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JPMorgan Chase & Co. (NYSE:JPM)

Q2 2007 Earnings Call

July 18, 2007 9:00 am ET

Executives

James Dimon - Chairman of the Board, President, Chief Executive Officer

Michael J. Cavanagh - Chief Financial Officer

Analysts

Guy Moszkowski - Merrill Lynch

Glenn Schorr - UBS

Mike Mayo - Deutsche Bank

Meredith Whitney - CIBC World Markets

John McDonald - Banc of America Securities

David Hilder - Bear Stearns

Betsy Graseck - Morgan Stanley

Nancy Bush - NAB Research

Ron Mandel - DIC

Presentation

Operator

Good morning, ladies and gentlemen and welcome to the JPMorgan Chase second quarter 2007 earnings call. This call is being recorded. Today’s presentation may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are subject to significant risk and uncertainties. Please refer to JPMorgan Chase’s filings with the Securities and Exchange Commission for a description of the factors that could cause the firm’s results to differ materially from those described in the forward-looking statements. At the conclusion of the presentation, you’ll have the opportunity to ask questions. (Operator Instructions) At this time, I would like to turn the call over to JPMorgan Chase’s Chairman and Chief Executive Officer, Jamie Dimon and Chief Financial Officer, Mike Cavanagh. Mr. Cavanagh, please go ahead, sir.

Michael J. Cavanagh

Great. Good morning, everybody. Thanks for joining us. We just wanted to give it a few minutes for everybody to get dialed in. We’re going to do the usual format. There’s a presentation that I’ll run through. It’s available on our website. I’ll hit the quarter. Jamie’s going to chime in with some comments overall and then we’ll take some Q&A at the end.

If you go to the presentation and we’ll start on slide 2. You’ll see over on the left side we had a strong quarter: $4.2 billion of net income; $1.20 of EPS, which was up 21% from a year ago; and a return on tangible common equity of 26%, so again very pleased with the results. Just to give you a taste of what’s going on in the numbers, and I’ll drill into it in a minute, it’s strong results in the investment bank and private equity. We had records in asset management and TS&S, and also in good revenue and margin growth in retail, offset by some additions to home equity reserves that I’ll tell you about in a minute as well.

I’m not going to spend a lot of time going through the presentation on the year-to-date but let me just cover a little bit of it for the overall firm here. For the first-half of the year, revenues of $38 billion were a record. Profits of $9 billion were a record as well, and a return on tangible common equity of 28% definitely moves us into a league into which we want to be playing.

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EPS was $2.54 for the first-half of the year and if you look back over the last four quarters, $4.53, so results are definitely running at an entirely different level than what we had a couple of years ago, so we are pleased with that.

Lastly on this page, when you look at the overall firm’s revenue growth, up 25% in the quarter, when you -- $4 billion year over year, that number, when you just adjust for acquisitions and accounting issues and divestitures, is an underlying growth rate of 18% organic, so obviously we feel great about that. That number done on the same basis for the first-half of the year is 19%, so very strong top line performance across the businesses.

Moving on now to get into the details of the businesses, going to slide three in the investment bank, you see here a circled number. We had net income of $1.2 billion on revenue of $5.8 billion and an ROE of 23% in the business. The next circled number you have there, we feel great about the record investment banking fees of $1.9 billion, which is as good as we’ve seen from anybody and the best obviously we’ve ever done, up 39% from a year ago. Record advisory revenues and record equity underwriting but also strong on the debt underwriting side as well.

You see again, I won’t read them all to you but the table results for the year-to-date so far, whether you do it on a volume basis or a fee basis, just demonstrate how strong our corporate finance franchise is, so again, very pleased there.

Moving along to fixed income markets, you see we had revenues of $2.4 billion. That’s up 15% from a year ago and that’s really driven year-over-year strength across most all products, with weakness year over year in commodities, which was very strong in the second quarter of a year ago, and down only slightly, 6%, which we feel pretty good about versus our record first quarter of this year.

I’ll just embellish a little bit there that -- remember, this fixed income market includes securitized products where we have our mortgage trading activity, and that activity was up or that business was up revenues quarter over quarter and year over year, so we feel very good again about the performance of our mortgage trading folks in this environment, both last quarter and this quarter.

I’ll just make the comment here that this includes, this business includes close-out of all exposures to the Bear Stearns hedge funds. As you know, we settled up and were made whole in the early days of their issues and so we are out, no exposures there.

Equity markets at $1.2 billion in revenue, up 115% year over year and down from a record quarter last quarter, so we feel very good about the results there. And then on the expense side, really just driven on the comp side. You see we had a higher comp-to-revenue ratio in the quarter of 45% than last quarter, but that just brings us to a year-to-date level of 43%, which is what we said to expect for the year.

And so on the credit side, really just credit cost increasing, adding to some reserves, just reflecting growth in the business.

Moving on to retail on slide 4, here I’ll take you through some of the drivers of the P&L before we go to the P&L itself, and here we couldn’t feel better about the underlying momentum in the business. You see we’ve got checking accounts up 14%. That’s the anchor that’s helping us grow deposits to $219 billion, up 4% -- that’s when you exclude the Bank of New York acquisition -- and up a bit quarter over quarter. You see mortgage loan originations of $44 billion, up strongly year over year, 41%, and likewise when you move down through the branch production statistics themselves. Through the branches, we continue to do a great job of investment sales, mortgage loan originations, and credit cards off a little bit from very strong numbers last year.

