How JPMorgan's Earnings Could Make or Break the Dow's Quarter

JPMorgan Chase (JPM 0.15%) will release its quarterly report on Friday, and the bank has already warned its shareholders that rising interest rates could lead to a big pullback in its mortgage business. As the first component of the Dow Jones Industrials (^DJI -0.98%) to report earnings in the month of October, JPMorgan's results could define not only its own future course, but also the tone of the entire Dow as it attempts to end 2013 on a winning note.

JPMorgan and the banking industry as a whole have done an incredible job of recovering from the financial crisis. Although some hard-hit banks still haven't returned to business as usual, JPMorgan and rivals Wells Fargo (WFC -1.11%) and US Bancorp (USB -1.49%) have all seen their shares regain their pre-crisis levels. Yet rapidly changing conditions in the bond market have led to interest rate volatility, and that poses a threat to JPMorgan's mortgage business and internal investment portfolio. Let's take an early look at what's been happening with JPMorgan Chase over the past quarter and what we're likely to see in its report.

Stats on JPMorgan Chase

Source: Yahoo! Finance.

Will JPMorgan earnings fizzle as rates rise?
Analysts haven't been too excited about JPMorgan's earnings prospects in recent months, having cut more than 10% from their third-quarter estimates. But they've been more optimistic about the long run, adding a couple of pennies per share to their full-year 2014 projections. The stock has nevertheless suffered a setback, falling 5% since early July.

At first glance, JPMorgan seemed to carry substantial positive momentum into the quarter. Back in July, the company's second-quarter results were quite strong, with earnings rising 31% and even besting Wells Fargo's 19% net-income rise. But much of JPMorgan's success came from its investment-banking and private-equity segments, with activity in debt and equity underwriting helping to boost investment-banking-related fee income by 38%. By contrast, on the key retail side of the business, JPMorgan saw net income fall 6% despite rises in deposits and mortgage originations. With the mortgage tailwinds expected to turn into headwinds in the third quarter, JPMorgan expected to see mortgage volumes fall as much as 40%, topping Wells' expectations for a 30% decline in mortgage activity.

Arguably the bigger obstacle that JPMorgan faces is the ongoing onslaught of litigation and regulatory difficulties. Late last month, reports surfaced that the bank was discussing a potential $11 billion settlement with state and federal authorities to put to rest allegations of improprieties related to its mortgage practices. That came right on the heels of the bank's $920 million settlement over the London Whale trading scandal, which included a rare admission from JPMorgan of its wrongdoing. Taken piecemeal, shareholders have largely been willing to discount one-time settlements as insignificant to long-term-profit potential. But with new allegations regularly surfacing, investors have already gotten tired of the seemingly endless string of settlement payments JPMorgan has made.

Interest rates also pose a huge threat. JPMorgan CFO Marianne Lake said last month that a two-percentage-point rise in rates could cause $15 billion in losses in the value of the bank's bond portfolio. Even though rising net-interest income would offset some of those losses, the potential for future disruptions when the Federal Reserve starts cutting back on its bond purchases under quantitative easing is huge. Wells has a smaller bond portfolio but could suffer proportionately more because of its smaller capital base. In combination with fee-driven income declines from slower mortgage activity, the impact could be large, and that's a big part of why investors are expecting falling year-over-year revenue and net income.

In the JPMorgan earnings report, look at the results of each of the bank's business lines. Where profits and losses come from should give you insight about the prospects not just for JPMorgan but for many of its peers as well, and the way investors take the news could define the Dow's direction for the rest of 2013 and beyond.

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