Jamie Dimon Unbound

Jamie Dimon, the chief executive of JPMorgan Chase, chided elected officials yesterday in a withering, no-holds-barred speech at Harvard University, where he earned his masters in business administration.

Dimon, whose bank is estimated to receive $25 bn in taxpayer bailout money, criticized the government's slow decision-making, charging that the US government suffered "institutional sclerosis...[and was] unable to make a decision to make this country healthy."

The speech came a day before JPMorgan (JPM), the largest U.S. bank by market value, released a mixed third quarter earnings report, and within hours after Dimon's bank was forced by US Treasury Secretary Henry Paulson to sell a $25 bn stake in the form of dilutive preferred shares to the government.

Mixed report, in that without a special one-time gain the bank garnered due to Dimon's tough dealmaking in buying Washington Mutual, JPMorgan's profits would have dipped into the red. 

JPMorgan can use the $25 bn it is expected to get from the government, as that injection represents a fifth of its severely battered net worth as the company is now digesting the severely damaged real estate assets it picked up from buying WaMu and Bear Stearns.

JPMorgan bought the collapsed Bear Stearns firm last March, and just over six months later, bought the near-dead Washington Mutual. 

However, like other banks in the bailout, JPMorgan's future earnings will get dinged due to the stiff dividend payout the government is demanding on its equity stake in the bank.

And like other banks, despite its heavy exposure to beaten-up housing markets in California and Florida, JPMorgan is using rosy estimates for house price declines, which helps its earnings as it doesn't have to set aside more in cookie jar reserves.

Although the program is voluntary, Treasury essentially forced nine major U.S. banks, including JPMorgan, to take a total $125 bn investment from the federal government.

Treasury will invest $25 bn in preferred stock in Bank of America (BAC)--including soon-to-be acquired Merrill Lynch (MER)--as well as in JPMorgan and Citigroup (C); $25 bn in Wells Fargo; $10 bn each in Goldman Sachs Group (GS) and Morgan Stanley (MS); $3 bn in Bank of New York Mellon (BK); and about $2 bn in State Street (STT).

The remaining $125 bn will be parceled out among the 8,400 banks and thrifts nationwide who apply.

JPMorgan's Mixed Profit Report

JPMorgan Chase posted an 84% fall in third-quarter net income to $527 mn, or 11 cents a share, after $5.8 bn in writedowns, losses and credit provisions, versus $3.4 bn, or 97 cents a share, a year earlier. Shares in JPMorgan rose as earnings beat the 21-cent loss analysts predicted on average.

However, the bank's latest earnings report shows how Dimon's hard-charging dealmaking is anything but sclerotic, as it helps his bank's profit results.

JPMorgan bought WaMu for a bargain basement price of $1.9 bn. Buried in a footnote, you'll see that the value of the hard assets JPMorgan picked up in the acquisition exceeded this garage sale price, so JPMorgan got to book a $581 mn extraordinary gain.

Without that gain, JPMorgan would have lost 6 cents a share, which would have still beaten analysts' estimated 21 cents a share loss. Though that is still not a positive result, JPMorgan is swallowing billions of dollars in potentially bad assets from WaMu.

Estimates have it that to date, JPMorgan has taken $18.8 bn in writedowns and credit costs, about a third of what Wachovia Corp. and Citigroup each have reported.

"Given the uncertainty in the capital markets, housing sector and economy overall, it is reasonable to expect reduced earnings for our firm over the next few quarters," Dimon said in a statement.

"However, with a total loan loss allowance of $19 bn (including Washington Mutual) and an 8.9% Tier 1 capital ratio, we feel well-positioned to handle the turbulent environment and, most importantly, to continue to invest in our businesses and serve our clients well," Dimon's statement added.

JPMorgan's latest results include $3.6 bn in mortgage-related net mark-downs and a $642 mn loss on Fannie Mae and Freddie Mac preferred securities.

The results also included $640 mn of losses tied to the company's takeover last month of Washington Mutual. 

Warning signs abound, however. JPMorgan says it had total nonperforming assets of $15.9 bn at September 30, 2008, up from the prior year level of $3 bn. That included $8.1 bn from WaMu.

Non-interest expense was $11.1 bn, up $1.8 bn or 19% fm prior year, driven by higher compensation expenses and costs from the Bear Stearns takeover. 

