I am submitting JP Morgan (JPM $42.63) as a short to rejoin the club.

 

I only made one submission last year which was Bank of New York (BK) as a long on 6/2/07 at $40.45 which has returned +7.4% since vs. the BKX Index which is down 24.6% and the S&P500 Financials Index which is down 28.1%. In other words, BK was indeed a great value.

 

I believe JPM is soon to experience a significant decline in EPS, as well as P/E ratio. The EPS declines will be caused by a combination of increased loan loss provisions from several lending categories and write-downs on Held For Trading securities. JPM likely will not stumble hugely in any one area but the bank is exposed in too many areas where loss levels are normalizing. Call it a death by a thousand cuts. The P/E will decline from its current 10.5X P/E to the 10X average of its peer group as it becomes apparent that JPM is not bulletproof. The two most immediate catalysts when this information will leak into the market and share price are 1) the annual analyst day on February 27^th and 2) 1Q08 Earnings release on April 18^th.

 

JPM shares have shown amazing resilience in the current credit crisis. Consider that since 1/1/2007 JPM has seen A) a collapse in volumes of M&A, levered loan syndications, high yield underwriting, IPO issuance, and most other structured products, B) more than $3B in writedowns in CDOs, levered loans, and other securities, C) a significant increase in losses in home equity, subprime mortgages, other 1-4 family mortgages, and residential construction lines D) increases in problem assets in auto lending, credit card loans, student lending, and rising corporate bankruptcies E) the overhang of the collapse or downgrading of both the monoline bond and mortgage insurance companies and finally, F) most recently a collapse in prices of several other classes of on-balance sheet securities including CMBS, ARS and non-agency MBS. Oh yeah, let’s not forget that the economic outlook has moved from that of strong economic growth to a potential recession.

 

Despite all this bad news, JPM owners have only lost an amazingly small 5% since the start of 2007 to 2/25/08 vs. 25% declines in the KBW Bank Index and the S&P500 Financials Index where many direct competitors in the investment/commercial bank space are off upwards of 50%. Much of this amazing outperformance can be attributed to CEO Jamie Dimon who has bobbed and weaved – at least to investors and the press – through the crisis so far. Amazingly, the Board of the company recently gave Jamie a $30M option grant specifically for losing ‘only’ $2B in CDOs last year. However the hits are starting to get larger and finally are going to land squarely on JPM in the immediate future according to what has actually been disclosed by the company.

 

 

If you believe we will easily avoid a recession despite the housing crisis and the seizing up of the credit markets than a short on JPM is not for you – in fact if you believe in this sunshine and rainbows scenario you probably just want to buy all the banks. However if you believe we are going to have at least a mild recession than you should consider what has happened to bank non performing loans and share prices in past credit cycles. Yes, the Fed has lowered rates but if you read the financial press you will see that this monetary easing has clearly had little effect and credit is still tightening across most cycles of the economy.

 

So let’s look for a moment at bank performance over the last 20 years:

 

 

 

(NB - Unfortunately I was not able to import these charts - you can look the data up on FDIC.gov if you want though - in 1990-91 NPAs/Total loans rose to 3.2% and then fell until the next peak in 2001-2002 at 1.2% - no surprise the KBW Bank Index fell both times that problem loans rose and recovered when problem loans peaked).

Note that in the recession of 1990-91 where the major bank problem was in real estate, the bank index fell by 50% and non performing loans as a % of total rose to over 3%. In the more mild recession of 2001-2002 where the major bank problem was in corporate loans, the problem loan ratio rose to 1.2%. Banks ended 2007 with non accruals/total loans at about 75bps. Thus, if we assume that this credit cycle will be in between the last two in severity we could see problem assets triple from here, and if we have a repeat of the last real estate led cycle then this ratio could quadruple! Note that while the KBI Index did fall 25% from its peak last year, it has staged a significant bounce as the Fed got more aggressive in January. If this credit cycle plays out like what happened in the early 1990s then bank stocks still have at least another 25% to fall from here.

