bank holding company, too. Those three changes consisted of:

* An investor who will have a seat on the bank holding company’s board could now own as much as 24.9% of the outstanding voting shares of the bank holding company, an increase from the prior limit of 10%.
* An investor could not own as much as 33% of the total equity of a bank holding company – versus the prior limit of 24.9% – provided that the investment does not include ownership of 15% or more of any class of voting securities of the target company.
* And the investor would now be permitted to actively attempt to influence certain governance matters of the bank holding company and was no longer be required to be a completely passive investor.

As if that weren’t enough, on Dec. 22 of last year federal banking regulators adopted a shelf-approval process to facilitate bidding by private equity funds on failing and failed depository institutions Simpson, Thacher said.

“In order to increase the pool of bidders … federal banking regulators recently adopted special pre-clearance procedures to enable parties that do not already own an insured depository institution, most notably private equity funds, to qualify as bidders,” the law firm wrote in a memo.

Up Steps Private Equity

And while private equity firms without a doubt appreciate the openings they’ve been given, none of the shops want to become bank holding companies. The reason: A firm that’s labeled as a “bank holding company” is also deemed to be a “source of strength” to the banks it owns or controls. That means the holding company has to make available its resources to support its banks. Private equity companies don’t want to expose their vast pools of capital to any one investment. Just as Cerberus Capital Management LP refused to put any more money into its failed Chrysler LLC investment – leaving taxpayers to bail it out – firms are loathe to be put into a position to support a bank holding with anything more than what was deemed as a suitable capital investment at the outset.

Just last spring, for instance, The Blackstone Group LP (NYSE: BX) was sued by one of its prospective investment targets when it backed out of buying credit-card processor Alliance Data Systems Corp. (NYSE: ADS). Blackstone’s concern was over conditions imposed by the Office of the Comptroller of the Currency, which required Blackstone to provide at least a $400 million backstop to support Alliance Data’s credit-card bank, which is regulated by the OCC.

"No private equity firm wants to [be labeled as a “source of strength” to companies it controls] since it is an unlimited call on capital," Hal Scott, a Harvard Law School professor who also serves as director of the Committee on Capital Markets Regulation, recently told CNNMoney.com.

The Committee on Capital Markets Regulation recently published a series of regulatory recommendations, including one that would have regulators remove restrictions on private equity firms owning banks.

This article has been reposted from Money Morning. You can view the article on Money Morning's investment news website here.