With many bank earnings now available for the second quarter, I thought I would summarize them all in one post. But there is so much useful data in the earnings results of JP Morgan Chase alone, that it seems more illuminating to start with just this bank. Prepare yourself for some serious financial porn below (lots of numbers), but don’t be afraid. You’re entitled to look. After all, if you are a US taxpayer, you own part of Chase, so these are your results as well.

The press is full of admiration for the new Big Boys on the block – JP Morgan Chase and Goldman Sachs. These are the two banks which have managed to keep their heads above water, steal market share from all their weakened competitors, and return their unwanted TARP money to the Treasury. CEOs Jamie Dimon of Chase and Lloyd Blankfein of Goldman Sachs are attributed with a special kind of financial genius that not only foresaw what was coming, but profited from the disaster. The problem with this laudation is that it is simply undeserved once you dig into their financial reports.

We’ll start with Chase because this bank divulges reams of information and normally gets credit from investors for its transparency. This quarter, we certainly have reams of information, but transparency is somewhat lacking. The reason is that the comparisons to last year’s second quarter are very confusing, since Chase had not yet merged with Washington Mutual, and Chase does not give us tables of the before and after differences. Instead, we get numbers like enormous revenue growth and record earnings that are probably only the result of the merger. We just don’t know, but it is prudent to be very skeptical of the press release exclamations over record this and record that.

Here is something else that is not only confusing, but simply bizarre. By now, one year after the merger, Chase would normally be trumpeting the success of its merger with Bear Stearns, how it has helped revenue and net income, and how the bank is ahead of its plan for obtaining synergies (that’s corporate code for how many people have been fired or quit). I’ve gone through the press release and the investor presentation and have found only one small reference to Bear Stearns. It’s as if the merger never took place and that company doesn’t exist anymore. This is also puzzling because Chase made so much of its money this quarter from investment banking and trading. Wasn’t Bear Stearns a contributor to this success?

The success looks fantastic - $1.47 billion of revenue from the Investment Banking division, compared to $304 million a year earlier – until you realize Chase earned even more from investment banking, $1.61 billion, in the first quarter of this year. The press release of course doesn’t trumpet this fact, so the press (who rarely do their own analysis of corporate earnings), doesn’t know about it and can’t therefore talk about it. It is really remarkable how what gets reported in the press is dictated almost to the letter by what a company says in its press release.

For example, the press is thrilled with the second quarter net income for Chase of $2.72 billion. This was up from $2.14 billion in the same period last year, and much more important, was well beyond what Wall Street analysts were expecting. Wall Street always concentrates on how a company performed compared to expectations, and Chase outstripped what the analysts thought it could produce. But to put this performance in context, we should look at a two year comparison.

In the second quarter of 2007 – just about the peak of the housing bubble – Chase had $19.82 billion of revenue and $4.23 billion of net income. This quarter, the new Chase had $27.71 billion of revenue, as the result of merging with Washington Mutual and Bear Stearns, but revenue has collapsed to $2.72 billion. This is a devastatingly poor performance, and that is the real story here that you are not going to read about in the press.

In fact, the situation at Chase is deteriorating, as represented by poor performance throughout the company except in Investment Banking. This too is ignored by the press, but the fact is that all the other businesses at Chase are sinking into losses or, at best, treading water. Look at some of these divisional results:

Retail Financial Services

There are two parts to this division: retail banking, which manages checking and savings accounts at over 5,200 branches nationwide, and consumer lending for mortgages, home equity lines of credit (HELOCs), auto loans, and student loans. The first part of the business did well, producing $970 million of net income, through wider deposit spreads (we’ll talk about this in a minute), and “higher deposit-related fees.” Banks are ratcheting up fees in retail banking to obscene levels, and engaging in predatory practices like pushing consumers into overdrafts and charging them a small fortune in usury interest. They are doing this because they can, and because they have to.

To see why, look at the results of the second part of this division: Consumer Lending. This business lost $955 million, wiping out total income for the Retail Financial Services business. The reason was the bank set aside $3.8 billion for additional losses on consumer loans, and this expense eats directly into the bottom line. Where did these losses come from? You would think much of this would arise from the well-publicized problems with subprime mortgages, and Chase did increase its charge-offs for these mortgages from $192 million last year, to $410 million this quarter. This was an implied charge-off rate of 11.5%, so nearly one out of every eight subprime mortgages at Chase has resulted in a loss.

But an even greater amount of loss was incurred in prime mortgages: ( $481 million) this quarter, four times greater than last year at this time. The charge-off rate for prime mortgages was 3.07% this quarter, up from 1.08% last year, and 0.44% in second quarter 2007. The problem for Chase is that its prime mortgage portfolio is so much larger than its subprime portfolio, that it can ill afford even a 3% charge-off rate.