And again, branch number, 3,089. We had 30 new branches open for the quarter and are on track to open 125 to 150 for the year, so continuing to invest strongly in the distribution system branches and sales people in this business for future growth.

Moving on to slide 5 and just hitting the P&L here, I’ll start on the revenue side. You see we had revenues of $4.4 billion, which was up 15% year over year, 13% when you exclude the Bank of New York. And that’s obviously strong revenue growth, and the same quarter over quarter. We feel very pleased there and that’s coming out across the board, better results off of strong originations on the mortgage side, higher levels of servicing helping drive revenue growth in the mortgage business. And in the branch business you see strong net interest revenue driven by higher deposit balances and basically quarter over quarter a stable deposit margin. Of course, the fee side you see and looking at the detail in our supplement, strong fee growth there.

So revenues still very good -- again, 15% up year over year, 13% ex Bank of New York, and if you go down to the expense line for all the reasons I said on the prior page, expense growth year over year just driven by the higher production and the investment in the retail distribution system. So between revenues, expenses, a nice improvement in operating margins.

That next point is just the $587 million I’m going to drill into in a second, but obviously that increase in credit cost chewed up the profit increase we otherwise would have seen to get us to the $785 million net income in the business.

I’m going to drill into credit a little bit. Let me spend a minute on slide 6 just telling you about what we’re seeing and what we’ve done on the home equity side. So in the upper left box, you see the delinquency trend in recent months starting to pick up. When we move over to the upper right, you see the trend in nice growth that we’re happy about in our portfolio, so a $91 billion portfolio that’s been growing, but the next line you see net charge-offs dollar-wise up from $68 million to $98 million this quarter, so all by itself a $30 million increase is not too material for us but that charge-off rate of 44 basis points is up and through the cycle levels that we’ve previously talked about.

So to just explain what’s going on here and then the reserving actions we took, what we are seeing as you drill into the portfolio is that when you cut the geographies and look at markets where housing prices have been relatively weaker, flat or down versus areas where we’ve had continued strength, in those weaker areas you are seeing stress in delinquencies and losses on particularly high loan to value loans, so it’s the over-levered situation where housing prices come off and we’re experiencing a higher level of severity of loss in those situations. This is especially true when it comes through the wholesale or broker channel and especially true where we’re reliant on stated income.

So obviously the increase in charge-offs is running through the numbers but on top of that, we decided to act and add to and strengthen our allowance for credit losses in this portfolio, added $329 million to the allowance. Based on everything we currently know, we see that this charge-off rate probably goes up by as much as, you know, around 25 basis points from the 44 basis points we had in the quarter, which translates to the $98 million worth of quarterly charge-offs gradually increasing up to a level that could be as high as $150 million, $160 million a quarter based on everything we currently know. So we think we are acting to all the information we have and to carry through this into the future so it’s all our current expectations but obviously if conditions change and future events change, we may be back with a different story in the future.

But what we also did, just to be clear, is that we tightened up underwriting standards here. You can see that that means lowering loans of value maximums, also reducing dependence on stated income and raising minimum FICO scores. That particularly going after the broker channel but true across the underwriting sales broadly. And that translates really into if you applied these new standards against where our production came from last year out of the broker channel, it would eliminate about a third of our originations coming out of that channel in home equity and about 70% of the losses. The team there continues to look to tighten up and react to future information.

So that’s it on the home equity side. Just splashing in front of you, page seven, this is exactly what we took you though last quarter when we showed you the increase in losses there. Remember we had $20 million of net charge-offs you see in the upper right last quarter added to reserves last quarter for the same reasons of what we expected to see coming through in the future. So what you’re seeing here are the slight pick-up, the $26 million, all the point is here is that it’s completely consistent with the expectations we had last quarter. The reserve increases we made last quarter we think continue to be proper and fine and really no news on the sub-prime front is the point.

Moving to slide 8 on card services, so just starting at the top on the right side, you just see we had a net income of $759 million for an ROE of 22%, down 13% from a year ago. If we just go through some of the drivers of the P&L in this business, you see we had average outstandings of $147 billion, up 7% from a year ago and down seasonally sequentially by about 1%, consistent with what you normally see in the patterning of balances coming off of tax season and so forth, so we feel fine about the outstandings growth there.

The next point I just want to make here was charge volume. You see we had $88 billion worth of charge volume on the cards. That’s a 4% increase year over year, which is a slower rate than what we’ve been growing at before. I just want to make it clear -- that’s made up of two components. One is the actual sales spend going through charge volume. The other is the dollar amount of balance transfers, also run through the $88 billion of charge volume. And what we’ve done is become much more targeted about our marketing efforts of balance transfers and so actually in the quarter, our sales volume of actual purchases, restaurant meals, retail sales and so forth, up 10% year over year, which we think is in line with our market share, so growing fine there. And our balance transfers are actually down, making up the difference to get to the only 4% growth overall. We expect that to continue into the future so for the next several quarters or until we normalize at a new level, we’re still doing balance transfers, just at a lower level. We will see lower overall blended rates but driven by lower year-over-year balance transfer growth, but healthy sales is what we expect.

