The mixed performance in the second quarter of JP Morgan’s investment bank – which may not be quite as profitable as it looks – signals grim reading next week for its main US rivals.
Strip away the noise around the $5.1bn in trading losses in the chief investment office at JP Morgan Chase, the restatement of its first quarter earnings, and the distracting chaff of some neat accounting effects. Surely there is some good news from JP Morgan’s investment bank – which has shown the rest of Wall Street a clean pair of heels over the past few years?
On the face of it, the answer looks like a qualified yes. Reported revenues and pretax profits were down by just 7% on last year. Pretax return on equity was a top-of-class 29%.
But scratch a little deeper and the answer is less encouraging. Once you strip out the gains on JP Morgan’s own debt – which as Jamie Dimon is fond of reminding us have no impact on underlying performance – JP Morgan seems to have struggled in the second quarter.
Revenues from capital markets (that is, FICC, equities and investment banking) fell by 21% compared with a year ago, while pretax profits are down by 27%. Pretax return on equity shrinks to just 22%, compared with 30% a year ago and 35% in the first quarter of this year (a full chart of JP Morgan’s underlying results for the second quarter is below).
Compared with the first quarter of this year, capital markets revenues fell by 26%, while pretax profits tumbled by 37%. On the plus side, this is better than my own forecast of a fall in pretax profits of 43% from the first quarter. This is mainly due to brutal cost control (the bank slashed expenses in the second quarter by 20% compared with the first) and slightly better than expected investment banking revenues (which fell by just 9% compared with a forecast of 20%).
On a less positive note, FICC revenues collapsed by 30% compared with the first three months of the year and equities were down by 27%. Looking into next week, when the rest of Wall St reports its second quarter results, it is hard to avoid the feeling that other banks will be hit just as hard – if not harder – by the decline in activity and revenues, and that their costs will prove less flexible.
Take a step back from the the past three months and the results point to a relentlessly downward trend. On a trailing 12 month view (in other words, over the past four quarters), capital markets revenues of $23bn at JP Morgan have fallen by 16% compared with the same 12 month period a year ago. Underlying pretax profits of $8.0bn over the past 12 months are down by more than a quarter compared with a year ago, and by more than a third over two years:
And this from the ‘best’ investment bank on the street (although admittedly the competition has not been particularly stiff over the past few years)…
Too good to be true?
To make matters worse, there are lingering questions over whether the investment bank at JP Morgan is quite as profitable as it says. It’s pretax ROE of 22% in the first quarter is based on allocated equity of $40bn. This has long looked generously low, and it could be about to go up.
In the wake of the trading losses by the London Whale, the bank’s remaining synthetic credit positions are being transferred across to the investment bank (where arguably they should have been sitting all along – if indeed they should have existed at all). This will add around $30bn in risk-weighted assets to the investment bank, which logically should mean an increase in equity – and, by definition, a fall in profitability.
JP Morgan doesn’t say what its RWAs are for the investment bank, but we know from a presentation in February by its chief executive Jes Staley that they were $457bn at the end of last year on a Basel III basis. Assume that the bank is halfway through its planned ‘RWA mitigation’ exercise to reduce these by $54bn over the course of the year, and you are left with RWAs of $440bn. Add on $30bn and you have $470bn. Against this, $40bn of equity – a ratio of just over 9% – looks a little thin. Bump that ratio up to a more conservative 10%, and equity in the investment bank would increase to $47bn.
This of course reduces ROE – to 18.6% in the second quarter at a pretax level or roughly 13% net. There are also concerns over whether JP Morgan fully allocates some of its central costs to its investment bank and other divisions, which could flatter its performance. Assume that one third of the unallocated costs in the corporate centre are carried by the investment bank and you get a pretax ROE of 17%, or roughly 12% net.
This figures looks suspiciously close to the headline estimate of its cost of equity of 12%. In other words, we are left with the worrying conclusion that if the ‘best’ investment bank on Wall St can’t beat its cost of equity, what hope is there for everyone else…?