The granddaddy of consumer losses this quarter results not from first mortgages, but second mortgages, known as home equity lines of credit. Chase took a $1.3 billion loss in charge-offs for these products, up from $511 million last year. The charge-off rate doubled to 4.61% in one year. Chase has $138.1 billion of HELOCs on the books, and it is doing what it can to control this portfolio. Originations of new HELOCs were down 89% from last year, meaning it is very hard to get one of these lines of credit from Chase anymore. This should not be surprising; HELOCs have a registered lien on the property subordinate to the first mortgage holder, but with a 50% or more decline in housing values in key markets, the collateral value has diminished for the first mortgage holder, and virtually disappeared for the second mortgage holder. Chase is sitting on a $138.1 billion book of these second mortgages, a sizeable portion of which is now unsecured and subject to very large ongoing losses. When banks were busy booking these home equity loans early in the decade, no one anticipated the collateral would be worthless, so this product has turned out to be a disaster for the banks. Don’t expect home equity lines of credit to be easy to get anytime in the future unless you have an enormous amount of equity built up in your home.

The only good news in the HELOC business is that charge-off rates at Chase appear to be stabilizing, but for all other products, including auto and student loans, such events as delinquencies, foreclosures, provisions, and ultimately charge-offs are all increasing. Chase can’t predict when its basic consumer lending business will stabilize, because that depends “on unemployment”, which unfortunately is already at levels worse than expected even by the Fed in its stress test scenarios. The best Chase can say is that charge-offs will continue at the current pace for the rest of the year, with happier days perhaps in 2010. One thing you can bet on, the big banks are going to continue assessing absurd fees on retail banking products in order to make up for these losses. This can easily cost you hundreds of dollars more a year if you don’t monitor your checking and savings account usage like a hawk, and avoid overdrafts by all means possible.

Card Services

The credit card business has been the crown jewel of banking in the US for 25 years, earning a legitimate 20% return on equity because the interest rate on credit cards can easily exceed 30% p.a. Banks have justified this interest rate on the grounds that credit cards are unsecured, which tells you by the way what the interest rate should have been on home equity lines of credit considering that they turned out pretty much to be unsecured lending as well. Nonetheless, even with extreme and usurious interest rates, the credit card business has collapsed in a tsunami of consumer defaults.

In 2007, the charge-off rates for credit cards at Chase was 3.52%. It jumped up to 4.86% last year at this time, and this quarter reached an incredible 10.04%. Double-digit charge-off rates in any line of banking used to be found only in stress test scenarios, under the heading of the unthinkable – a global depression. Now they are found in all major credit card portfolios, suggesting that this is certainly no ordinary recession we are in. For the record, Chase earned $759 million in quarter two of 2007 from its credit card business; this quarter it lost $672 million, a swing of $1.4 billion in earnings, and the losses are worsening even from last quarter.

There is no good news here for Chase. One of their most important businesses and consistent money earners is now staggering under incredible charge-off rates, with no relief in sight. The weakened consumer has begun to drag down bank performance in a very serious way. This, too, is one of the real stories at Chase that somehow missed the headlines.

Other Businesses

Most of the other businesses at Chase saw reduced profitability. Commercial banking – lending to corporations – generated a $368 million profit, up slightly from last year. This was the only improving business in the group. Treasury Services, which sells cash management products to corporations and governments, earned $379 million, down from $425 million last year. Simply put, there was less demand for the product, according to the bank. Asset Management, which represents Chase’s mutual funds, earned $352 million, down from $395 million, because customers were continuing to liquidate holdings.

Then there is something called Corporate and Private Equity. This is basically the CFOs office, which remains one of the most remarkable aspects of modern banking. Banks like Chase have over a trillion dollars in assets, offset by a nearly equal amount of liabilities such as deposits and long term debt. Because these assets and liabilities are not balanced either in size or maturity, someone has to watch the imbalances, which can generate huge amounts of earnings swings. The art and science of Asset & Liability management is expected to manage these swings and keep them positive where possible, which is often equivalent to predicting where interest rates are going. In today’s environment, that is relatively easy for short term rates: they are at zero percent and not going up anytime soon (it’s a very different story for long term rates). The Chief Financial Officer is responsible for Asset & Liability management, often using a staff of less than 20 people, even at a bank like Chase.

This quarter, the CFO earned $820 million in “trading gains” attempting to manage the balance sheet risks. This represented a huge swing from a loss last year of $319 million, and also represented a significant portion of the $2.72 billion Chase earned overall during the quarter. The remarkable thing is not simply the size of this contribution, but the fact that merely a handful of people are responsible for this work. It is one of the reasons the CFO in banking is often considered just slightly less important than the CEO.