Skipping down to then just the revenue, I’ll talk quarter over quarter. So you see that revenue is flattish versus the prior quarter. Net interest margin, managed margin, 811 basis points, slightly declined to 804. We had interchange income growth in dollars but in the net interest margin side, just to point out we changed some of our billing practices in the quarter, two-cycled billing and over limit fees a bit and that took out about 15 to 20 basis points of net interest margin quarter over quarter. So that’s the story sequentially on the revenue side.

Credit here looks very stable. You see the 362 basis points net charge-off rate, still running strong versus what our normalized levels would be expected to be in the business, so feeling good about the credit story here and expenses really just continue to be a good story in the business. That’s card.

Moving on to slide 9, commercial bank, here we had net income of $284 million and we had higher revenues offset by lower expense growth, but again higher provisioning driven by higher portfolio growth offset some of the otherwise margin expansion. When we look at again the balance sheet drivers of the business, liability balances or deposits up 16% versus a year ago and loans up 14%, so strong growth again in the business driving the revenue side. Good expense management, so you see our overhead ratio in the business is about 49%. Again, on the credit side, the portfolio looks good. You see net charge-offs of 5 basis points to the positive actual net recoveries, and as we look into the portfolio, what we see, we see no signs of weakening in the portfolio, so feel good there.

Treasury and security services on slide 10; I said up front we feel good about the results here. It’s a record profit of $352 million for a quarter, up 11% from a year ago. Pretax margin of 32%, moving towards our goal of getting to 35% or so in the business. And again, record revenue here, $1.741 billion, up 10% year over year, and that is again more of volume growth across the business and balance sheet growth as well, offset by some spread compression in both pricing and product and FX rates.

Sequentially versus last quarter, just to point out that this is the strong quarter of the year, seasonally strong with dividend fees and in Europe, so we’ll see the usual patterning. Going from second to third it will tick down a bit, and expenses up 9% versus the prior year, getting you to the $352 million of net income in the business.

Last business, again a great story on page 11 or slide 11, asset management. Here again another quarter of record net income, up 44% from a year ago to $493 million and a pretax margin of 37% on record revenues of $2.1 billion, up 32% really coming across the board. If I really just had to point you to what’s driving it, it’s obviously the assets under management. You see them up to $1.1 trillion, up 23% year over year, which includes 38% growth in the alternative asset space.

I think one of the more impressive numbers here is just the sub-bullet there that talks about the net inflow, so away from market appreciation, assets under management just driven by new inflows of $101 billion over the past year, basically right around 10% of assets under management, so we feel great about the flows in, which is really driven by the strong performance of the business and that continued with $30 billion of net inflows in this past quarter.

Finally, we’ll talk about corporate. So here in corporate, starting in the upper right side, you see on the private equity side a very strong quarter. Private equity gains of $1.3 billion, so an outstanding result and an outstanding half-year in the private equity space. And then moving down to the lower left, you see the rest of corporate, which was $280 million negative for the quarter, but that included $227 million worth of bond losses as we repositioned the company’s investment portfolio, given the changing rate environment. So when you adjust that out, it’s $139 million for the quarter, or $163 million of loss for the year-to-date, $80 million a quarter on average, so right in line with the $50 million to $100 million guidance we had given at the beginning of the year. So again, we feel good about the corporate space and just give the caveat that again, as we always say, the private equity results are going to be very much driven by market conditions and will be volatile, as will the corporate results themselves. There’s some lumpiness in how they come through.

So to close it out before I give it to Jamie, slide 13, capital. We couldn’t feel better about the strength of our balance sheet, so capital ratio is very strong, as you see here and capital itself, tangible common equity growing nicely year over year, $67 billion -- the same kind of growth, $10 billion in tier 1 capital. And again, a lighter quarter on the buy-back side, $2 billion worth of repurchase, so feel great about the strength of the balance sheet and also just great about the liquidity position of this company. Remember it’s something like $600 billion worth of deposits supporting this balance sheet and also just a very strong liquidity position overall.

With that, I will hand it over to Jamie to make some additional comments before we go to Q&A.

James Dimon

Mike, thank you very much. Let me give you a little bit of a quick overview on the company. I won’t repeat what Mike said but you really do see across the board good margins, real growth in most areas, better returns on capital and we should all feel pretty good about that.

I also want to point out that return on capital, which I always look at first as a competitor as a key measure, and we did note that the investment bank is now performing among some of the better. And as someone points out to me, Goldman Sachs was at like 38% year-to-date. I just want to point out if you put our asset management company, our investment bank and our private equity results together, they have the same return on capital that Goldman Sachs did and that’s the business that they are combining when they look at that.

Also, in credit card, we hired a great new CEO who has hit the ground running, Gordon Smith. A lot of you will get to meet him but he comes out of American Express and he’s going to add an awful lot of value and insight into our credit card operations.

Mike did a great job talking about consumer so I’m not going to speak about it at all, and I will speak about the investment bank. Some of the risk in the investment bank that are getting heightened scrutiny today, but the backdrop against that is we have a very strong global economy, corporations are strong, there’s full employment, growing employment, full employment in the U.S. -- this is not a recession and put in the back of your mind that that would be the condition that would be bad for, really bad for credit, leveraged loans, non-leveraged loans, consumers, et cetera. So the backdrop itself is actually pretty good.