Shareholders equity stood at $137.7 bn, but the bank did not release full financial results including a balance sheet, making it difficult to ascertain the health of its assets and liability.

And while a highlight of JPMorgan's Bear Stearns rescue was the notion that JP coveted Bear's brokerage unit, that unit contributed a measly $93 mn to the parent's overall $14.7 bn in net revenue.

Also, assets under management firm-wide were $1.2 tn, down $10 bn, or 1%, from the prior year, "due to lower equity markets and equity product outflows, offset by liquidity product inflows across all segments and the addition of Bear Stearns assets under management," JP said in a statement.

JPMorgan raised $11.5 bn selling common stock Sept. 26 after announcing that it took over the deposits and branches of ailing Washington Mutual.

Banks and securities firms globally have reported almost $640 bn in losses, writedowns and credit provisions since the start of 2007, according to data compiled by Bloomberg. They've raised $611 bn in capital to offset those losses, Bloomberg estimates.

Merrill Lynch, which Charlotte, North Carolina-based Bank of America is buying, may post a net loss of $7.68 bn tomorrow, because of $10 bn of writedowns on loans and bonds, according to an Oct. 8 report by Morgan Stanley analyst Patrick Pinschmidt.

Dimon Criticizes Wall Street

In his speech at Harvard, Dimon also said that not all business executives were corrupt fat cats, a charge that's taken on extra valence during this election season as US taxpayers have been forced to bail out rampant recklessness on both Wall Street and Main Street.

Dimon made the wide-ranging speech, touching on topics such as US energy policy and executive pay, as political chatter has it he may be tapped to be the new Treasury Secretary in a Barack Obama administration.

"There is a belief that somehow every business person is corrupt. Some of these companies are more charitable and more honest than the average congressman," Dimon said, adding though that "a lot of people made a lot of money who did not deserve it. That is a fact."

But Dimon also shot some arrows at slow-off-the-mark Wall Street executives, in a veiled aside many believe was aimed at Lehman Brothers' Richard Fuld.

"I am shocked at the number of people who were just looking at the train coming down the tracks and were still worrying about whether they had a strategic plan for 2009. We cancelled all that. We cancelled all trips, all travel. We needed to have a sense of urgency and a lot of people did not have the ability to act," Dimon said.

And Dimon attacked Wall Street for jerryrigging complicated derivatives such as collateralized debt obligations (CDOs) that not even the Street's executives understood. "CDOs squared? What the hell were we thinking? These things were way too complicated," he said.

Bank Borrowing Costs Still High

Meanwhile, the costs for banks to borrow money from each other are stuck at unusually elevated levels despite synchronized, coordinated action by governments around the world to stop the credit crisis.   

Three-month Libor, the most important interbank lending rate that is used to price all sorts of loans, has barely budged at about 6.25%.

How the Government's Equity Stake Works

The terms of the government's preferred shares investment restrict banks' use of capital. Banks taking part in the government's preferred stock investment plan must pay a rich 5% dividend during the first five years of the investment, which then rises to 9% after the fifth year.

Participating banks can't hike their dividends during the first three years of the investment, unless they redeem or transfer the Treasury's shares. That means they can't cash out of the government's stake for three years unless they do so with another dilutive equity raise.

Despite the fact that preferred shares are non-voting, Treasury also gets to approve any stock buyback plans. Also, banks can't offer golden parachutes to incoming executives they hire to salvage their banks, though existing compensation plans stay intact.

On top of all this, the Treasury also has the right to buy common stock equal to 15% of its total investment in the firm, in a bid to show taxpayers it means it when it says it wants to make a profit off of this injection. The government has the option to convert these warrants into stock, giving it a larger stake in the bank while diluting existing shareholders. Also, Treasury can sell the warrants, earning taxpayers money if the share price rises.

What the Government's Investment Means for the Banks

According to Meredith Whitney, a top bank analyst at Oppenheimer Equity Research, based on most recently reported data, the capital injections provide a healthy boost to the nine banks' book value, loosely understood as net worth (assets minus liabilities). The taxpayer funds represent anywhere from a low of 13% to a high of 52% of total shareholders' equity at the nine financial institutions.

