Without Prop Trading, JP Morgan Looks a Lot Like Citigroup

Includes: BAC, C, GS, JPM, MS
by: Reggie Middleton

Well, it looks like Blankfein, Dimon, et. al. really should have tried harder to make that meeting with the President a couple of weeks ago. It appeared as if he may have had something important to discuss.

As my readers and subscribers know, I have been very bearish on the big money center banks since 2007, and quite profitably so. The last 3 quarters saw a much larger trend reversal than I expected, that resulted in the disgorgement of a decent amount of those profits - a disgorgement that I am still beating myself up over.

You see, as a fundamental investor, I don't do well when reality diverges from the fundamentals for too long a period. Luckily for me, fundamentals always return, and they usually return with a vengeance.

There was a massive overvalutation in banks throughout the bulk of last year, again! I made it clear to my subscribers that the banks simply have too many things going against them: political headwinds, nasty assets, diminishing revenue drivers, over-indebted consumers, and a soft economic cycle. I also warned explicitly that I didn't think Obama would be nearly as lenient on the banks as Bush was.

Well, the headwinds are stiffening. On that note, let's take an empirical look at just what this means in terms of valuation (note, I will following this up with a full forensic re-valuation for all subscribers, incuding a scenario analysis of varying extents of principal trading limits). Some of these banks are I-N-S-A-N-E-L-Y overvalued at these post bear market rally levels considering the aforementioned headwinds. Methinks fundamental analysis will make a comeback in a big way for 2010 as it meets the momentum and algo traders in a mutual BEAR feast on the big investment banks cum hedge funds. I can't guarantee it will happen, but the numbers dictate that it should. We shall see in the upcoming quarters.

We have retrieved information about trading revenues for Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), JP Morgan (NYSE:JPM) and BoFA (NYSE:BAC). We have also retrieved some balance sheet data to reflect the trend in investment holdings and the level of leverage, but I will address that in a future post for the sake of expediency. While the banks don't break out the P&L for principal trading, we can sort of back into it. Remember, traders are fed bonuses off of net revenue, not profit.

Goldman Sachs

Trading revenues accounted for more than 50% of the total revenues over the last 8 quarters. The impact on earnings is magnified with the total trading revenues amounting to more than 150% of the total pretax income over the last 8 quarters except for the last quarter in which the earnings were positively impacted by substantial decline in compensation expense which was negative 519 million in 4Q09 against 5.4 billion in 3Q09. The negative compensation charge during the quarter was owing to accounting adjustments

Principal investments which are purely GS proprietary transactions contribution ranged within 5% to 15% of the total revenues except in 4Q08 when the huge write downs in principal investments offset the positive revenues from other sources. Revenues from principal investments ranged within 15%-50% of the total pre-tax income except in 4Q08.

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Note: In the GS income statement, revenues from trading and principal investments is the GS total revenues from trading activities. This revenue item comprises of two heads - trading and principal investments.

Revenues from proprietary trading in FICC (Fixed income, currency and commodity) and Equities is clubbed with the trading revenues earned on the transactions done on behalf of clients and is reported under the former head. In first nine months of 2009, nearly 41% of the trading revenues came from interest rate related transactions and 37% came from equities.

GS trading revenues break up (in $ million)


% of total


% of total

Interest rates




















Commodities and other










The latter head primarily represents net investment gains/ losses from certain corporate and real estate investments and investment in the ordinary shares of Industrial and Commercial Bank of China Limited. Total principal investments amounted to 20.7 billion which is just 6-7% of the total investment portfolio of GS.

Thus, most of proprietary trading revenues is included in the former head . However, it's difficult to differentiate between proprietary trading and client-related trading. Revenues from principal investments in case of GS and MS are not trading revenues but are write-ups/downs on certain illiquid investments which are segregated as principal investments. We have created various scenarios to demonstrate the impact of a decline in trading revenues on earnings.


Morgan Stanley

Trading revenues contribution to total net revenues ranged with 15%-150% of the total revenues over the last 8 quarters except in 1Q09 when the trading revenues were more than offset by write-downs in principal investments. The impact on earnings is magnified with the total trading revenues amounting to more than 100% of the total pretax income over the last 8 quarters except in 1Q09.