On the wholesale side, I’m going to split it into trading, financing and loans. On the trading side, sub-prime, Mike mentioned that the mortgage results were actually quite good. We do have some sub-prime residuals. I think when the 10-K comes out, they will be kind of on a gross basis, about $1 billion, of which maybe less than half of that would be non-investment grade. We’ve been over-hedged, in effect, because while we’ve been writing down the residuals, we’ve also been making more money on the hedges and they are done very conservatively. Conceptually, you mark them to market or mark them to model. Just remember we’re fully conservative, like tight discount rates, we’re forecasting forward high loss rates, so what’s on our books we think is pretty clean and pretty hedged. It could be worse but it also could be better.

Our CDO trading positions, I’ve put them in the normal range. Some of them came out of Bear Stearns but again, I would put us in the conservative category -- it could be worse, it could be better but we’re not particularly concerned about it. I would put them in the normal position type category, not excess types of positions.

And financing, we do finance sub-prime warehouses but they are mark-to-market, there are margins, there are calls. We feel very comfortable about it. We also financed CLO loan warehouses. We look through them. The loans are marked to market individually. There is protection, some of them, so we have a lot of insight into it. We feel good about. And we finance hedge funds. Hedge funds, you know, hedge funds -- the Bear Stearns example is an example of a hedge fund that was over-leveraged with a liquid collateral finance short. We were involved in that so we were a little bit behind that. We were never behind the eight ball in having excess collateral. We always had excess collateral even at very conservative marks, and we don’t do a lot of that. So I would tell you we feel pretty good. We don’t have a lot of liquid collateral and margins are called every day. I think when it comes to CLOs and CDOs, probably everyone has increased their margin requirements at this point, so we’re not truly concerned about that.

I should also mention probably in the sub-prime because it is important, both in the retail side and in the investment banking side, a lot of our sub-prime residuals are chased home finance. And chased sub-prime residuals have loss rates about half of the average because I think we just did a better job underwriting, though worse than we thought. We did make some mistakes but they are half the average and so I think what’s on the balance sheet is actually probably pretty good.

On the leverage loan side, the backdrop is pretty good in terms of the economy and remember, all these deals have on average 25% plus equity in them, so they are not like some of the deals that were done 15 years ago with very little equity but you do have a lot of the high-yield bridges and leveraged loans, kind of a little freeze in the marketplace as risky assets get repriced which in my opinion is a healthy thing for the market. So as you look at the big picture, there is $100 billion of bridges and of high yield bonds in the pipeline looking forward and there is $200 billion of leveraged loans. These are like the next four or five months, kind of in the market, kind of visible supply, things that have been announced and obviously there will be things that haven’t been announced and that’s a -- and I think that is a causing a repricing of covenants and pits and all those kinds of things, but we try to underwrite each loan individually such that we end up owning a loan, we don’t feel terrible. Yes, we’d have some write-downs on it, et cetera, but -- and there are some hung bridges out there. Again, there’s nothing that’s on our balance sheet we’re particularly concerned about but if you see this continue, you will see the street taking on a lot of bridge loans and more aggressive repricing of those things because that can’t last forever.

But Mike also pointed out, I just want to reiterate it, we have strong loan loss reserves. We actually increased them in the investment bank by $160 million this quarter and we have strong loan loss reserves in commercial banking. We added loan loss reserves in home equity but we feel really good about our balance sheet and our position in general.

We will stop there and take the questions and the things that are on your mind.

Question-and-Answer Session

Operator

(Operator Instructions)

We’ll go first to Guy Moszkowski with Merrill Lynch.

Guy Moszkowski - Merrill Lynch

Good morning, gentlemen. I just want to follow-up actually on the point that Jamie was just talking about with respect to the leveraged loan and high yield overhang that’s out there for LBOs, and the fact that investment banks are on the hook for a fair amount of bridge lending and even bridge equity.

I was hoping that you would actually give us a little bit more of a sense for what your position is in this regard, JPM’s, not just the broad market number with respect to bridge commitments already funded and what you think your overhang is.

James Dimon

I’m not going to give you specific numbers, Guy, because I don’t think we disclose those, nor have I seen anyone disclose them. I think that of the -- there’s loans and there’s bridges, and I want to separate that. The loans remember are usually much more secure and senior, et cetera, than the bridges. But with the bridges, there are a couple of hung deals out there. We are involved in a couple and that’s life. That’s the world we live in and we think the loans themselves are good, though we obviously are going to pay a lot of attention to it.

If you look at the business, you know, we have our share of ongoing loan and on the other hand, I do think there is some deals I’ve seen out there which are not good. I’m not going to mention them, the names, but we are involved in ones we still think are not good so the real protection is that you actually, for everything you do, you underwrite thinking you may own it one day. So if a lot of stuff we have out there ends up on our balance sheet, we’re still okay. We won’t like it but we’ll be okay. We may have to put up some reserves against it and -- I should also point out I’m not going to go to equity bridges other than to say our private equity positions on our balance sheet not in the investment bank are $6 billion. That’s now under 10% of our equity, so it’s fairly conservative. And the bridge equity would change that number but not dramatically. But in terms of the company’s balance sheet, I’m not too worried about it.

