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:

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.

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