When the coronavirus pandemic swooped down on the economy in March, it created a situation that very few could have imagined in January or February. The pandemic forced all banks to set aside huge sums of cash to prepare for future loan losses because tens of millions of people were suddenly out of work, while many businesses faced a doomsday scenario.
As the nation's largest bank, JPMorgan Chase (NYSE:JPM)set aside close to $19 billion in the first half of the year to cover potential future loan losses because of its far reach into the U.S. economy and exposure to the many industries and business segments it operates in . That's more than any other bank in the country.
While the first few quarters of the year have been difficult, I am cautiously optimistic that the worst is over for JPMorgan. Here's why.
Huge provisions and forward-looking accounting
This year, most banks are operating under the new current expected credit losses (CECL) accounting policy. Prior to this policy, banks would only mark down a loan when an event occurred that made them believe the borrower's ability to pay them back had deteriorated.
CECL asks banks to be more forward looking by setting aside cash for potential losses on the life of a loan as soon as that loan is originated and put onto the balance sheet. CECL is new and somewhat controversial, but ideally it should have banks thinking more holistically about losses in their entire portfolio, and earlier on in the process.
JPMorgan's nearly $19 billion credit provision through the first half of the year is the highest provision JPMorgan has taken over a six-month period. Collectively, the bank has now set aside more than $34 billion to cover future losses, or enough to cover losses for 3.32% of its total loan book .
"And given CECL covers the life of loans, if our assumptions are realized, we wouldn't expect meaningful additional reserve builds going forward," JPMorgan Chase's CFO Jennifer Piepszak said on the company's recent earnings call . Getting the assumptions right is always a big "if," but it does seem like the bank is thinking conservatively.
JPMorgan in July said its base case assumes that real U.S. GDP will contract 6.2% cumulatively between the end of the second quarter and the end of the year, and will still be down 3% at the end of 2021. The bank's base case also assumes unemployment ends the year at almost 11% and is still at 7.7% at the end of 2021 .
Unemployment in July fell to 10.2%, and Piepszak said the bank actually reserved for a scenario worse than the base case. She also said the bank did account for loan deferrals when it reserved for losses, so it seems pretty well prepared .
Another important consideration is that the bank has managed to stay profitable, despite the fact that the huge provisions it took in the first half of the year directly cut into profits. JPMorgan turned a profit of nearly $2.9 billion in the first quarter and nearly $4.7 billion in the second quarter .
No such thing as certainty
While I certainly believe the bank has provisioned prudently and has performed extremely well given the circumstances, it would be remiss of me to say there is no risk at all. If there is one thing the coronavirus pandemic has taught us, it's never say never.
CECL is still new, and if there are more state lockdowns in the future or another big spike of coronavirus cases in the fall that result in much lower spending activity, JPMorgan could have to build reserves significantly again. However, given how quickly the virus struck in March and how unprepared the U.S. was to deal with it, I do not think another period of lockdowns or a spike in cases would force the bank to build reserves as substantially as it did in the first half of the year. Furthermore, with the quick adoption of digital and remote trends during the past several months, I believe the world is more prepared for another period of lockdowns than it was earlier this year.