I think equity bridges are a terrible idea. I think they are bad. I think they are bad financial policy. I don’t think they are good for the banks. I don’t think they are good for the private equity guys, so I hope they go the way of the dinosaur because they are basically one-sided put on our balance sheet. I also think the street is kind of topped up on them. There’s only so much you can do and feel comfortable with it and it’s kind of silly to take all that kind of downside risk and have known of the upside potential.

So we feel fine about the ones that we underwrite. We don’t lead with equity bridges and we don’t underwrite and try to underwrite those as if we are going to own them soon, otherwise we don’t want to be involved in it. And there are pieces of the equity bridges we are going to keep. Maybe we can make some good money if we have a diversified portfolio, so you will us actually make the decision to keep some of those over time.

Michael J. Cavanagh

But also in the credit market, deals are getting done so there is financing happening out there, obviously you all know that. It’s selected issues, the highest leverage, some of the non-cash based stuff that are having some issues so -- and with the strong economic backdrop, there’s a little bit of right now what we see is a reset a little bit of credit market conditions but we’ve got the patience to work through that.

Guy Moszkowski - Merrill Lynch

If I could just follow-up, given the fact that some of the indigestion that we are talking about actually did occur late in the second quarter, did it effect the investment bank’s results, either as an offset to fees or reduced fixed income trading revenues or an increase in credit provision in the quarter? Or would we expect that any noise like that would be more likely a third quarter event?

James Dimon

There was a little bit in there in this quarter but I would not put it in the material category, and it went against the fixed income line because obviously the fees are not going to -- you might take a markdown here or there.

I also want to point out the investment bank does have on some kind of macro hedges to protect somewhat, and these hedges are never perfect, but to protect somewhat against large swings in the market.

Guy Moszkowski - Merrill Lynch

Finally, on the same topic, how would you view the ability in the current much more difficult market conditions to renegotiate terms of some of the facilities that you’ll be syndicating? How easy or difficult are you finding it to negotiate with some of the sponsors on this stuff?

James Dimon

I think some of the sponsors are trying to be as flexible as they can in the ways that don’t hurt their deal but can help the financing in terms of covenants or moving the package around a little bit. And some are being much tougher, with the idea that the bank signed up and that’s that. They get paid to take that risk and they are taking that risk. So it’s a little bit of both. At the end of the day, it may -- we’ll fix the term we want to do business with going both ways, so I think of new deals going forward, yes, I think there’s been no -- it’s been a pretty dramatic thing.

Remember, it’s in everyone’s benefit that the market functions.

Guy Moszkowski - Merrill Lynch

Okay, thanks very much for that. I appreciate it.

Operator

We’ll go next to Glenn Schorr with UBS.

Glenn Schorr - UBS

Thanks, guys. Mike, just an accounting question follow-up on some of the stuff. Is there something that, whether it be the hung bridge that you’ve underwritten to balance that you decide that you are better off hanging on to than blowing out at distressed prices? Or something in the leverage loan area that you take on, does that go on your books as a loan and does it work out accounting wise as a loan, or is that a security and mark to market?

Michael J. Cavanagh

It’s a held for sale loan. It’s mark-to-market. We mark them down to what we think the fair value is, the same with every such instrument on our investment bank balance sheet.

James Dimon

Portions, we don’t expect the whole. So when we actually have that in the supplement, you can actually see our loans on the balance sheet haven’t changed dramatically, right?

Michael J. Cavanagh

Right. Held for sale loan category in the investment bank is where you’d see any bridges that get funded go. It’s fair value.

Glenn Schorr - UBS

And then Jamie, I think I agree and I’ve heard similar comments on your big picture assessment of what’s still good in the world and I don’t want to say that these issues are isolated to sub-prime CDO and leveraged lending because we keep adding categories on where these things are isolated, but I think if you look at the great environment that the investment banks have enjoyed over the last four years between M&A and financing, packaging, high yield underwriting, and even maybe the market, a lot of it has been built on the backs of cheaper debt. And while corporate balance sheets are still good, the cost of financing feels like it’s going up as these -- I don’t know -- refined price discovery in these different pockets. How would you assess that? A, do you agree with it and B, how much has the cost of debt backed up such that all these great things that actually have some follow-on impact?

James Dimon

Well, you can guess it up as much as I can. The numbers I have seen is that the leverage side of the business is probably about 22% of the -- which is about the percentage for us, by the way, so we’re not dramatically different. But that also means that 78% is non-private equity and you do have a lot of corporations out there who do M&A, financing, advice, equity issuance, et cetera, so -- and as you pointed out, a lot of those corporations are large and very active, so just as one side of the market goes down it doesn’t mean the other side won’t pick up slack. I eventually expect to see more strategic buyer M&A over time.

I think Mike pointed out that we are building our business and we don’t build our business trying to guess what it might be like next quarter or next year. The investment bank was number four in M&A globally and in the U.S. and EMEA, but in every other single category, equity, debt, EMEA, Latin America, Asia, we were one, two or three. TMBS, high yield loan, equity, and that’s pretty unbelievable.

So we are going to continue building that because that’s people, coverage, products, service, and you are building that for 30 years. You are not building that because you think it might be good or bad in the next 18 months.

Glenn Schorr - UBS

Okay. Thanks, guys.

Operator

We’ll go next to Mike Mayo with Deutsche Bank.

