JPMorgan and the Concentration of Risk

Should the economy worsen dramatically over the next several years, the rescue of Washington Mutual (WM) by JPMorgan Chase (JPM) will be remembered as the event that brought the American financial system to its knees.  While the terms garnered by JPMorgan may appear favorable on first review, the deal raises far more questions then it answers in regards to the health of the financial system of the United States.  There is a significant possibility that this rescue may have begun the process by which the financial risk of lesser banks is thrown upon the three majors in an attempt to save the entire financial system.

In concentrating the financial risk of our system in JPMorgan, Citigroup (C) and Bank of America (BAC), there is the acute chance that we will inadvertently kill our rescuers, leaving us no choice but to rely on a federal assumption of banks that are truly too big to fail.  Should the economy take a dramatic turn for the worse and unemployment rise dramatically, JPMorgan’s current loss assumptions will prove shortsighted.  As we have seen over the last several months, when such assumptions are realized by the investment community to be inadequate, terrible things happen.  JPMorgan with its massive derivative exposure can ill afford the unfortunate series of events that will undoubtedly come about should the losses associated with the Washington Mutual acquisition prove considerably larger than currently expected.  

Based on JPMorgan’s current estimates, the purchase of Washington Mutual will cost the venerable bank very little, namely a $1.9B dollar payment to the FDIC, an $10B dollar capital raise and a $31B dollar write down of the firm’s newly acquired loan portfolio.  While I certainly have no qualms with the first two items, the third appears to be questionable.  Below is a table of JPMorgan’s assumed losses on Washington Mutual’s loan portfolio:

	Projected Remaining Losses as of 9/30/08 ($B)	Estimated Balance as of 9/30/08
Option ARMs	$10.346	$50.300
Mortgage	2.183	51.100
HE Loans & Lines	11.739	59.500
Subprime	6.438	15.100

The home equity (HE) and mortgage loss assumptions are almost laughable in my opinion, as they place far too much faith in Washington Mutual’s underwriting capabilities.  Unless there is a profound turnaround in the real estate markets out West, I simply do not see how losses on the home equity loans will not be much higher than currently expected.  It seems reasonable to me that JPMorgan should have marked the loss assumptions for home equity loans up to such a level that they match the percentage decline of home prices in the most depressed housing markets. 

According to JPMorgan’s own assumptions, the company expects losses to expand to $42B should the recession deepen, and to $54B should the recession become “severe”.  These figures would represent an $11B and $23B dollar reduction of capital at the bank on top of the $31B dollar write down that JPMorgan has agreed to take initially.  It is important to note that these figures take into account 7.5% and 8.0% unemployment respectively.

Throughout the credit crisis, and for that matter throughout its history, JPMorgan has been viewed as having a fortress-like balance sheet.  The Washington Mutual acquisition should put to an end this belief in the impenetrability of JPMorgan’s balance sheet, especially if the economy were to worsen.  At the end of September, JPMorgan will have a capital base of $107B and a Tier 1 Capital Ratio of 8.3%.  While the company’s capital base will have increased from $99B at the end of June, the Tier 1 Capital Ratio will have fallen dramatically as it stood at 9.2% in June.  Such a rapid decline in this key metric is appalling, as it would suggest that JPMorgan is now nothing but a mere mortal.  

Should the country enter a “severe” recession, as defined by JPMorgan, the company would find itself with a Tier 1 Capital Ratio that would be quickly approaching 7% (barring additional capital raises).  When compared to its peer’s capital ratios, which can be found here, we would see that JPMorgan would have the lowest capital ratio of them all should events unfold in such a manner.  The loss of its fortress like balance sheet will likely place the company under considerable strain as it will force it to restrain its derivative and investment bank operations.  The future, while still existing for JPMorgan, has gotten bleaker with the acquisition of Washington Mutual.  If we were to continue with the “fortress” metaphor, it is as if Jamie Dimon has lowered the drawbridge, raised the gates and proceeded to welcome the Barbarians into Camelot. 