Specifically, for Morgan Stanley (MS), the $10 bn injection represents 28% of total shareholders' equity. For Wells Fargo (WFC), the $25 bn injection represents 24.8% of equity, Whitney estimates.

For Citigroup (C), the $25 bn injection represents 18.3% of equity. For JPMorgan Chase (JPM), the $25 bn injection represents 18.8% of equity. For Goldman Sachs (GS), the $10 bn injection represents 21.9% of total equity. For a combined Bank of America (BAC) and Merrill Lynch (MER), the injection represents 12.6% of equity, Whitney says.

The Government's Dividend Demand Hurts

However, the preferred shares' dividends will sting, especially since they come out of after-tax results, Whitney says. Based on the latest available data, the dividend costs range from $500 mn after tax for the $10 bn capital injections to $1.25 bn for the $25 bn injections, Whitney estimates.

On a per share basis, for Goldman, the annual preferred dividend cost per share is $1.12, or 12% of Whitney's per share earnings estimate for 2009 of $9.21.

For Morgan Stanley, the annual preferred dividend cost is 47 cents a share, or 15% of Whitney's 2009 estimate of $3.16. For Bank of America with Merrill, the annual preferred dividend cost per share is 24 cents a share, or 12% of Whitney's 2009 estimate (which does not include Merrill) of $1.95.

For Citigroup, Whitney figures the annual dividend cost per share is 22 cents a share. For JPMorgan, the annual dividend cost per share is 35 cents a share, or 18% of Whitney's 2009 estimate of $1.95. For Wells Fargo, the annual dividend cost per share is 38 cents, or 25% of Whitney's 2009 estimate of $1.95 (neither the share count nor estimate reflect the Wachovia transaction, Whitney notes).

Government's New Warrants Costly, Too

Along with the capital infusion, the Treasury gets warrants to buy shares equal to 15% of the amount of preferred shares issued. Whitney says the banks' shareholders get to weigh in here, and if they do not consent, the warrants' price will be reduced by 15% every 6 months, up to 45%.

But after 18 months, and without shareholder approval, the Treasury can swap the warrants for other securities at the Treasury's discretion.

If the government does exercise its warrants, expect even more shareholder dilution beyond the preferred shares investment.

For Goldman Sachs, Whitney estimates 12 mn warrants for the Treasury, representing 2.7% dilution. For Morgan Stanley, Whitney figures 67 mn in warrants, representing 5.9% dilution. For Bank of America, an estimated 123 mn in warrants, representing 2.3% dilution.

For Citigroup, expect an estimated 210 mn in warrants, representing 3.5% dilution. For JPMorgan, expect an estimated 88 mn in warrants taken by the government, representing 2.4% dilution. And for Wells Fargo, Whitney estimates 110 mn in warrants, representing 3.2% dilution.

But say the banks say forget it, we want the government out of our businesses. Another stiff price to pay here too. To redeem the Treasury shares, in the first three years, the institution could be forced to do another dilutive equity offering.

The government has given the banks an incentive to raise capital. If the bank raises more equity than the amount of the preferreds by Dec. 31, 2009, the amount of shares represented by the warrants will be reduced by 50%, Whitney says.

Government's Investment Eases Leverage Ratios

The government's capital injection will lower capital leverage ratios for the banks taking the government's offer, Whitney says.

But even with the injections, Goldman Sachs and Morgan Stanley continue to look over-levered relative to their new bank peers, Whitney says. Goldman's leverage ratio as of the third quarter was 23.7 to one, and on a pro forma basis, the injection lowers the ratio to 19.5, Whitney figures.

Morgan Stanley's leverage ratio at 3Q08 was 27.6, and on a pro forma basis, the injection lowers the ratio to 21.6 to one, Whitney estimates. The leverage ratio for Bank of America (including Merrill) was 13, and on a pro forma basis, the injection lowers the ratio to 11.6.

Citi's leverage ratio was 15.4, and on a pro forma basis, the injection lowers the ratio to 13.

JPMorgan's leverage ratio was 13.3, and on a pro forma basis, the injection lowers the ratio to 11.2.

Wells Fargo's leverage ratio was 12.7, and on a pro forma basis, the injection lowers the ratio to 8.3.

Can Banks Earn Their Way Out of the Mess?