Mike Mayo - Deutsche Bank

Good morning. I have another question on capital markets and leverage lending, less about pricing than term. The level of "covenant-light" loan has certainly gone up this year and I was wondering about your philosophy towards those types of loans and if you are seeing changes in the covenant.

James Dimon

I think you’ve seen it, Mike, already playing up dramatically in terms of covenants, though I would tell you that covenants and loans are one factor of underwriting, but there are some loans I’d rather have with no covenants. I think the company is very good and the management is very good and et cetera and it is not the covenant that protects you.

But I do agree that it probably got too lax and you are seeing them come back with a little bit of a vengeance here.

Mike Mayo - Deutsche Bank

What percent of your leveraged loans don’t have covenants?

Michael J. Cavanagh

I don’t know the number off-hand. I would say some but not predominantly.

Mike Mayo - Deutsche Bank

And then a separate request related to --

James Dimon

But like I said, I don’t think that’s the thing that separates good loans from bad loans.

Mike Mayo - Deutsche Bank

Related to securities processing generally, what are you guys seeing in the market between the mergers with State Street, Investors Financial, Bank of New York and Mellon? You had a very strong quarter and so did everybody else. Are you see more rational pricing at all?

James Dimon

Our assets under custody are now $15.2 billion and I think, if I saw State Street, the deal they did was 14.9, but in terms of rational pricing, the answer is no. It is pretty competitive out there.

Mike Mayo - Deutsche Bank

Thank you.

James Dimon

Personally, I don’t expect that to change either, so --

Operator

We’ll go next to Meredith Whitney with CIBC World Markets.

Meredith Whitney - CIBC World Markets

Good morning. I don’t have a question on capital markets but I do have a question on the regional or retail banking division. A lot of investors have called me and asked me about what your retail bank ambitions are and I wish you would reiterate your longer term retail bank ambitions and then comment specifically -- I’m just going to go for it -- on commerce bank.

James Dimon

I’m not going to comment on commerce bank but the -- if you mean the, what we expect to earn over time, I think we would say an overhead ratio of 50, not including the amortization of CDI or certain intangibles, and ROEs of 28 to 30 in total. We still expect to have that. We’ve had kind of years of growth in our retail bank, store by store, new ATMs, new branches, new bankers, new products.

I should also point out that our mortgage business, as much as the mortgage business is under stress, our market share is going up by a couple of percentage points and we expect to gain share in a very big business and both mortgages and sub-prime usually have a dramatic change in sub-prime over time, but we think we’ll be a stronger player coming out of this.

So our mortgage origination was up substantially this quarter.

Meredith Whitney - CIBC World Markets

Specifically in terms of what do you want to be when you grow up in terms of scale -- I appreciate that you guys have made it very clear in terms of the returns you expect but I’m looking for more broadly scale.

Michael J. Cavanagh

I think, Meredith, we think it’s a business that needs scale. We think we already have scale in the states we’re in. I think we have plenty of opportunity to fill in in the footprint we’re in, so if the question is over time do we see ourselves going beyond our footprint, there’s a logic there but it’s got to be done in a way that makes sense for the shareholder. So we could do it ourselves or we could acquire.

Meredith Whitney - CIBC World Markets

Okay, and could you just reiterate your acquisition guidelines?

James Dimon

I get tired of saying this. I’ll say it again -- it’s got to have business logic, the price has to be right and we have to have the ability to execute. The most important job we have is to grow our business organically, which you see taking place. For example, we opened I think 120 branches last year, though we did do the Bank of New York acquisition. If we have things like that that we can do that we think make a lot of sense for our shareholders, we will certainly do that and we certainly have the capability at this point to do that.

Meredith Whitney - CIBC World Markets

Thank you.

Operator

We’ll go next to John McDonald with Banc of America Securities.

John McDonald - Banc of America Securities

I have a couple of questions on the card business. Are you seeing any improvement in payment rates as home equity has slowed that would lead to perhaps better balance improvement?

James Dimon

No.

Michael J. Cavanagh

No, it’s off the highs of a year ago but pretty stable from where it’s been the past quarter.

John McDonald - Banc of America Securities

Okay, and Mike, did you make any commentary about the outlook for card losses as we go into the second-half? Obviously they’ve been very strong so far.

Michael J. Cavanagh

We didn’t make any commentary so it’s just a broad -- other than to say that we continue to run below normalized levels, so the trends of gradual normalization of bankruptcy losses and gradual returns to normal is what we would be expecting.

James Dimon

We would expect bankruptcy loss to be going up and so charge-offs will be higher next year than this year. That’s not about next quarter but next year.

John McDonald - Banc of America Securities

Okay, and then just finally on the card margin, obviously some of the payment practice or collection practice has changed and it had an impact this quarter. What are the other things that will influence your card margin? Are you still pulling back on some of the teaser and what are the competitive environment conditions you’re seeing there?

James Dimon

We are slowly de-emphasizing some of the teaser and some of the balance transfers and that is affecting outstandings, which we would expect very slow growth in, but we don’t expect to change profit that much because some of that stuff wasn’t as profitable. But the business other than that, Mike mentioned the spend is up 9 or 10 -- the real spend, you know, people using their card to buy things, is up 9% or 10%. We hope that will continue.

