More Phantom Profits for Banks?

JPMorgan Chase (NYSE: JPM  ) surged over 6% yesterday on news that accounting adjustments related to its acquisition of Washington Mutual might lead to gross gains of $29.1 billion.

As Bloomberg reported:

When JPMorgan bought Seattle-based WaMu out of receivership last September for $1.9 billion, the New York-based bank used purchase accounting, which allows it to record impaired loans at fair value, marking down $118.2 billion of assets by 25 percent. Now, as borrowers pay their debts, the bank says it may gain $29.1 billion over the life of the loans in pretax income before taxes and expenses.

Which all seems fine and well. Along with Wells Fargo (NYSE: WFC  ) and Bank of America (NYSE: BAC  ) , banks that have acquired distressed mortgage lenders often take dramatic writedowns on newly acquired loans, hoping to mark them back up in the future in hopes of a profit. Unlike some recent accounting games played by banks like Citigroup (NYSE: C  ) , there's absolutely nothing shady or wrong about this -- it's the business of buying distressed loans. Buy assets. Mark 'em down. Make money in the future. No doubt about it, this is great news for banks.  

Here comes my good buddy, Mr. Devil's Advocate
Of course, this logic depends on whether the banks mark down those acquired loans by a wide enough margin in the first place. If a bank doesn't give a large enough haircut to the loans it acquires, future writedowns, rather than writeups, might be what's expected.

And in the case of JPMorgan Chase and Washington Mutual, we have some interesting numbers to pour through. First noted by Calculated Risk, a JPMorgan investor presentation dated September 25, 2008 disclosed the assumptions used to mark down Washington Mutual's book of mortgage assets. Here are those assumptions:

Metric

Current Estimates

Deep Recession

Severe Recession

Peak-to-Trough Home Price Declines

(25%)

(28%)

(37%)

Unemployment

7%

7.5%

8.0%

Source: JPMorgan Chase.

What's interesting about these numbers -- especially unemployment -- is that we're already considerably worse than JPMorgan expected when it bought WaMu last fall. Unemployment is currently at 8.9% and expected to rise. And as part of yesterday's housing report, we learned that peak-to-current home prices nationwide are off 32.2% with show no signs of abatement. Both metrics are either currently, or appear to be on track to, surpass JPMorgan's worst-case assumptions.

Still scratching my head
The conclusion here is a matter of bewilderment: How a bank can expect massive writeups after marking down a portfolio using assumptions that now look dramatically optimistic. Logically, there are two scenarios to explain this discrepancy: Either JPMorgan wrote down the loans at a rate that wasn't consistent with its own assumptions, or the future writeups being reported won't materialize. Either outcome is a lesson on the imperfectness of forward-looking assumptions, and neither is helpful for investors looking for balance sheet clarity.

For related Foolishness:                               

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 27, 2009, at 10:45 AM, portefeuille wrote:
  • Report this Comment On May 28, 2009, at 5:49 AM, 7footmoose wrote:

    As I am sure you already know, there were significant portfolio write downs taken by WaMu itself prior to its sale. As I understand, JPM further wrote down the WaMu loan portfolio to approximately 60% of its original book value. As in all loan write downs recovery's or final losses are recognized at final disposition of the loan asset. The Bloomberg piece only states that if enough of the originally written down loans were to be recast and somehow be repaid there is this huge pile of loan loss reserves set aside for the disposition of these problem loans which might not be needed and then could be taken into income. While the likelihood that there will be this kind of recovery is very small there is a mathematical and accounting possibility. My advice is, don't count on it happening.

  • Report this Comment On May 28, 2009, at 9:20 AM, Big50Shooter wrote:

    "Either JPMorgan wrote down the loans at a rate that wasn't consistent with its own assumptions, or the future writeups being reported won't materialize. Either outcome is a lesson on the imperfectness of forward-looking assumptions, and neither is helpful for investors looking for balance sheet clarity."

    Balance Sheet Clarity!!!

    You ask for a lot, don't you Morgan?!?

    I mean, without doing some "adjustments" we (investors) might be able to see through the ponsy schemes which are "corporate profits" for these bad boys, and that might scare some of us into thinking that they are lying.... We can't have that now, can we?

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