Whitney warns the road is rocky here, given the fundamentals of home price declines.

A brief history from Whitney, taken directly from the analyst's report:

Home prices in the US took off post 1994 as more could qualify for mortgages and mortgages were easier to come by. Home ownership grew from a base of 64% to a peak of 70% while mortgage securitization volumes grew annually from $35 bn in 1993 to over $900 bn in both 2005 and 2006.

But since the onset of the credit crisis over 14 months ago, less than $100 bn worth of mortgage securitizations have been done and accordingly, today home ownership stands at 68%.

With no hope for the return of mortgage securitization and overall liquidity continuing to dry up, Whitney believes that fewer mortgages will be available, fewer people will qualify for mortgages, and home ownership will head materially lower. All of these factors create a recipe for meaningfully lower US house prices.

Due to constrained liquidity, Whitney estimates that at least 5 mn fewer Americans will be able to A) put down 20% for a mortgage, B) qualify for a mortgage, and C) find a bank to fund a mortgage.

Currently, the futures markets are pricing in returns to 2002/2003 levels. This doesn't make sense to Whitney, as she and her team ask, why stop there? Homeownership levels were higher then than today, and securitization volume was breaking out to new highs in those years.

According to the Case-Shiller Housing Composite-10 cities, housing prices have declined 20% from peak-to-trough already. Whitney argues that the magnitude of house price declines in the next few years could likely exceed beyond that of market expectations.

Housing futures imply a housing price peak-to-trough drop of 22% by November 2008, a drop of 29% by November 2009, and a drop of 33% by 2010. Under this scenario home prices would return to levels last seen about eight years ago, essentially wiping out nearly a decdes' worth of home price appreciation.

Less Liquidity Driving Home Ownership Down

Whitney says that from 1965 to 1994, the average home ownership rate in the United States was 64%.

From 1995 to 2008, the home ownership rate increased, peaking in 2004 at 69.2%. Since 2004, the rate has declined to 68.1% as of 2Q08, with an average of 68% for the year. Clearly decreases in the home ownership rate indicate a falling number of homebuyers. 

Shutdown in Securitizations a Main Driver Downwards

House prices have had an undeniable correlation with global issuance of residential mortgage securitization volume, Whitney warns.  

As Whitney has argued before in prior reports, the liquidity provided by the securitization markets was the "Great Enabler" that allowed people to buy homes with cheap financing, thus, driving up home prices to excessive levels. With the abrupt halt to securitization issuance last summer, far fewer potential buyers can find funding to "enable" purchases.

Whitney says that, when a year ago former Citi head Chuck Prince said then while the music is playing, you've gotta dance, the music was in the process of coming to a grinding halt. The shutdown in the securitization market has had a profound and underappreciated impact on consumer liquidity and home price declines.

Securitizations financed over six times the amount of mortgages as did traditional bank lending since 2000. Whitney estimates. To put into context, until 1995, securitizations had accounted for no greater than 90% of the mortgage volume of on balance sheet bank lending.

Whitney's point here is that when the securitization markets came to a grinding halt last July, liquidity dried up dramatically and almost instantaneously.

While many assume that the securitization boom began in the 1990s, it is clear from the data that the real securitization boom began this decade, Whitney says.

During the 1990s, residential mortgage securitization volumes averaged $30.2 bn on a quarterly basis. From 1991 to 1995, residential mortgage securitization averaged $9.8 bn per quarter. From 1996 to 2000, the average quarterly volume increased to $59.7 bn.

The quarterly volume for residential mortgage securitization rose above $100 bn for the first time in 2Q98. From 2001 to 2004, the average quarterly volume jumped to $174.4 bn and it further increased to $208.3 bn per quarter from 2005 to 2007.

Securitization dropped significantly to $43 bn in 4Q07 and dropped further to $33.5 bn in 1Q08. The second quarter saw a slight rebound to $60.7b, but that is still well below the quarterly averages of the past few years.

Housing Correction Exceeds Expectations

Whitney believes that the magnitude of the housing correction will be beyond that of market expectations.

The historical data of the Case-Shiller Housing Composite-10 spans back to January 1987. The house price index hit a peak in June 2006 (price index value of 226.29). January 2007 to June 2008 represents 18 consecutive months of year-to-year declines in housing prices with 18% depreciation over the period. To date,  housing prices have declined 21% from peak-to-trough. Remember, futures markets estimate declines of 33% through 2010.