Michael J. Cavanagh

And I guess, John, we should see some widening of the net interest margin, just a slowdown of some of the aggressive marketing we have will just mean some of the older vintages start, as they start to mature and get to their go-to pricing, we’ll get a little pick up there, offset a little bit by -- you know, the more we grow our spend business, the more we have what we call transactive balances where you are not earning it on the spread line, you are earning it on the fee line, so that’s a fact of the -- away on the net interest side.

John McDonald - Banc of America Securities

Is there any more expense leverage in card, Mike, from pulling back? Obviously that trend’s been positive last quarter or two.

James Dimon

It’s almost none.

Michael J. Cavanagh

We feel pretty good about the operating expense side, so it’s simply a function of opportunities to spend money on marketing and how that moves around one quarter to the next.

John McDonald - Banc of America Securities

Okay, thanks.

Operator

(Operator Instructions) We’ll go to David Hilder with Bear Stearns.

David Hilder - Bear Stearns

Good morning. Just a question on --

James Dimon

Actually, David, we had a few questions for you.

David Hilder - Bear Stearns

Sorry, can you hear me?

James Dimon

Yes, I’m sorry. Go ahead.

David Hilder - Bear Stearns

A question on accounting for private equity. Could you talk about how the reclassification of some carried interest from net revenue to compensation expense might have affected the number that you’ve shown, both in the first and the second quarters?

Michael J. Cavanagh

I’ll just give you rough numbers. It’s a little bit over $100 million in each quarter of increase in revenue and expense, if I’ve got my numbers right.

David Hilder - Bear Stearns

Sorry, just over $100 million?

Michael J. Cavanagh

Yes, just over $100 million per quarter. Obviously it would be a function of how big your revenues are in that period but for these past two quarters, call it 120 or so of carry that -- in revenues, that was the swing.

David Hilder - Bear Stearns

While we’re on it, any change in your guidance on what you might expect as obviously a theoretical quarterly run-rate, around which it will clearly be lumpy?

Michael J. Cavanagh

I think I’ll -- Jamie can change my comments if he wants to, but I will say really, we’re out of the business of trying to forecast that. You can look at what you see is our invested balances of about $6 billion or $7 billion there. Obviously as we put money out the door, we’re expecting to get private equity like returns over time and our team obviously has been doing a very good job posting those kind of results. But when you actually see it, it is very much a function of what the exit opportunities really turn out to be, so it’s very hard to predict one quarter to the next what we are going to end up with. So I think we all have enough track record here to understand the range of outcomes we could end up with but we’ll be wrong. Every time we’ve tried to predict it, we’ve been wrong so I’m going to stop trying.

David Hilder - Bear Stearns

Okay, thanks very much.

Operator

We’ll go next to Betsy Graseck with Morgan Stanley.

Betsy Graseck - Morgan Stanley

Thanks. Good morning. Jamie, when we were going through the introduction, you were indicating related to all of the areas that are top of mind with investors, leveraged loans, CDOs, sub-prime, et cetera, that you felt very comfortable. I just wanted to get an understanding as to what do you see in the business that leads you to that conclusion?

James Dimon

Well, I was referring to very specific line items. We’re paid to worry, so we always worry about things.

I think if I just size it up, if you look at the positions and the size, they are not that big a deal and we’re kind of hedged and we’ve done okay and we’re conservative accounting, so I was saying that sub-prime and CDO, they are not something that I think should keep people up at night. Yes, they could swing $100 million, $200 million here or there but they aren’t something that’s going to damage this company or ability to grow or anything like that.

On the financing side, we’re very conservative. We do feel very comfortable there. On the loan side, you know it like I do. I’m not -- there I am less comfortable because I can’t predict the outcome of the market, but like I said, the way we look at it, and this I obviously don’t expect to happen, is if all of it ended up on our balance sheet, we would be okay. We might take some markdowns and take some reserves, but we already have a lot a of loan loss reserves and we underwrite every loan as if we might end up owning. So the bad news is you might end up owning it. The good news is we’re doing a lot of business and we do think a lot of the business is good business. The ones that weren’t, we didn’t do.

Betsy Graseck - Morgan Stanley

You are sitting here with a capital ratio that’s in excess of your peer group. Is that part of the reason why?

James Dimon

Well, that’s another thing. JPMorgan Chase now is earning a rate in excess of $25 billion pretax a year. That’s probably more of a double from three years ago and we’re not really taking that much more risk as a total company, and we hold a lot of capital. So when you look at that, it’s hard to say you should be afraid of anything, and so yes, those do give us comfort -- earnings, capital, margins, good accounting.

Betsy Graseck - Morgan Stanley

Given the changes in the marketplace, is there anything you can say about how the pipeline shifted for you? Your invested banking pipeline?

Michael J. Cavanagh

The pipeline continues to be big but it’s very much a function of what, how the market conditions ahead of us play out.

James Dimon

Honestly, Betsy, we’re all not going to know because there’s only a little bit of stuff that is expected to get done in July, so a lot of it is August, September, October, and we are all going to be watching it at the same time and we’ll see. We could -- like I said, the backdrop is pretty good and risky assets, we thought risky assets have been repriced for a while so I don’t think there’s any -- if it ends up just being a, even a semi-dramatic repricing and then things start happening again. It would be far worse if we were going into a recession. Then you have a whole bunch of different series of issues.

