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How J.P. Morgan is proceeding with extreme caution—and still making plenty of money

If a modern-day Rip Van Winkle had been slumbering since February and just awoke to read J.P. Morgan’s headline numbers for Q3––before witnessing the masked throngs and boarded-up storefronts––he wouldn’t know that an economic crisis is ravaging American.

Before the market close on October 13, the banking colossus smashed expectations by announcing $9.4 billion in net income, the second-highest quarterly number in its history. That’s a 4.4% gain over Q3 on $29.15 billion in revenues that slipped just a hair from last year. Wall Street analysts were forecasting a 2% fall in sales and 12% drop in profits, the latter driven by another big slug of provisions to cover future loan losses. The analysts reckoned that J.P. Morgan would book $2.8 billion in credit costs to bolster its reserves for looming write-downs that it hadn’t seen coming in the previous two quarters.

As it turned out, J.P. Morgan took around one-fifth of the predicted provisions. That underscores the most important takeaway from the release and conference call: The consumer and even most corporate borrowers are looking like much better credits than a few months ago as the economy rebounds faster than expected. The big unknown is whether the meltdown that appeared to be around the corner is lurking down the road.

In one of his most noteworthy statements, CEO Jamie Dimon declared that credit losses will remain mild until late next year. He says that’s mostly because the government’s unprecedented government aid to families and businesses, and the banks’ forbearance programs, have delayed defaults or months that would have come far earlier. CFO Jennifer Piepszak provided a rough timeline. “We’ll see delinquencies pick up in early part of 2021, and charge-offs will come in the back half,” she said.

Asked to put a number on how big those charge-offs could be a year hence, Dimon and CFO Jennifer Piepszak declined to even venture a guess. Dimon said that although more rounds of stimulus would “improve the picture,” by far the biggest factor is the pace and durability of the recovery, and how fast lost jobs return. Because the outlook is so uncertain, Dimon said, J.P. Morgan is basing its estimates of future losses on a scenario that’s lot more negative than the Federal Reserve’s “Base Case” numbers that forecast positing an stubbornly- high unemployment rate 7.7% in Q4 of next year, and national income running 2.4% below last year’s levels.

The big positive is that J.P. Morgan has plenty of capital to withstand future losses, and keep credit flowing, even in the direst of scenarios. In fact, its position epitomizes how much better fortified lenders are today than at the dawn of the financial crisis. “It’s night and day,” says David Fanger, SVP of the Financial Institutions Group at Moody’s Investors Service. “The big banks are far stronger in capital and liquidity. They’re holding much bigger credit reserves than at this point in the cycle in 2008.” He adds that the Fed-imposed cap on dividends and prohibition on share buybacks is forcing them to horde cash that further buttresses their balance sheets. Another safeguard: New accounting rules requiring lenders to take all anticipated losses, over the entire life of their loans, not when they stop paying, but when analysis of shifts in the economic climate show they’re likely to go bad in the future.

Despite his caution on forecasting the fate of the consumer who will determine the bank’s future profitability, Dimon made two observations that showed optimism. First, he hopes that the Fed will lift restrictions on stock buybacks soon so that “we’re allowed to do it before the stock is much higher.” That comment suggests Dimon sees no need to keep accumulating earnings previously spend on repurchases as an additional buffer for future losses. Second, he revealed that prudently navigating the pandemic doesn’t rule out acquisitions. Dimon revealed the J.P. Morgan’s in the market for an asset manager. “Our doors and telephone lines are wide open,” he said. “We’d be very interested. We do think you will see consolidation in the business.”

Here are five trends that stood out in the Q3 report.

Trading and investment banking

The shift in J.P. Morgan’s profitability from the biggest traditional source, the consumer, to trading and capital markets, is nothing short of astounding. The much-criticized universal bank model is demonstrating what Dimon always claimed was a big plus, that it offers broad diversification by uniting businesses that rise and fall at different times. The waxing in those Wall Street staples as the results in consumer wane is what’s supporting J.P. Morgan in the crisis.

The Corporate & Investment Bank, one of the four major profit centers, posted net income of $4.3 billion, triple the figure in Q3 of 2019. The star was trading, or what’s called “markets.” Bond, commodity and equity trading combined garnered nearly $7 billion in revenue, up 27% year-over-year. Investment banking revenues, propelled by the surge in new IPOs, were also extremely strong. All told, the C&I segment accounted for 46% of J.P. Morgan’s profits, up 31% in the year-ago period.

Consumer lending

In Consumer & Community Banking, revenues and profits both retreated by 9%, with earnings falling $4.25 billion to $3.87 billion. That shrank the segment’s share of total profits from around half through all of last year to 41%. The reason for the pullback is two-fold. First, the pandemic has pummeled demand for consumer loans. In the past year, the combined portfolio for home, auto and credit cards has fallen from $384 billion to $332 billion. Second, the interest collected on the average loan shrank as Fed’s flooded the markets with liquidity to counter the COVID crisis, shrinking rates across the entire spectrum of lending. Interest income dropped by $1.1 billion or 13% in Q3 versus Q3 of last year.

An exception to the retreat was a jump in lending to small businesses driven by the federal Payroll Protection Program that guaranteed loans to employers that kept their workers employed. The initiative doubled J.P. Morgan’s portfolio to the likes of restaurant chains and contractors to $44 billion in the past several months.