It was not specified how these trading gains arose, though it was made clear that the risks are not incorporated in the bank’s Value at Risk model, which measures the potential daily loss from trading given an extreme adverse event that might occur only 1% of the time. The VAR model is restricted to Investment Banking activity only, which was the one stellar part of Chase’s performance this quarter.

Investment Banking

Net income for Investment Banking was $1.47 billion for the quarter, which along with the CFO’s trading gains represented most of the income of the bank. The division earned $393 million just from advisory fees on mergers and acquisitions, plus a record $1.1 billion in fees from equity underwriting. The fees from underwriting debt came to $743 million. Now it is pretty clear looking at the IPO market and records of new equity issuance that corporations and venture capital start ups were not issuing large amounts of stock. This market pretty much remains dead – with one exception – the banking industry itself, forced to raise new capital at the direction of the Federal Reserve. So you had a captive audience of customers forced to raise stock, and forced to go to just a handful of surviving equity underwriters like Chase.

As to the debt side, there was certainly a resurgence of new debt issued in the high yield market, better known as junk bonds. But another big, big issuer of new debt was the US government itself, and Chase was right there reaping in extraordinary fees from underwriting this debt.

Another part of Investment Banking, called Fixed Income Markets, is where the speculative trading takes place. This business generated $4.9 billion in revenue, up from $2.6 billion. At least judging by the Value at Risk number of $250 million for the quarter, Chase has certainly ramped up its speculative juices (VAR was $150 million the previous year). Most of this risk taking took place in bond trading, with equity and FX risk distant second and third players. But some interesting facts are to be found in the footnotes, especially this statement: “(There were) no markdowns related to leveraged lending commitment and mortgage related expenses.” In the previous year, such markdowns came to $1.1 billion, so here is another billion dollar swing in Chase’s favor. What this seems to mean is that Chase didn’t have to take any mark to market losses on its trading assets, unlike last year when it was forced to under much stricter accounting standards. So, perhaps, the FASB ruling liberalizing the mark to market accounting rules might have been worth a billion dollars of revenue this quarter for Chase.

Offsetting this was a $733 million loss from “tightening of credit spreads.” Presumably this refers to the funny business that goes on with accounting for a bank’s own debt. Since debt that has been issued publicly is bought and sold at public prices, it is possible to calculate what it would cost the bank to buy back its debt. If in doing so it would make a gain, it can take that gain into net income, which banks have been doing for the past two quarters as the value of their debt has sunk lower and lower on the markets. Now that this debt is recovering in price, Chase and other banks are forced to reverse these gains and declare a loss.

There was an additional $575 million loss resulting from the credit portfolio hedges Chase maintains. Have you noticed how many different half-billion and billion dollar revenue swings occur at a bank like Chase? While the overall net income was $2.72 billion, the variability of this net income is quite great, because a number of different activities can push the number into a different direction. As a consequence, earnings at Chase are quite unpredictable, which is actually unhealthy because the bank is so complex. Investors don’t like unpredictable earnings, with good reason, and this is probably why Chase’s stock this week didn’t really rise much despite all the “unexpected good news.”

Bailout Heaven

How dependent is Chase on the federal government and its many bailout programs? The answer is very dependent, but quantifying this dependency is difficult because so much of the bailout programs are kept secret.

One example of this is with a portfolio called Held for Sale Loans. This is described by Chase as its leveraged loan portfolio, so it probably consists of the so-called pipeline loans that got caught in the 2008 credit freeze and could not be sold at the anticipated time for anywhere near the anticipated price. One answer to this problem portfolio is for Chase to write down these leveraged loans, but as we have seen this quarter, it felt no need to do so now. A second option is to sell the loans, but to whom? Probably the only buyers are what are known as vulture hedge funds, willing to put in low-ball bids that Chase would never accept in a million years. Still, Chase reduced this portfolio by $12.5 billion, bringing it down to $6.8 billion. The only logical other buyer would be the Federal Reserve under one of its many programs to relieve banks of toxic assets, but the Fed refuses to identify what it holds on behalf of which banks, and the Congress just killed an effort to audit the Fed to find out. Lacking specific facts, we can only make a reasonable speculation that this is just one of the many ways Chase is benefiting from government largesse.

We’ve already discussed some of the indirect ways as well, such as the forced equity underwriting and debt issuance that redounded to Chase’s benefit in the form of hundreds of millions of dollars in fees. There is also the fact that Chase was able to issue debt in its own name with a Aaa rating plastered on it, courtesy of the federal government. This is what one analyst at S&P calls an “unlimited subsidy”, because it is one of the most potent bailout benefits available to the banks.

What you can see here is a picture of ongoing bailout benefits, which are unappreciated by the general public because the press talks about the bailout programs as if they all occurred back in March or September last year when Bear Stearns, Merrill Lynch, WaMu and other firms were sold to surviving banks.