Betsy Graseck - Morgan Stanley

And then, just given the pre-funding that you’ve done on the sub-prime losses in the residential book, I would expect that at this stage, you’ve reserved for what you think the deterioration is likely to be in that asset class. I know S&P raised their expectations for sub-prime June loss to 11% to 14%. I’m wondering, is that in your level of pre-funding for that asset class?

James Dimon

But our, first of all, losses are lower than that which means underwriting was better than that, so yes, we -- our forecast is forward and fully reserved for -- Mike specifically gave you numbers that we expect the loss rates in home equity to be 65 basis points, which is our high around there, and we fully reserve for that looking forward. It could be worse, it could be better, but that’s what we’ve done.

Michael J. Cavanagh

But it’s based on everything we know. It’s what we expect to happen as we sit here. Sub-prime additions change a lot, Betsy. That could obviously have a -- make adjustments, but both sub-prime, like we did last quarter, all the talk of how sub-prime is changing and getting worse, everything that is happening was fundamentally contemplated on what we did in the first quarter and we are not trying to lie to ourselves in how we deal with home equity this quarter. So it’s based upon what we know, what we’ve seen in weakening and how it plays to our portfolio.

Betsy Graseck - Morgan Stanley

Thanks.

Operator

We’ll go next to Nancy Bush with NAB Research.

Nancy Bush - NAB Research

Thank you. My question was just answered.

Operator

We’ll go next to Ron Mandel with DIC.

Ron Mandel - DIC

In regard to credit costs in the investment bank, for example, you point out that you had net recoveries but dealt a reserve by 160, or had credit cost of $160-some million and as I look at the indicators with loans flat and NPAs down and so on, I’m just wondering what led you to that magnitude of reserve building.

James Dimon

Lower covenants, more leverage --

Michael J. Cavanagh

Yes, I mean --

James Dimon

-- exactly the stuff we’re talking about.

Ron Mandel - DIC

Well, but I thought that those loans, the type of loans you just referred to with lower covenants and so on were in held for sale, so they would be marked down through the FIC line and not reflected in the reserve.

Michael J. Cavanagh

Yes, but the reserves, a lot of this reserve stuff was for ALRC, which is the stuff that’s not on the -- commitments not on the balance sheet.

Ron Mandel - DIC

ALRC is what?

Michael J. Cavanagh

Allowance for lending related commitments. So the allowance for loan ratio, for allowance to loans is stable quarter over quarter at 176 basis points. So really, no change there and we just, lending related commitments, so undrawn exposures. That’s where really the quarterly increase in reserves went.

Ron Mandel - DIC

But if the exposures are, become -- don’t they go directly into loans held for sales if they are part of a syndication process and never actually get reflected as loans that would be hit by the reserve, I guess?

Michael J. Cavanagh

Correct. That’s the accounting.

James Dimon

Then you would have a flip in reserve and we’d just simply move to another category.

Ron Mandel - DIC

Okay, and related to that, as you’ve said, you had some mark-to-market of hung bridges and so on in the quarter, from loans available for sale in the second quarter. But a lot of the deterioration within the, you know, after June 30th and I guess I’m wondering if conditions at the end of the quarter were the same as today, whether the mark in loans available for sale would be greater than what we saw in the second quarter, or what you reflected in the second quarter?

James Dimon

I don’t know what you saw at the end of the quarter but --

Ron Mandel - DIC

Well, I didn’t see it but I meant what you said was reflected in FIC revenue in the quarter.

James Dimon

I would say it’s all reflected in there, okay? I don’t think this happened the last 17 days.

Ron Mandel - DIC

I’m not following you, Jamie, in that regard.

Michael J. Cavanagh

For the stuff that we are talking about the existed issues on the financing front now or at the quarter end, there’s no material change from where we were at quarter end to now, Ron.

Ron Mandel - DIC

Okay, that’s very helpful, thanks. And then, just one other reserve related question and that was in the home equity, where you increased the allowance by $329 million and you said that was related to 25 basis points. But 25 basis points of the $91 billion would be about $225 million, so I’m wondering what the difference reflects there -- between the 329 and the 225, that would be 25 basis points of the $91 billion.

Michael J. Cavanagh

I can take you through the math offline, but basically the answer is that it’s reserves that we think are appropriate relative to the expected loss in that portfolio and it does translate to dollar loss per quarter, going from about the $98 million you saw in this quarter out to, ramping up to 150, 160 like I said. We can come back and prove out the math for you.

Ron Mandel - DIC

If you got to 160, would that come out of the reserve and you wouldn’t make additional provisions?

Michael J. Cavanagh

No, I think it’s basically saying it’s covering for a charge-off rate that would run through P&L at that level with no need to take reserves higher. If that’s what we experience in losses, there’s no need for us to further strengthen our reserves.

Ron Mandel - DIC

Right, so the reserve wouldn’t change but you’d just have a provision equal to the higher charge-off?

Michael J. Cavanagh

Correct.

Ron Mandel - DIC

Okay, good. Thanks very much.

Operator

That does conclude our Q&A session. Mr. Dimon, Mr. Cavanagh, I would like to turn the call back to you for any additional or closing comments.

Michael J. Cavanagh

Thank you very much, everybody, for dialing in and we look forward to talking to you next quarter. Take care.

Operator

That does conclude today’s conference call. Again, thank you for your participation and have a good day.

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