Credit costs

The report’s most astounding feature is the unexpected drop in credit costs from crisis heights to below where they stand even in good periods. The shift from a sharp spike and steep fall are partly explained by a radical change in the accounting standards that dictate how banks must treat credit expense. Until this year, lenders booked credit costs, called “provisions,” mostly based on the length of time loans were delinquent. So in a bad economy, as more and more customers stopped paying, the credit costs would keep mounting quarter after quarter.

But at the start of 2020, the Financial Accounting Standards Board overturned the old regime. FASB stipulated that banks take a hit on all loans on their portfolio that the bank’s models forecast will go bad at any time in the future, even if the home or business owner was still paying right on time. The arrival of Current Expected Credit Loss provision, or CECL, coincided with the onset of the pandemic. The upshot: Banks took gigantic losses in Q1 and Q2 in a big, upfront wallop that in past crises, they’d have parceled out over many quarters.

J.P. Morgan was no exception. In 2019, its credit losses were running at roughly $1.5 billion a quarter. The entire industry was benefiting from a balmy climate where relatively few car, credit card or small business loans were going into default, a benefit that countered the drag of low rates and brought one of the best runs in banking history. When the world changed in Q1, J.P. Morgan followed the CECL guidelines by taking a $8.3 billion blow for all the losses it saw coming. Then when the outlook turned darker in Q2, it too another $10.5 billion in provisions. In just two quarters, J.P. Morgan absorbed a blow that was six times bigger than the total damage for 2019, with two-thirds coming on the consumer side. Hardest-hit was the $140 billion credit card portfolio.

It appears that J.P. Morgan did a good job estimating those future losses during the depths of the crisis. In Q3, the bank registered credit losses of just $611 million, 6% of the figure in Q2. In the consumer bank, the number dropped from $5.8 billion to $794 million. Overall, J.P. Morgan registered around $1.2 billion in losses on loans that looked alright in Q2 but that it now deemed would go bad. It also took “reversals” for mortgages and corporate credits that came due, and that borrowers paid back, money that flowed back into earnings. So the cost of $611 million is actually the net of the new hit from CECL, and the loans it reckoned were going bad, but that customers repaid, providing a kind of windfall.

The future

CECL is forcing lenders to assess potential losses far into the future. The new rules have provided added shelter against the COVID hurricane. What’s remarkable is that so far, J.P. Morgan is seeing a tiny fraction of its loans go delinquent. In the $438 billion consumer portfolio, only 1.62% of home loans are 30 or more days past due, the same fraction as a year ago, and in cards, the non-payment rate of 1.57% is well below the mark in September of 2019. The reason: So far, more people have been paying down or retiring their card balances than are falling behind.

J.P. Morgan’s followed CECL by taking $20 billion in upfront credit expense in just three quarters for good reason. Those provisions signal that its models predict that it will actually write off that dollar amount in loans in future quarters. Of course, that $20 billion hit assumes an economy much worse than under the Fed scenario. On the conference call, Dimon and Piepszak cited that although forbearance has ended for auto and card loans, it’s still allowing customers with $28 billion in mortgages to defer payments. As all the deferrals programs run out, and aid from the stimulus fades––unless a new one is forthcoming––defaults will inevitably rise starting in 2021, and as Piepszak noted, lead to a surge in actual charge-offs late in the year. She’s also expecting trouble from airlines, retailers, hospitality, and other service sectors roiled by the pandemic.

But keep in mind, J.P. Morgan has already taken the $20 billion hit upfront. For the bank to face more loan losses, the consumer will have to suffer far more stress over the next year or two than shown under its conservative projections for the economy’s future. The big question is whether things will get that much worse.

Deep reserves

Right now, it’s remarkable that J.P. Morgan has managed to build a thick cushion against future losses, and still generate substantial earnings over and above what it’s putting aside. But can that trend continue? J.P. Morgan now holds $34 billion in reserves for future loan losses, a $20 billion or 142% increase from the start of the year. On the call, Dimon said that if the recovery tracks the Base Case scenario, J.P. Morgan will have $10 billion in excess reserves that it won’t need. Recouping reserves would provide a big lift to future profits.

What J.P. Morgan has going for it is a combination of gigantic reserves and big earnings power that would enables it swell its reserves if things get much worse, and still have plenty of profit left over. On the call, Dimon pointed out that after paying the regular $2.5 billion dividend and covering loan loss provisions in Q3, J.P. Morgan booked $7 billion in extra earnings that it added to capital, providing a stronger bulwark for future credit losses.

J.P. Morgan’s in no danger of getting in the same kind of trouble that crippled banks in the great financial crisis. Still, if the U.S. enters a period of grinding long-lasting unemployment, it could still take more CECL hits––as well as suffer from flagging loan growth––that could make it a lot less profitable than in last year’s golden days, or even in the last quarter. Wall Street certainly isn’t convinced. Its share price fell 1.6% following the strong Q2 report, and its price-to-earnings ratio is languishing at a paltry 13.

Chris Wolfe, an analyst for Fitch Ratings, sounds a note of caution. “The banks are significantly better off than in the global financial crisis,” he says. “They should be well-reserved through into 2021. But it’s too early to tell how adequate their reserves are over the cycle. We’ll have to see the progress in containing the pandemic, and see how the employment data rolls in.”

So far, J.P. Morgan is proceeding with extreme caution, and still making plenty of money.

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