FIN 4303 – Commercial Banking Assignment – Part 1

Return on equity equals the product of the equity multiplier and return on assets. It measures the

net income produced for each dollar of equity capital. The equity multiplier reflects the amount of leverage the bank uses to finance its assets. As the equity multiplier increases, the firm’s solvency risk increases. Return on assets measures net income produced for each dollar of total assets. Return on assets is the product of asset turnover and profit margin. Profit margin represents the firm’s ability to control expenses. Asset turnover measures the ability to produce net income from assets. These ratios are most useful when used as relative valuations against other firms in the commercial banking industry or over time1.

1 Saunders, Anthony. Financial Markets and Institutions

Return on Assets .5%

Asset Turnover 3%

Equity Multiplier 12.1 times

Return on Equity 6.3%

Profit Margin 17.3%

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Figure 1: JPMorgan Chase & Co. 15

Figure 2: Industry 15

Figure 3:

Ratio Analysis 15

15 http://www.fdic.gov

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Interpreting the Trends

From 2000 to 2001, JPMorgan Chase & Co.’s (JPM) ROE decreased resulting from a decline in net income, and thus profit margin. The recession had a large impact on JPM in 2001. Net income dropped due to unfavorable spreads, reductions in asset values, and less liquidity in equity markets2. Losses on private equity investments and lower investment banking fees caused revenues to decline3. The investment banking segment’s operating revenue shrank in reaction to reduced demand for M&A and equity underwriting in the market4. The firm also incurred higher non-interest expenses, namely merger and restructuring costs, related to the JP Morgan and Chase merger. JPM recognized higher than expected charge-offs in consumer and loan portfolios, forcing them to increase their provisions for loan losses5.

Over the next years, from 2002 to 2003, JPM was able to significantly increase its profit margin as a result of a 64% decrease in the provisions for loan losses that had been increased the previous year. This decrease reflects improvement in JPM’s previously troubled commercial loan portfolio, as well as a higher volume of credit card securitizations. The higher profit margin caused ROE to increase from 1.6% to 11.5%, and also resulted in an increased ROA. JPM’s total assets declined relative to equity, and they had to turn to outside, more costly debt financing due to reduced demand for their loans; these actions were at the root of the decreasing equity multiplier6.

From 2003 to 2004, JPM’s previously inflated ROE decreased from 11.5% to 2.9% as a result of a large increase in equity capital, primarily the result of JPM’s merger with Bank One. Also as a result of this merger, noninterest expenses increased from $19 trillion to $30 trillion. Although this 8.6% decrease in ROE is large, it merely offsets the prior increase of 9.9%, and in fact the 2.9% ROE remains higher than the 1.6% that was recorded at the beginning of 2002. JPM’s lower net income in 2004 can be attributed to merger costs, charges to conform to accounting policies as a result of the merger, and a charge to increase litigation reserves. Lower net income in this period led to a lower ROE, ROA, and profit margin. According to the annual report, had JPM not incurred these charges, ROE would have been 11% 7. Further eroding potential earning was an increase in competitive pressures which forced prices down for loan models8.

ROE significantly increased from 2004 to 2005. Due to healthy growth in the economy, net income increased and resulted in higher profit margins and ROA than the previous year. During this time, short term interest rates continued to rise and capital and equity markets remained strong9. The equity markets remained strong in 2006, and JPM’s margins and returns held steady. This would later be recognized as the calm before the storm.

In 2007, the mortgage crisis weakened the credit market10, and ultimately caused many troubled wholesale and consumer loans. JPM had not planned for this to happen and was forced to once again increase provisions for loan losses. JPM’s acquisition of Washington Mutual and Bear Stearns resulted in

2 2001 Annual Report, pg. 24 3 2002 Annual Report, pg. 69 4 2001 Annual Report, pg. 30 5 2002 Annual Report, pg. 69 6 2003 Annual Report, pg. 24 7 2004 Annual Report, pg. 20 8 “Report on the condition of the U.S. banking industry: 4th Quarter, 2004.” Federal Reserve Reports FRY-9C and FR Y-9LP. http://www.thefreelibrary.com/Report+on+the+condition+of+the+U.S.+banking+industry:+fourth+quarter,…-a0134672382. 9 2005 Annual Report, pg. 25 10 2008 Annual Report, pg. 35