 

So now if you accept that we might have a bit of a recession and that we are seeing a real estate led credit cycle, what will JPM actually earn this year?

 

 

I believe I can reasonably mark down JPMs EPS for the year from the current consensus JPM is $4.21 (Bloomberg reported consensus as of today) to about $3.00. I find it hard to believe the stock will not fall if EPS declines by 30% vs. current expectations. In addition, the company refuses to release exposure data on many pressured areas of the market, and if losses from these areas are commensurate with its industry position, it is possible that JPM will generate little if anything in profit this year.

 

My numbers are much lower than that on the Street partially because very few sell-siders are willing to disagree with Mr. Dimon and slavishly plug his guidance numbers into their models (not all to be fair as UBS and KBW have been doing some of their own thinking on this name). Amazingly of the 20 sell-side recommendations out there, 11 are ‘Buys’, 8 are ‘Hold’ and only 1 is a ‘Sell’ (and that one ‘sell’ is from the permabears over at Portales). This is a much, much higher average recommendation which is a reason why I believe JPM will see significant multiple compression when its ability to generate profits in this current down part of the credit cycle turns out to be only average.

 

So let’s walk through why the $4.21 is too high:

 

I start with the $4.21 consensus and then assume (along with most of the sell-side) that net charge offs will be matched $ for $ with provisions considering the deterioration in asset quality across the banking industry. If NCOs are not matched then the quality of reported EPS goes down quickly.

 

Moving through JPMs business units is tedious but pretty easy:

 

Consumer –

Home Equity – I am using a 3% NCO rate for ’08 on the $94B JPM has of these loans. A significant portion was sourced through the mortgage broker channel (JPM won’t say of course, but 1/3 to 1/5 is likely). Losses for other players in this area are soaring. Wells Fargo took the $12B it had of Home Equity sourced through the broker channel and put it in a liquidating portfolio with an expected loss rate of +10% and reserved more than $1B against it. JPM claims that 1/3 of its loans in this area are ‘problem category’ ones with LTVs over 90%, with lower FICO scores and on homes in recently ‘hot’ markets JPM will not release what % of its paper is in second position behind Option ARM or interest only first mortgages. Jamie Dimon has increased his 2008 loss rate on the whole $94B several times in the last few months – at the end of the 3^rd quarter it was 50bps, then 100bps, then 150bps, then 160bps, and most recently (at the CS conference earlier this month) is was 160bps for the year but 170bps for 1Q08.

 

160bps of losses = $150M. However, if we assume that JPM’s problem book is similar to WFC’s and use the latter’s number of 10% cumulative loss rate on stressed Home Equity and assume that most of the losses will take place over 1.5 years (these are pretty short term loans) then losses at JPM should be in the range of 7.5% this year on 1/3 of the book or [$31B*.075 = $2.3B]. If we assume 75bps of losses from this remaining 2/3 of the book that is another [$63B*0.75% = $472M] for a total of $2.8B vs. guidance [$94B*1.6% = $1.5B]. The delta on this area vs. guidance is $1.3B ($900M after tax)  $0.27 in EPS. Don’t forget that this is actually a conservative scenario as there is so much government suasion to not foreclose on homeowners even on a 1^st mortgage – it is going to be increasingly difficult for JPM to kick people out of a home for a home equity loan and consumers will figure this out and act on this information – in other words both frequency and severity of losses will likely spike dramatically even past this analysis of 2% losses in ‘08.

 

First Mortgage – JPM has $56B here. Of which about $15B is subprime. The company refuses to release the amounts that are Alt-A, interest only or low-doc.

