Even though earnings at the banking giant dropped compared with 2019, I still thought JPMorgan Chase (JPM +1.23%) had an excellent year in 2020 given the cards it was dealt. With the economy running at an extremely slow pace because of the coronavirus pandemic, the bank generated more than $29 billion in profits while setting aside billions to cover potential loan losses that may or may not materialize.
While the bank showed its resilience in 2020, there could be even better days ahead in 2021 if the country can get the public health crisis under control and the economy can bounce back.
Image source: JPMorgan Chase.
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Most banks' financial performances are heavily tied to the economy, and when the pandemic was officially declared in March 2020, it looked like the banking sector would be facing lots of loan losses. Bank reserves were magnified because most large banks operate under current expected credit losses (CECL) accounting guidelines developed as a result of the 2008-09 Great Recession. Those rules require banks to reserve for potential losses on the entire life of their loan book. That means banks are preparing for loss content that they expect to occur in the future even if there is no reason to believe at the time that certain borrowers will go into default. The outcome is banks front-loading loan reserves more heavily than ever before.
Banks prepare for loan losses by reserving capital in advance. That capital is subtracted from earnings each quarter through a provision and added to a total loss bucket known as the allowance for credit losses.
In 2020, JPMorgan Chase collectively provisioned nearly $17.5 billion for potential future loan losses and ended the year with more than $30 billion in total reserves. However, while the provision eats directly into profits, the money is not lost until the loans are actually charged off, which means the bank has determined that the debt is unlikely to be collected (even when debt is charged off, it can still be recovered).
Normally, charge-offs materialize within a few quarters of loans coming into danger of defaulting. But the pandemic has created an unprecedented economic scenario where intervention from the Federal Reserve and trillions of dollars in stimulus being injected into the economy have bolstered consumers and businesses, delaying a significant amount of loan losses from happening. In fact, the stimulus has been so extraordinary that there is a decent chance that many of the loan losses JPMorgan initially projected earlier in 2020 may not happen at all.
Potentially releasing reserves
The way that banks calculate their reserves is through complex financial modeling that is based on certain economic conditions. There are base cases and more adverse scenarios. In the third quarter of 2020, the most recent scenario data available, JPMorgan under its base or central case assumed that U.S. unemployment would end 2021 at 7.3% and that U.S. gross domestic product (GDP) would end this year down 2.4% from the end of 2019.
Currently, U.S. unemployment is below that level and GDP is expected to grow significantly this year. But the big thing to know is that on the bank's most recent earnings call, CFO Jennifer Piepszak said the bank is reserved at approximately $9 billion above the current base case. She also said that while the macroeconomic outlook has improved, the bank's modeling is still heavily weighted toward its downside scenarios, meaning that it is thinking conservatively when it comes to year-end GDP and U.S. unemployment numbers.
If President Joe Biden oversees more stimulus, the pandemic gets under better control, and the economy bounces back like people are hoping and expecting in the second half of 2021, many expected loan losses may not come to fruition. This would allow JPMorgan to release lots of reserves back onto the income statement through a negative provision, which could significantly boost earnings.
How much could the bank release? It's a good question. Many consider the central case that JPMorgan is using, where unemployment ends the year worse than it is now, to be conservative, so the $9 billion the bank has in reserves above its base case is certainly a possibility. It's also important to note that following JPMorgan's adoption of CECL accounting on Jan. 1, 2020, the bank's total reserves prior to the pandemic were $18.6 billion. At the end of 2020, the bank's total reserves were $30.7 billion. Now, JPMorgan has not said that it will ever get back to its original CECL reserve level, but it shows the huge potential for reserve releases should the economy snap back quickly this year.
A lot can still happen
While many experts and economists are much more optimistic about the broader economy now than back in 2020, there is still a lot of uncertainty about the potential for coronavirus mutations and the effectiveness of vaccines. But if the pandemic does get under control and economic conditions improve quickly, a reserve release of $9 billion or so throughout the year may not be out of the question.
Banks still face many challenges including a low interest rate environment, so JPMorgan's core earnings power will likely not be as high as it was in 2019, when the bank generated record earnings of $36.4 billion. But a $9 billion reserve release, which would equate to roughly 25% of its 2019 earnings, coupled with other factors like the massive amount of share repurchases JPMorgan is planning this year, could potentially power the bank to record earnings in 2021.
