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Whoops, there goes our profit
Commentary: Merrill and J.P. Morgan hint at the scale of coming damage
By David Weidner, MarketWatch
Last Update: 12:01 AM ET Aug 14, 2008
NEW YORK (MarketWatch) -- Big deal: the other day, J.P. Morgan Chase & Co. filed its quarterly report with the Securities and Exchange Commission.
Nothing unusual in that. The bank had already done the dirty work by announcing its second-quarter results on July 17. And in that report, everything was looking up. J.P. Morgan JPM had a $2 billion profit to show. The only apparent downer was the $500 million in charges taken for the acquisition of Bear Stearns Cos.
So Monday's filing really wasn't much more than making it all official. Generally, 10Q's are just the numbers with the legal stuff thrown in. Sure, between the time when results are announced and when the filing is made, things can change. It happens, but when it does, it's generally a surprise.
You probably know by now that J.P. Morgan's 10Q did include one of those surprises. Slipped in on page 10 of the report was a disclosure that its investment banking arm held some collateralized debt that had lost about $1.5 billion in value since the end of the quarter.
J.P. Morgan tells me that they weren't trying to hide anything. They say it was at the top of the filing and those filings are highly scrutinized. Maybe so. On the other hand, they didn't give this the fanfare the second-quarter profit received: press releases and conference calls.
In other words, it took about a month, maybe less, for J.P. Morgan to lose about 75% of its second quarter profit.
It doesn't get much worse, or does it? J.P. Morgan, a bank many -- including me -- thought had weathered the banking crisis and moved on, said it could get worse and may be worse already because the investment bank still had a $19.5 billion exposure in Alt-A mortgages, $1.9 billion in subprime mortgage exposure and an $11.6 billion exposure in commercial mortgage-backed securities.
For these securities, though hedged, "the trading conditions have substantially deteriorated," the bank said. See full story.
Here we go again
Anyone get the feeling that the banking and credit crisis is about to get worse? We may be waiting a lot longer than the third quarter for the bleeding to stop.
J.P. Morgan seems to be taking one of the two strategies that have emerged during the crisis: hold onto the junk and hope the market turns. This is the same plan that's in place at Lehman Brothers Holdings Inc. LEH and was in place at Bear Stearns Cos.
There's a technical term for the other strategy that's being employed at Merrill Lynch & Co. MER and to some degree at Citigroup Inc. C: dump it.
Merrill employed this strategy back on July 29 when it took a healthy haircut and accepted 22 cents on the dollar for about $30 billion in collateralized debt obligations that were stinking up the balance sheet. About the only good news the market took from this was that there was actually someone willing to buy it.
The point is that even though there are different strategies, there is a single truth: the books on Wall Street are still loaded with stuff that stinks.
Not everyone is holding their noses. Brad Hintz, the Sanford Bernstein analyst and former chief financial officer at Lehman, is among the best who have assessed the situation. He doesn't think the Alt-A loans and the subprime loans are going to be a problem. Most of that stuff has been written off. "After all, the marks can't go past zero," he wrote me in an e-mail.
'Impossible to hedge'
That doesn't mean Hintz is whistling like Frank Quattrone past the courthouse. He's worried about a couple of things: commercial mortgage backed securities, the kind J.P. Morgan copped to having $11.6 billion worth, and good old prime mortgages, which like the Titanic would never default and are now taking on water.
If the prime stuff goes, the whole system implodes and we're all sleeping in the park. The commercial stuff is more likely to fail.
'We may be seeing a sequel to August 2007 but without the fraudulent borrowers and without the no-money down issues.'
- Brad Hintz
"Commercial whole loans are difficult or impossible to hedge and knowledgeable players in the commercial mortgage market are attempting to sell their positions while they still can. So we may be seeing a sequel to August 2007 but without the fraudulent borrowers and without the no-money down issues," Hintz said.
The good news is that commercial mortgage underwriters never gave them out at souvenir night at the ballpark like the residential guys did. They weren't gymnastics judges, but the commercial guys had, at least, some standards.
The coming sell-off
OK, but I have to disagree with Brad on one issue. He says most of the Alt-A and subprime write-offs are finished. The numbers seem to back him up, too. A rough count by Bloomberg on Tuesday found that the world's 100 biggest banks had written off $510 billion. That sure beats Reuters' tally of $341 as of July 30, but both are huge numbers and it's been more than a year since these securities have gone belly up.
The answer is found in J.P. Morgan's announcement and Merrill's asset sale. The market didn't see either of them coming. At J.P. Morgan, most analysts took the $2 billion profit at face value and pronounced a turnaround. Deutsche Bank's Mike Mayo wrote J.P. Morgan is "one of the few financial firms that are playing offense and showing revenue growth."
The outlook on Merrill was the same. Most analysts estimated Merrill had less than $20 billion face-value exposure to risky CDOs and other borderline securities after it announced a worse than-expected write-down of about $9 billion on July 17. Remember, Merrill sold $30 billion at a 78% discount a few days later.
No one really knows what's lurking in the vaults of Wall Street, but we do know we can't call an end to this mess. It says so right on page 10 of that filing J.P. Morgan made on Monday. You might remember, the disclosure that sent the market reeling by nearly 100 points?
No big deal.
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