For Further Review:

NY Times Article on the Deal

JPMorgan Presentation 

Disclosure: None

Comments

[Philly Jim:]

The risk was already consumed by the banks being taken over, now they are being eaten up by the bigger banks for a bargain, the whole idea of consolidation into just a few mega banks is manifesting from this credit crisis. When loans were being given to people for hundreds of thousands of dollars after they had just recently filed bankruptcy (2003-2005), you have to wonder, who gave the green light on these subprime loans? It didn't come from the bottom, it came from the top. Interest rates slashed to their lowest, and at the same time free money without a down payment for people with horrible credit and you try to tell me this financial crisis wasn't anticipated? Perhaps a grand opportunity to operate in a new highly competitive global environment without worrying about paying taxes on profits for years, and being able to acquire good assets for pennies was the ultimate plan?!? Maybe it is something that needs to be done to prevent communist owned banks from taking over the world with all their concentrated wealth, how can the West compete with thousands of little banks spread out over an ideal capitalist society?

2008 Sep 26 02:28 PM

[Jimmy Lathrop:]

As opposed to much of the drivel peddled on the internet, this was an extremely informative and well-written piece. Thank you very much.

2008 Sep 26 08:42 PM

[morosem:]

<quote>
Should the country enter a “severe” recession ... the company would find itself with a Tier 1 Capital Ratio that would be quickly approaching 7% ... When compared to its peer’s capital ratios, ... we would see that JPMorgan would have the lowest capital ratio of them all should events unfold in such a manner.
<unquote>

Is the author of this article suggesting that if USA enter a “severe” recession, only JPM's Tier 1 Capital Ratio would be impacted adversely while all the other banks' would not?

2008 Sep 26 11:13 PM

[dixie:]

It appears there are approximately 6 guerilla banks operating in the country. These monster banks have big appetites. It appears that the Federal Government plans to satisfy their hunger by throwing them most of the mid-size and smaller banks as food.

A few years downstream our country will truly be a "planet of apes."

2008 Sep 26 11:23 PM

[Steven Hansen:]

i share the concern of this consolidation cycle creating superbanks and eliminating competition. already Bank of America's purchase MBNA has changed the terms for the worse on your credit card use (hidden charges and fees on using your credit card overseas).

on the other hand, it might be easier for the federal oversight agencies as most of America's deposits would be in just a few banks.

there is no win-win here.

2008 Sep 27 03:04 AM

[The Realist:]

HE Loans & Lines are barely 20% writedown. This is insane.

For example, if you purchased a house in 2003 at $300k and its value went up to $400k and you took out a $50k line of credit life was good. But when that home dropped back down to $300k you now have a HELOC that has no equity behind it.

These HELOCs are not percentage writedowns, they are 100% writedowns on many of them. To assume only 20% will be written down is nuts.

2008 Sep 27 05:38 PM

[nyka:]

Philly Jim -- Were you bitten by periods as a youth? Why else would you avoid them? By now, you should know that periods or semi-colons -- not commas -- seperate independent clauses (complete thoughts). Try using them; they really don't bite, despite what you were told in the third grade.

2008 Sep 27 10:09 PM

[nyka:]

The hand -- try capitalizing the first words of sentences. That's something you should have mastered in the third grade. You did complete the third grade -- didn't you?

2008 Sep 27 10:11 PM

[nyka:]

Who's the author of this piece -- the mayor of Doomsday City -- or just a former holder of Washington Mutual stock?

2008 Sep 27 10:13 PM

[Kinabalu:]

Federal bank regulatory authorities started pushing bank consolidations as a way to lessen banking risk almost 20 years ago (the early '90s). It might have been a good idea then (most of the 2300 banks and S&Ls closed in the late '80s and early '90s were small) but now we are seeing the other side of the problem. Too big to fail is a much bigger problem than too small to care about.

2008 Sep 28 02:39 AM

[sumosama:]

Great article! Thanks for the facts and research!

2008 Sep 29 11:10 AM