To put some numbers on the ongoing bailout benefits, it helps to look at Chase’s interest rate spread – the difference between what it pays for money and what it earns. In this past quarter, Chase earned 1.45% on its deposits with other banks, a paltry 0.41% on Fed Funds sold, but then 4.91% on trading assets, 3.64% on securities held, and 5.65% on loans. Averaging all this out, Chase earned 4.00% on its assets.

Compare that to its cost of funds. Chase paid only 0.70% on interest bearing deposits of any sort. It paid 0.23% on Fed Funds purchased. It paid 0.24% on commercial paper, 1.59% on “beneficial interest”, and 2.60% on long term debt. Its weighted average cost of funds was 1.04%.

On a net basis, Chase earned a whopping 2.96% spread between interest earned and interest paid. That’s of course pure money in the bank, and that comes courtesy almost entirely from the federal government, especially the almost non-existent cost for short term money. By the way, if you are a Chase retail customer, you didn’t earn anywhere near 1.04% on your deposits, or even 0.70%. On the retail side, Chase is paying around 0.10% on consumer deposits, simply because it can (consumers have shifted significant amounts to Chase on the theory it will be a surviving bank – no one wants the risk of having money in a defaulting bank).

As wonderful as this is for Chase, there are some macro-economic issues at stake here. The federal government, by keeping money as cheap as it is, is taking money away from savers and shipping it off to the banking industry to recapitalize it because of their substantial losses. At some point, and maybe we’ve reached that point, this becomes counter-productive. The average person in the US can no longer earn any decent money on their deposits, and certainly not enough for most people to live on. This is probably slowly pushing more and more consumers into financial distress and ultimately into default. Chase may be a net loser in a big way, but seems happy at the moment to accept cost-free funds without any complaint.

The other purpose of this cheap money policy is to get banks lending again. How is that going? Judging by Chase’s balance sheet, not too well. From the second quarter of last year, wholesale loans at Chase are down from $242.3 billion to $231.6 billion. Consumer loans are down from $466.0 billion to $449.0 billion. Chase seems to be actively closing down any new home equity lines of credit. It is squeezing its credit card holders ferociously by increasing the minimum monthly payment from 2% of balances to 5% of balances, as of next month. Auto loans and student loans are down, as are loans to the security industry. Chase is clearly not in the business of lending more money to America, despite whatever it may say about new accounts signed up or new mortgages originated.

At Least They Are Not on Life Support

This is probably the best thing that can be said about JPM Chase: it is not on life support, nor is it a crippled giant like many of its competitors. It has more capital at its disposal than most big banks. But if it isn’t crippled, it certainly is wounded, and it has not been able to stanch the bleeding. Chase is first and foremost invested in the American consumer, and it is being savaged by an unprecedented level of defaults in its core businesses. The fact that it can make profits in investment banking and trading is of little comfort. A lot of this profit is forced business generated by government policy, and is not going to be repeated. The rest of this profit is fickle, depending on market circumstances.

The basic banking business of Chase is hurting badly, as seen in this quarter’s meager return on equity of 3% (or 6% if you ignore the $1.16 billion non-cash cost to Chase of paying back its TARP money this quarter). These are the sorts of returns banks made in the 1970s, before they discovered ways to lure Americans into debt servitude. One of the reasons Chase has such a low return on equity is that it has built up what it calls a “fortress balance sheet”, with common equity of $146.6 billion this quarter. Such a high level of equity drives down the return on equity ratio, but think how much higher the capital would be if Chase hadn’t received so much government support. Without the government bailout, banking would require so much capital as to offer hardly any return to its shareholders.

In fact, it sounds more and more like commercial banking, in a world where risks are priced and capitalized properly, is a world of modest profit and modest returns for shareholders. Doesn’t that sound like a utility to you? That’s what banks were for most of the past century, until free market theory was used to push banking into a world of aggressive risk taking, outsized profits, and Midas-like bonuses. It worked only because banking has a “put” to the federal government to come to its rescue in times of trouble.

This put has never been applied so vigorously as today, now that Chase and its big competitors have become the ultimate conduit financial vehicle for the federal government. The Treasury and the Fed are propping up so many different markets that it is estimated some 30% of all finance comes from Washington now. Chase is one of the selected vehicles for channeling all this money, and it is allowed to take a generous transaction fee on every dollar. This is no longer banking, but rentier finance for a few institutions granted monopoly rights – again, the classic definition of a public utility.

Despite all this, Chase, as one of the biggest and best of its breed, is unable to generate anything but a 6% return on equity, and that is a variable 6% at that, prone to disappear in any quarter. What must life be like at Bank of America or Citigroup, where the troubles are worse? Or at Goldman Sachs, which is operating in an alternate universe that allows it to receive bank benefits without any of the discipline?

We’ll talk about these institutions in the next post.