Principal investments contribution to total revenues has been less than 5% of the total revenues over the last 8 quarters except in 4Q08 and 1Q09 during which huge write-downs were recorded in the principal investments. Revenues from principal investments ranged within 15%-25% of the total pre-tax income except in 1Q09.

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JP Morgan Chase


JPM’s trading revenues come primarily from principal transactions (JPM’s proprietary revenues). Trading revenues contribution to total net revenues ranged with 5%-15% of the total revenues over the last 8 quarters except in 4Q08. Total trading revenues ranged within 20%-100% of the pretax income except in 4Q08. As a commercial bank, JPM is doing horribly in terms of earnigns due to credit losses. I actually see this getting worse in the near future before it gets better, and as it gets better, it will do so gradually. Stripped of the risky, yet profitable prop trading, JPM will be looking a lot more like Citigroup (NYSE:C) than many pundits may think!

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Cute graphic above, eh? There is plenty of this in the public preview. When considering the staggering level of derivatives employed by JPM, it is frightening to even consider the fact that the quality of JPM's derivative exposure is even worse than Bear Stearns and Lehman‘s derivative portfolio just prior to their fall. Total net derivative exposure rated below BBB and below for JP Morgan currently stands at 35.4% while the same stood at 17.0% for Bear Stearns (February 2008) and 9.2% for Lehman (May 2008).

We all know what happened to Bear Stearns and Lehman Brothers, don't we??? I warned all about Bear Stearns way before they collapsed (Is this the Breaking of the Bear?: On Sunday, 27 January 2008) and Lehman as well ("Is Lehman really a lemming in disguise?": On February 20th, 2008) by taking a close, unbiased look at their balance sheet. Both of these companies were rated investment grade at the time, just like "you know who".

Now, I am not saying JPM is about to collapse, since it is one of the anointed ones chosen by the government and guaranteed not to fail - unlike Bear Stearns and Lehman Brothers, and it is (after all) investment grade rated. Who would you put your faith in, the big ratings agencies or your favorite blogger? Then again, if it acts like a duck, walks like a duck, and quacks like a duck, is it a chicken??? I'll leave the rest up for my readers to decide.

Free stuff: Independent Look into JP Morgan. Plenty more of this in the public preview. When considering the staggering level of derivatives employed by JPM, it is frightening to even consider the fact that the quality of JPM's derivative exposure...

Bank of America (this may be a literal moniker sometime soon if the system relapses):

Trading revenues contribution to total net revenues ranged within 3%-25% of the total revenues over the last 8 quarters except in 4Q08. Although the trading revenues contribution to the total revenues has been declining over the last few quarters, the impact on earnings has been magnified because of reduced earnings (owing to high provisions for loan losses and reduced income from other sources). While the trading revenues amounted to 20-30% of the pretax income in 1Q08 and 2Q08, it has amounted to more than 100% of the total pretax income over the last 6 quarters.

If the Bulge Bracket Sector starts to move down, "Look Out Below!"

I seem to have been one of the very few was bearish on Goldman and Morgan Stanley in early 2008 (see links at the bottom of this post as well as Get Your Federally Insured Hedge Fund Here, Twice the Price Sale Going on Now! and It appears as if the patina on Goldman's Stock is fading... and The Riskiest Bank on the Street).

As illustrated to subscribers, the bulk of the valuation increase for the big investment banks stems from the peer group bear rally premium of the last 9 months. If, or more accurately, when that premium dissipates, the whole sector will drop in fundamental value. I don't believe the banks are worth what they are trading at now, but comps are comps. Let's take a look at the comp trend.


As you can see, thanks to the bear market rally, the enire I bank peer group has enjoyed a big bump in valuation - one that I believe will prove to be transient, to say the least.


If I am right, then these I bank stocks will collapse, as the value drivers just aren't there to drive the valuation. Nearly all business units are trending down save a bump or two, FICC and trading arbitrage can't last forever (some analysts say the party is over already), and eventually the credit losses and asset devaluations on the balance sheet will come a knockin', despite the "get 4 quarters' worth of free mark to market lies" from the powers that be. Residential real estate is resuming its downtrend (see If Anybody Bothered to Take a Close Look at the Latest Housing Numbers...) as credit loses resume their uptrend (seeThe Truth! The Truth? Banker's Can't Handle the Truth!!! andResidential Lending Credit Losses Worsen as Unstainable Government Support Proves... Unsustainable).

Disclosure: Short all tickers mentioned above