Ben Bernanke recently observed that “a recovery in economic activity appears to have begun in the second half of last year … [and] financial markets have improved considerably”, adding the caveat that “significant restraints on the pace of the recovery remain”. We agree with both points. For US banks, the restraints in question – beyond the obvious fact that the US economy looks set to remain sickly for some time – include the still-bleak outlook for commercial real estate and the uncertainty caused by the imminent introduction of new capital and liquidity rules by end-2010 (see blog). But JPMorgan’s (JPM) recent Q110 results definitely point to a brighter future for the US banking sector. Once again, it managed to beat market expectations with a Q110 net profit of $3.3bn, up 55% YoY, and an EPS of $0.74, well ahead of consensus expectations of $0.64. The strong headline result was complemented by a robust balance sheet. At end-Q110, JPM’s Tier 1 ratio stood at 11.5% (Q109: 11.4%) and its common Tier 1 ratio came in at 9.1% (Q109: 7.3%). In many ways, though, it was not surprising that JPM should outperform market expectations, as it has consistently done so for the past few quarters. The more important question that arises is: do its results contain any indications about the likely performance of the rest of the US banking sector?

Almost certainly. JPM’s results contain two features which suggest that most large US banks will have enjoyed a good start to 2010. First, there was the strong performance of JPM’s investment bank, which remained its most profitable business, accounting for around 76% of the company's total net income. Fixed Income Markets was again the star performer within the division, producing $5.5bn of its total $8.3bn of revenues. Investment banking revenues at most large institutions fell in Q409 compared to Q309, leading several commentators to suggest that the extraordinary profits produced by investment banking in mid-2009 could be fading. But JPM’s Q110 investment-banking revenues of $8.3bn represented a 69% QoQ increase and were higher than the $7.3bn and $7.5bn achieved in Q209 and Q309 respectively, while its net profit was significantly higher than that generated in any single quarter of 2009. This suggests that investment banking business conditions remain favourable, and that the likes of Goldman Sachs and Morgan Stanley in the US – as well as European banks with large investment-banking divisions like Deutsche Bank and Barclays – could well have enjoyed a strong Q110.

Second, JPM provided further evidence that credit quality continues to improve. We previously observed that a fall in provisions in Q409 could have heralded the beginning of the long journey back to normality for America’s largest lenders (see blog). This now appears to be the case. The chart below shows that JPM’s total provisions have fallen significantly since Q309, driven in particular by a drop in provisions in the Card Services and Retail Financial Services divisions (the latter being made up primarily of various types of mortgage loans – see below). The fall in provisions in Q409 continued in Q110, and shows no signs of slowing.

JPM – Quarterly loan-loss provisions

Source: JPMorgan

The second chart gives further proof of the underlying improvement in JPM’s situation. It shows that net charge-offs for mortgage loans, which have so damaged US banking, peaked in Q409. It is significant that every loan category except home equity loans registered a decrease in net charge-offs in Q110 compared to Q409, adding weight to our view that the outlook for US banks is not as bleak as was thought a few months ago. Indeed, at end-2009, JPM predicted that quarterly home equity loan losses could reach $1.4bn over the next several quarters, prime mortgages $600mn and subprime mortgages around $500mn – whereas, in fact, actual losses in Q110 were well below these expectations at $1.1bn, $459mn and $457mn respectively.

JPM mortgage loans - net charge-offs as % of total loans

Source: JPMorgan

The evidence from JPM therefore suggests that the improvement in banks’ credit quality that first emerged in Q409 gathered momentum at the start of 2010. And it is no longer just the investment banks that are enjoying more benign conditions. The broad-based strengthening of JPM’s loan metrics suggest that other large consumer-oriented US banks, such as Bank of America and Wells Fargo, may also reveal surprisingly good Q110 earnings.

Nick Smallwood, Credit Analyst

Disclaimer:

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