 

Subprime loss at JPM were running at 2% annualized in 4Q (the highest yet) and the bank hopes it will remain in that range. However, most market watchers expect that this rate will rise in ’08 as teaser rates reset to much higher levels and the bank either has to foreclose or renegotiate and write off loan principal or accept a lower rate. So let’s use a 5% loss rate – that is 20% of the loans default and the loss rate severity is 25%. The delta then is 3% on $15B or (3%*$15B=$450M or $315M after tax or $.09 in EPS)

 

This leaves us with $41B in non-subprime first mortgage where some portion are ‘stressed’ low down, or alt-A, etc. JPM only suffered 11bps of annualized losses here in 4Q07 and hopes it will remain similar. Of course, delinquencies are rising fast (4% of total prime loans in the US are now past due), prices are falling and the banks are under pressure to negotiate rather than foreclose. Let’s assume losses rise to 30bps this year (clearly not a disaster) – the delta then is  about $100M or $70M after tax for a whopping EPS impact of $.02 – you can use a higher number if you’d like.

 

Auto – JPM has $42B. Losses were running at 127bps annualized in 4Q07 and the bank hopes it will come down from here a bit for all of 2008. Get real – oil is at $100, unemployment is ticking up, the Manheim used car auction index is plunging and repo firms have been towing in so many cars that they have had to start leasing extra lots to hold them all (see recent article in USA Today). Indirect auto loan delinquencies rose to 1.8% in 3Q07 (highest since 1991) from 1.6%in 2Q07 and continue to rise. I’m assuming 2% losses vs. JPM’s 1% - ‘guidance’ the negative delta here is $420M or $290 tax adjusted for a negative hit to EPS of $.09.

Card­ – JPM has $84B in on balance sheet credit card receivables. It is a higher quality portfolio vs. many large peers in terms of FICO, but that does not mean it is without losses. The net charge off rate has been going up pretty fast and deteriorated to 389bps in 4Q07. The bank is giving guidance of 4.5% for 1H08 and then improvement as the economy picks up steam again. Moody’s (that paragon of foresight) just released its expectations that credit card charge offs will continue to rise throughout 2008.  In a recession this portfolio could easily see losses over 6%, but let’s just use 5.25% on average for 2008 with a recession vs. guidance of around 4.25%. Thus our delta is 100bps on $84B or $840M, $575M after tax or $0.17 as a hit to EPS

 

So just by running through Retail Financial Services we have already found that EPS could fall by $0.64 just by tweaking JPM’s guidance for a mild recession.

 

Wholesale – JPM had $213B in assets in its commercial and investment bank at the end of 2007 and disclosure is poor. We know that $80B of this is non-US in nature, $2.7B is subprime mortgage, recent levered loans are $26.4B, and $7.5B is construction lines and that’s about it. The bank expects a 1% loss rate through the cycle in this book and currently has ($3.15B) 1.5% in reserves. Thus, it sounds like there are ‘excess’ reserves, but we have to deal with the levered loan write-downs first:

 

Were we to close the books on the 1Q08 today, JPM would have significant write-down losses. Yes, these losses are on paper only due to poor prices in the bond markets, but the same can be said about most of the losses recorded by UBS, MER and C and those stocks certainly reacted to these potentially temporary write-downs.

 

JPM has already taken a 6% mark on its $26B on hung levered loans; however this market is now trading on about 85 cents on the $1. So were JPM to take another 6% mark, the impact would be $1.5B which wipes out the 150% of the ‘excess’ reserves. Assuming 50% of this write-down is reserved through the income statement, the hit to earnings would be $750M or $500M after tax, or $0.15 to EPS.

 

And there will be lots of additional write-downs this quarter - KEY has $600M of CMBS paper held for sale which they announced last week would be written down by $50M due to new prevailing levels of cap rates, market prices and outlook. JPM is a big player in this space but we have not been told the exposure – the number here is likely $6B rather than $600M.

 

There is also the ARS crisis – JPM is one of the larger underwriters in this market for short term auctions. As auctions started to become hard to clear, large amounts of this paper ended up on the balance sheets of the underwriters. I have been told by one C employee that his bank ended up with $9B worth on the books. JPM is currently not disclosing their exposure. The secondary market is currently at $0.85 to $.90. As with CMBS the potential for a significant hit is high.