Supply Outpaces Demand: Home Supply Continues to Rise

The National Association of Realtors releases existing home sale data, and existing home inventory. Currently there is 10.4 months of supply available, down from the previous high of 11.2 in April.

The US Census Bureau releases new home sale and supply data, with data dating back to 1963. As of August 2008, there was 10.9 months of supply, down slightly from the peak of 11.2 months seen in March of this year. August marked the sixth consecutive month of double digit months of inventory, a trend that has never happened dating back to 1963.

Previous highs of 11.6 months of supply were made in April 1980, with a few other months of double-digit supply in 1981. In short, the current levels of inventory are unprecedented, Whitney warns.

Foreclosures Continue to Rise

On September 5, the Mortgage Bankers Association released 2Q08 data showing a sharp rise in loans in foreclosure. The percentage of loans in foreclosure was 2.75% in the second quarter, up from 2.47% in 2Q08, reaching the highest levels on record, dating back to 1979, Whitney says.

Home Prices Down Nationally, Worst in CA, FL, and NV

According to Case-Shiller peak-to-July 2008 price decline data, the largest declines to date are in Phoenix, AZ at -34.4%, Las Vegas, Nevada at -34.3%, Miami, FL at -33.5%, San Diego, CA at -31.2% and Los Angeles, CA at -29.7%.

Despite Significant Exposure to California and Florida, Banks Still Use Optimistic Peak to Trough Assumptions

Again, the futures market is forecasting a 33% decline in house prices, from its peak in the summer of 2006 to trough into 2010.

But the banks are using much rosier forecasts that effectively boost their current earnings results (see blog "Top Analysts Warns Banks Too Optimistic About Housing").

Bank of America is estimating a 25% to 30% decline, Citi is estimating just a 23% drop, JPMorgan figures house prices will decline 25%, and before it was acquired, and Wachovia was figuring on a 20.8% drop.

These estimates matter greatly in the banks' earnings, as the estimates are used to book loan loss and other credit provisions to cover future earnings shocks.

These reserves are deducted from present earnings. Lowball the house price decline estimate, and a bank does not have to set aside as much in cookie-jar reserves.

Banks Still Overexposed to Weak Housing Markets

Whitney says the banks under her review have significant, concentrated exposure to California and Florida through their loan portfolios, particularly in mortgage and home equity.

As a result of this high exposure, losses have risen as home prices have declined to a greater degree in these states than nationally. In addition, further home price declines are expected in these states (Bank of America assumed deterioration in California and Florida in the high 30% to just over 40% for the Countrywide transaction).

Overall, the banks' residential mortgage exposure to California and Florida ranges from 33% of the portfolio to 59% of the portfolio, Whitney figures.

In percentage terms of total mortgages, Wachovia has the highest California and Florida mortgage exposure at 59%, followed by Bank of America at 41%, Wells Fargo at 37%, JPMorgan Chase at 36%, and Citi at 33%.

In dollar terms, Wachovia's California and Florida portfolio is the largest at $99 bn, followed by Bank of America at $98.8 bn, Wells Fargo at $55 bn, Citi at $48.9 bn, and JPMorgan at $22.2 bn.

Home equity loan portfolios are big here too. Whitney warns that the banks under her review have sizeable exposure to California and Florida through their home equity loan portfolios. Exposures range from 20% to 41%, making home equity less concentrated than mortgages.

In percentage terms of total home equity loans, Wells Fargo and Bank of America have the highest exposure at 41% each in California and Florida, Whitney warns.

Citi follows at 35%, with JPMorgan at 21% and Wachovia at 20% (just in Florida).

In dollar terms, Bank of America has the largest home equity exposure, with $33.5 bn in California and $16.3 bn in Florida, for $49.8b total. Wells Fargo has $31.4 bn in California and $3.1 bn in Florida for $34.6 bn combined.

Citi has $17.1 bn in California and $4.7 bn in Florida for $21.8 bn total. JPMorgan has $15.2 bn in California and $5.2 bn in Florida for $20.4 bn combined. Wachovia does not disclose its California exposure and has $12.3 bn in Florida exposure, Whitney says.