A Second Look at JPMorgan's Earnings Reveals Worse News Than Expected

Source: The Motley Fool.

Earnings season is a frantic time for anybody who writes about stocks. When one of the companies that you cover reports results, we want to cover it as soon as possible. And once that's done, you move onto the next company that reports.

It's for this reason that I generally like to circle back around to the most important stocks in order to gain a fuller appreciation for why its earnings did why they did. And in this case, I'm doing so with JPMorgan Chase (NYSE: JPM  ) , the nation's largest bank by assets.

There's no getting around the fact that the headline figures for JPMorgan were disappointing.

For the three months ended Sept. 30, it reported a loss of $380 million, or $0.17 per share. It was the first quarterly loss for the bank since 2004, and the only period in which it didn't earn money under CEO Jamie Dimon's tenure at the helm -- which, by the way, is quite an accomplishment given that he was promoted on the eve of the financial crisis.

The lion's share of the decline came from a $9.2-billion charge-off that the bank recognized to build its litigation reserves, which now stand at a whopping $23 billion. The decision follows a series of legal and regulatory actions that are targeting the bank for everything from potential bribery in China to selling faulty credit card services here at home.

While these are true costs, as JPMorgan is allegedly working on an $11-billion global settlement that would cover the majority of the regulatory actions, they're nevertheless outside of the normal course of business. As a result, we have to back them out to get a better understanding of how JPMorgan's underlying businesses actually performed over the three-month time period.

Once we do this, the picture gets a lot cleaner. Starting with the bottom line, even after subtracting the litigation costs, JPMorgan's earnings before taxes nevertheless declined on a sequential basis by $664 million.

What explains the drop?

To start out with, it wasn't expenses, as the bank reduced its normal operating costs by $840 million compared to the second quarter.

It also wasn't loan loss provisions. As we saw with Wells Fargo (NYSE: WFC  ) , which reported yet another quarter of record profits on Friday, improvements in the credit environment led JPMorgan to slash its provision expense by $590 million. In the third quarter, in fact, it released a net $543 million in credit provisions.

Through process of elimination, this leaves us with revenue, which was indeed the problem. Over the three months, JPMorgan's top line contracted by $2.1 billion. And digging a bit further in, almost the entire drop was due to two things: mortgage banking and proprietary trading.

Just like Wells Fargo, JPMorgan's income from mortgage banking took a beating last quarter thanks to higher interest rates and concomitant lower refinance volumes. All told, its income from residential mortgages fell by $982 million.

The story was the same with proprietary trading, where the bank saw revenue drop by $1.1 billion. Taken together, these two pieces alone account for 96% of the drop in JPMorgan's top line.

The takeaway here is that, even putting the legal losses aside, JPMorgan had a tough quarter. And to make things worse, there's little evidence that things will improve in the fourth quarter.

What does this mean for bank investors?
In my opinion, it means that you have to be careful right now about choosing bank stocks. Are there good ones out there? Absolutely. But you have to know how to identify them. It's for this reason that our top banking analysts put together a brand new free report detailing how to find the best bargains in the banking sector. To download this insightful report instantly and for free, simply click here now.


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