 

I don’t want to spend much time on the monoline bond insurer mess – god knows more than enough speculation on this subject has piled up in the press recently. Jamie’s guidance is a $500M hit to JPM were the insurers to lose their AAA rating -  a $0.10 hit to EPS

 

Of the +/-$10B in subprime and construction loans – let’s be conservative and assume only a 10% loss rate – that’s another $1B or $0.10 to EPS.

 

The wholesale bank has more than $175B in assets that we have not discussed where disclosure is basically nil. We know that large areas of the markets have encountered dislocation and so that 1% loss rate through the cycle certainly seems like a number that could be conservative this year. 1% on that $150B base is $1.5B – let’s assume losses are lower than that – how about 50bps – that gets us to $750M or another $0.15 to EPS. This number seems quite low if we assume even a mild economic slowdown and a rise in losses in CRE, corporate C&I, etc to closer to average levels from the extremely low levels of the last few years.

There are lots of other areas where earnings will likely be lower than in ’07 simply due to market conditions. Some that come to mind include:

- a drop in underwriting fees for ARS auctions

- a drop in revenue from Cross Country Insurance (JPM’s captive mortgage reinsurance firm)

- lower net interest income from higher levels of non performing loans as per my assumptions

- lower asset administration fees from the Treasury and Securities businesses due to lower stock market levels and less structured finance issuance.

- lower asset management fees from the Asset and Wealth Management business due to lower stock market levels

- lower levels of student loan securitization deals as the market has seized up

- lower revenue as JPM has pulled back lines of credit to many home equity and credit card customers

- Let’s just assume these negatives reduces EPS by another $0.08 (2% of base guidance)

 

Summary – So let’s do the math…

 

            $4.21 consensus

-           $0.27 home equity

-           $0.09 subprime mortgage

-           $0.02 other first mortgages

-           $0.09 auto

-           $0.17 card

-           $0.15 levered loans

-           $0.10 monoline downgrades

-           $0.10 wholeseale subprime and construction loans

-           $0.15 other wholesale losses (maybe ARS, maybe CMBS, who knows)

-           $0.08 lower revenue drivers

=          $2.99

 

 

I expect that some clarity on these areas of lower earnings will become clear in the near future – either at this week’s analyst day or at 1Q08 earnings release in about 6 weeks.

 

If we assume that JPM’s P/E trades down to 10X 2008 as this ‘death by a thousand cuts’ becomes consensus, then the stock could trade at $30 which is a 31% drop from Friday’s close. I doubt that the shares will fall that far for a bank run by Jamie Dimon and put my target price at $35.

 

If you want to quibble with my assumptions that I am to negative, that $600 checks to working people and Mr. Bernanke in his helicopter will allow us to avoid a recession – then just cut my cut in EPS in half – you still get a drop in EPS of $0.60 or 15% - do you really think JPM is going up if estimates have to come down by $0.60?

 

Risk to the short is as follows:

- The economy moves from its current condition to strong, non-inflationary growth.

- I am right about the direction of loan losses and write-downs but JPM’s underwriting is so good that it avoids losses even though deterioration takes place across almost all the asset classes where it competes.

- JPM enters into a large M&A transaction (WM, STI, etc.) and the stock rises as the market focuses on cost saves and not potential acquired loan losses.

- The US government convinces its taxpayers to engage in a huge bailout of the banking industry effectively nationalizing all ‘bad’ mortgages and leaving the banks with the good stuff.

- JPM will have a large 1-time gain if the IPO of VISA goes well. It is possible that investors will listen to Jamie when he tells them that credit writedowns are 1-time in nature as well and so you should net the gain against the losses and so EPS only falls a bit each other. Most (but not all) sell-side analysts do not have this gain in their models as they do consider it to be 1-time in nature.