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an unusually large noninterest expense11, and called for an even further increase in provisions12, which now included a higher allowance for credit cards and real estate13. JPM realized $21 billion in losses, but without the acquisition this would have only been $4.9 billion. As a result of all of these changes, JPM had a decrease in net income, which included the write-off of loan loss provisions, as well as the acquisition. It became necessary to increase JPM’s equity capital to fill the gap which resulted from lower net income. The shift from earned capital to equity capital fueled a 3.1% decrease in ROE, from 9.4% to 6.3%. JPM’s equity multiplier increased from 2007 to 2008, magnifying the decline in ROE beyond what it would have been if the equity multiplier had remained at its lower 2007 level. The equity does not include $1.26 trillion in off-balance sheet lending in 2008, which did not affect ROE. This off- balance sheet lending represents transactional income for JPM rather than traditional interest income, and in 2007, JPM realized significantly more revenues through transactional income, such as service charges, than from traditional interest income. The poor economic environment, increasing LIBOR rates, increased counterparty risk, and less liquidity in the market place took a noticeable toll on JPM’s operations.

 Return on equity (ROE) measures profitability per dollar of equity. ROE decreased from 2006 to 2008. It surpassed the industry, indicating that JPM was more profitable per dollar of equity than the industry. It is possible that the industry average was skewed by failing banks due to the financial crisis, in which case our interpretation would be skewed as well. JPM’s higher ROE results from a higher ROA and a higher equity multiplier than the industry.

 JPM’s upward and downward trends in ROE tend to follow the industry, but its movements are more

extreme because JPM consistently has a higher equity multiplier than the industry. 11 2008 Annual Report, pg. 30 12 2008 Annual Report pg. 97 13 2008 Annual Report, pg. 98 * All Annual Reports retrieved from: http://investor.shareholder.com/jpmorganchase/annual.cfm

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 JPM’s ROE was smaller than the industry’s from 2001 to 2006 primarily because JPM’s profit margin and ROA were much smaller than the industry during this period.

 A consistently higher equity multiplier indicates JPM uses a higher percentage of debt to fund its assets than the industry. The equity multiplier magnifies movement in return on equity. A higher equity multiplier indicates higher solvency risk.

 In 2008, the firm had an equity multiplier of 12.114 times, while the industry had an average of 10.664 times. This represents JPM’s willingness to accept higher solvency risk in order to potentially realize greater returns. It should also be noted that JPM has a Tier 1 capital ratio of 10.9%, representing a healthy firm11.

 JPM’s return on assets increases and decreases with the industry, but JPM’s ROA remained below the industry until 2008. JPM had an ROA of .5% for 2008, compared with an industry average of .2%. JPM produced slightly more net income per dollar of assets than the industry. The firm had

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a higher ROA than the industry average because of its ability to better curtail losses during the recession than the industry.

 Prior to 2008 JPM’s ROA was lower than the industry, which indicates JPM was not effective in

utilizing its economies of scale to produce returns more efficiently than the market.  Historically, JPM’s ROA has been has been lower than the industry’s average. This is because of a

combination of a historically low asset utilization and profit margin compared to the industry. While sub-prime mortgage issues decreased JPM’s ROA, Asset Utilization, and Profit Margin for the previous two years, it is evident that the firm faired far better than the industry. JPM’s profit margin remained at a relatively healthy 17.3%, compared to the industry’s 6.8%. This number is skewed, given the number of bank failures and poor risk decisions undertaken by failing banks.

 Return on Assets is a product of JPM’s profit margin and Asset Utilization. The industry average

shows a general trend representative of changes in the market through mergers and acquisitions. JPM has historically had a lower Return on Assets than the industry. This changed in 2007 and 2008 when JPM had a higher ROA than the industry. While JPM didn’t necessarily increase its ROA substantially, the industry did have a decline in its Profit Margin for the same time frame. This was a result of a dramatic increase in its noninterest expenses.

 JPM’s profit margin is lower than the industry from 2000 to 2007, indicating JPM was less able to control expenses than the industry. In 2008 the profit margin for both JPM and the industry declined, but the industry’s declined more significanlty due to larger decreases in net income from loss writeoffs related to the financial crisis.

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 Asset utilization represents JPM’s ability to earn operating income given its assets. Asset utilization remains below the industrial average until 2007. Asset utilization does not include noninterest expense, an integral part to JPM’s write-offs in 2008. JPM also had a significant tax write-off from international operations that would not be included in this calculation, but would otherwise be calculated in ROA. This ultimately results in JPM’s asset utilization being on par with the industry, .030 compared to .029314.

 JPM’s Asset Utilization decreased in 2004 due to a merger with Bank One. JPM’s asset utilization

has historically dropped with every acquisition because its noninterest expenses increase without a corresponding immediate increase in profits.

14 2008 Annual Report, pg. 33

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FIN 4303 – Commercial Banking Assignment – Part 2

Financial Markets and Intermediaries Assignment 2 consists of an analysis of JPMorgan Chase’s (JPM) banking strategy. We will discuss time trend analysis and comparisons to the industry for seven financial ratios. We then go on to discuss the similarities and differences in breakdown of noninterest income, loan portfolio and deposit funding between JPM and the industry. JPMorgan Chase is a financial holding company and one of the largest banking institutions in the United States. It holds $162 billion in stockholders’ equity. The company is organized into six business segments, consisting of: Investment Bank, Retail Financial Services, Card Services, Commercial Banking, Treasury & Securities Services and Asset Management, and Corporate/Private Equity15. JPM has a nontraditional banking business strategy. JPM’s non-interest income comprises a larger portion of operating income than the industry. Historically, JPM’s Investment Bank segment has generated the most noninterest income for the firm. In 2008, however, Retail Financial Services generated the most noninterest income as a result of the Washington Mutual transaction16. Loans make up a smaller percentage of JPM’s assets than the industry. In addition, to loans, trading assets make up a large portion of JPM’s assets.

Due to the extremely large size of the bank and it’s market share, the industry is not the best benchmark for JPMorgan Chase. Larger banks typically have a smaller amount of equity capital, utilize fewer core deposits, and generate more noninterest income than smaller banks17. Commercial banks with more than one billion dollars in assets would be a more appropriate benchmark than the entire industry.

15 (2008 10-K, pg. 27) 16 (2006, 2007, 2008 10-K) 17 (Fin Markets textbook 374)

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JPM’s net interest margin is correlated to asset utilization. JPM’s lower than industry average net interest margin from 2000 to 2008 was reflected in its low asset utilization during the period. While net interest margin is net interest income as a percentage of earning assets, asset utilization is total operating income as a percentage of total assets. JPM’s earning assets remain relatively stable in relation to the firm’s total assets throughout the past ten years. The change between the two ratios, therefore, is a directly related to the firm’s change in provision for loan losses and can be seen particularly well when comparing how the two ratios relate between 2006 and 2008. While the firm’s net interest margin increases during that time period, the firm’s asset utilization decreases. Since there was no significant change in its earning assets to total assets, it was caused by the firm’s nearly four-fold increase in provision for loans losses.

JPM’s net interest margin does not follow the trend of the industry consistently. The gap between the net interest margin of JPM and the industry has decreased as the industry’s ratio decreased from 2000 to 2008. Industry earning assets have increased by a larger percentage than net interest income between 2000 and 2008.

From 2001 to 2002 JPM’s net interest margin decreased while that of the industry increased; this was a result of narrowed spreads in JPM’s deposit businesses and a decline in volume of commercial loans related to troubled commercial credits concentrated in the telecommunications and cable industries18.

From 2002 to 2003, JPM’s net interest margin increased while that of the industry decreased. JPM’s net interest income and earning assets increased 6.3% and .6%, respectively, compared to a 1.5% and 7% increase in the industry. JPM’s net interest income increased as a result of lower interest rates on consumer loans and lower funding costs. Trading related net interest income increased due to growth in trading assets19.

Due to a large increase in earning assets related to higher yields on consumer loans during 2004, JPM’s net interest margin decreased from 2.3% to 1.8%20.

In 2008, JPM’s net interest margin increased as that of the industry decreased due to JPM’s increase in net interest income. The increase was attributed to higher net interest income from the Investment Bank segment related to the acquisition of the Bear Stearns Prime Services business, wider spreads on certain fixed income products, the Washington Mutual transaction, a wider net interest spread in the Corporate/Private Equity segment, and higher consumer loan balances21.

18 (2002 10-K, pg. 20, 16) 19 (2003 10-K, pg. 25) 20 (2004 10-K, pg. 25) 21 (2008 10-K, pg. 34, 42)

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JPM’s allowance for loan losses is established and maintained to protect against charges on its

operating income. It is an estimate of uncollectible amounts that are used to reduce the book value of loans and leases to the amount expected to be collected22. It is representative of the firm’s realistic anticipation of loan losses.

JPM’s allowance for loan losses as a percentage of assets closely follows the trend of the industry, but remains below the industry average from 2000 to 2008. We believe the allowance for loan losses as a percentage of loans would be a better source of comparison between JPM and the industry because JPM’s loans make up a significantly smaller portion of its assets compared to the industry. JPM and the industry allowance for loan losses as a percentage of loans were 3% and 2%, respectively, in 2008.

From 2003 to 2004, the industry allowance for loan losses decreased as a result of total assets increasing due to improved credit quality related to strong capital markets. JPM’s allowance for loan losses as a percentage of assets remained constant as a result of increased allowance for loan losses and total assets, both related to JPM’s merger with Bank One23.

From 2004 to 2006, both JPM and the industry’s allowance for loan losses as a percentage of assets decreased as a result of the strength in overall market credit quality24.

In 2008, both JPM and the industry’s ratio increased as a result of a weak credit environment and higher estimated losses. JPM’s increased allowance for loan losses was related to high charge-offs on credit card loans and growth in retained loans25. Its Commercial Banking division increased allowance for loan losses in connection to the Washington Mutual transaction26.

JPM’s ratio started to converge with the industry from 2006 to 2008. JPM increased its total allowance amount at a faster pace than the industry average from 2006 to 2008. The increase is a result of JPM’s increase in total loan portfolio from mergers and acquisitions with Bear Stearns and Washington Mutual, which increased JPM’s poor loan quality ratio27.

22 http://www.occ.treas.gov/handbook/alll.pdf 23 (2004 10-K, pg. 30, 33, 41, 45) 24 (2005 10-K, pg. 29) 25 (2008 10-K, pg. 35) 26 (2008 10-K, pg. 52) 27 (www.occ.treas.gov)

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From 2000 to 2004, both the industry and JPM’s loan to core deposits decreased due to increased core deposits. JPM’s ratio was higher than the industry during this period.

Although core deposits increased from 2000 to 2008, core deposits as a percentage of total deposits decreased. This reflects JPM’s trend of relying less on local markets as sources of funds. Lower reliance on core deposits is typical of most large banks.

In 2008, JPM’s ratio declined sharply while the industry increased sharply. This inversion was a result of JPM’s increase in core deposits as a result of the Bear Stearns and Washington Mutual mergers28.

The loans to assets ratio represents the portion of JPM’s assets that are loaned to consumers

through a traditional banking structure. JPM consistently maintains a lower loans to assets ratio than the industry. While the industry’s

ratio is relatively constant throughout the timeframe, its small shifts are magnified in JPM’s trendline because of JPM’s substantial exposure to loan risks through its acquisitions. JPM had a decrease in its loans to assets ratio between 2001 and 2002 because of an increase in total assets, $8.5 billion decrease in loans, and $22.4 billion decrease in lending-related commitments, representing weaker demand and ongoing credit management activities29. Total loans decreased as a result of a reduction in commercial and industrial loans.

JPM’s loans to assets ratio increased between 2003 and 2004 because its gross loans doubled, while its total assets only increased 60%. This is a result of the Bank One merger, which contributed a large number of consumer and wholesale loans30.

JPM’s ratio increased in 2008 while there was an industry-wide decline in loans to assets due to JPM’s merger with both Washington Mutual and Bear Sterns.

28 (2008 10-k pg. 77) 29 2004 10-k pg. 52 30 (2003 10-K, pg. 101)

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Noninterest income as a percentage of operating income represents the amount of JPM’s income that comes from fiduciary activities, service charges on deposit accounts, gains from trading assets/ liabilities, and other noninterest income. It also relates to trends in provisions for loan losses and net interest income.

JPM consistently maintains a higher noninterest income as a percentage of operating income than the industry average. JPM earns a large percentage of its income from noninterest activities.

JPM’s increase in noninterest income as a percentage of operating income from 2001 to 2002 can be attributed to a decrease in total operating income. The decrease in operating income resulted from an increase in its provision for loan losses related to telecommunications and cable sectors31.

JPM’s subsequent decrease in provision for loan losses resulted in a decrease in noninterest income as a percentage of operating income from 2002 to 2003. JPM and the industry’s ratio increase from 2007 to 2008 due to decreases in operating income, attributed to larger provisions for loan losses related to consumer loans, the burst of the housing bubble and rise in loan defaults.

The Cost Efficiency Ratio is noninterest expense divided by total operating income. A high ratio is

indicative of an inefficient company. The cost efficiency ratio is inversely correlated with profit margin and reflects JPM’s ability to control costs. JPM’s high cost efficiency ratio from 2000 to 2007 was related to its low profit margin during the period.

JPM’s cost efficiency ratio decreased between 2002 and 2003 resulting from its implementation of Six Sigma productivity program and lower performance-based incentives due to poor-performing

31 (2002 10-K, pg. 17)

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markets32. The sharp increase in the cost efficiency ratio between 2003 and 2004 was a result of an increase in noninterest expense from JPM’s merger with Bank One33. JPM had merger costs of $448 million and litigation charges of $1.6 trillion in 200434. JPM’s steady decrease in its cost efficiency ratio from 2004 to 2007 was a result of a decrease in performance-based compensation and increases in operating income. JPM’s slight increase in 2008 resulted from its acquisition of Washington Mutual and Bear Stearns. In 2008, the Bear Stearns and Washington Mutual mergers accounted for JPM’s increased noninterest expenses for the year35.

While JPM’s equity-to-asset ratio has been consistently lower than the industry, its equity multiplier has been consistently higher than the industry over the past eight years, indicating that the industry utilizes more equity. The industry includes many banks that are smaller than JPM. Large banks, like JPM, usually operate with lower levels of equity because they have easier access to capital markets36.

JPM’s upward and downward trends in the equity to assets ratio closely resemble the industry. JPM’s ratio is consistently lower than the industry with the exception of the year 2004 when JPM’s ratio increased from .06 to .1 to equal the industry. In 2004, JPM’s total equity capital more than doubled primarily due to JPM’s merger with Bank One. Each outstanding share of Bank One common stock was converted into 1.32 shares of JPM common stock37.

The gap between JPM and the industry’s equity to assets began to widen again in 2006 as JPM’s equity to assets decreased. In 2006 JPM’s assets increased by a larger percentage than equity as a result of its acquisition of The Bank of New York, Inc.’s consumer, business banking, and middle-market banking businesses38.

In 2008, both the industry and JPM’s ratio decreased as a result of assets increasing by a larger percentage than equity. JPM’s assets increased as a result of its acquisition of The Bear Stearns Companies Inc. and the banking operations of Washington Mutual Bank. The Washington Mutual transaction added $310 billion in assets to JPM. Trading assets and loans made up the largest contribution to JPM’s assets from Bear Stearns and Washington Mutual, respectively39. 32 (2002 Q2, pg. 2) 33 10-k pg. 41 34 10-k 2006, pg 25 35 2008 10-k pg. 170 36 (Fin Markets textbook, pg. 374) 37 (2004 10-K) 38 (2006 10-K) 39 (2008 10-K)

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JPM has a nontraditional banking business strategy, whereas it does not rely as heavily on deposit- related fees as a source of income as the industry. In 2008, service charges on deposit accounts made up 10% of JPM’s noninterest income, compared to 20% of the industry’s noninterest income. Service charges on deposit accounts typically make up a smaller portion of JPM’s noninterest income than 10%. However, in 2008, JPM charged higher deposit-related fees and the Washington Mutual transaction contributed to more service charges on deposit accounts40.

JPM’s trading account gains/securities gains remained positive due in part to a gain of $668 million from the sale of MasterCard shares and repositioning the securities portfolio as a result of lower interest rates41.

Asset management, administration and commissions fees consistently make up the largest portion of JPM’s noninterest income42.

40 (2008 10-K, pg. 33) 41 (2008 10-K, pg. 61) 42 (2008 10-K)

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In 2008, JPM’s loan portfolio closely resembled that of the industry. Real estate loans made up the largest fraction of the loan portfolio for both. JPM’s loan composition across industries is typically more diversified. JPM’s real estate loans typically make up a smaller portion of the portfolio, but real

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estate loans increased in 2008 due to the Washington Mutual transaction43. Real estate loans include credit provided to real estate developers and investors from which repayment is contingent on sale, lease, or management of the property44. The deterioration of credit quality of the real estate industry contributed to JPM’s decrease in net income, and thus, profit margin in 2008. In response to the large increase in provisions for loan losses related to consumer loans, JPM’s loans to individuals decreased to 20% in 2008.

43 (2008 10-K, pg. 211) 44 (2008 10-K pg. 164)

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JPM’s funding strategy revolves around liquidity and diversifying funding sources45. We evaluated JPM’s core deposits as a fraction of total deposits to determine the amount of deposits it relies on from local markets.

In 2008, JPM’s core deposits, a cheaper and less likely to be withdrawn source of funding, comprised a slightly smaller portion of the bank’s deposit funding than the industry. From 2000 to 2008 JPM’s core deposits to deposits ratio has decreased. Larger banks typically rely less on core deposits than smaller banks.

45 (2008 10-K, pg. 76)