TEXT-S&P says JP Morgan ratings unaffected by Q2 results

July 13 - Standard & Poor's Ratings Services today said that its ratings on JPMorgan Chase & Co. (JPM; A/Negative/A-1) are not affected by the company's second-quarter results, which were lower as a result of Chief Investment Office (CIO) trading losses that were higher than we initially expected. JPM generated $5.7 billion of Standard & Poor's adjusted pretax earnings, down from $8.0 billion in the prior-year period. Results include a $4.4 billion loss from CIO trading, a $1.0 billion securities gain, and a $2.1 billion reserve release. According to management, JPM has reduced the synthetic credit default exposure within its CIO unit by about 70%. Losses from this portfolio have totaled $5.8 billion so far this year and, according to management, could increase under an extreme simulated scenario to between $800 million and $1.6 billion in additional losses. JPM has shut down the CIO's synthetic credit group, which the company says has added roughly $2.0 billion to earnings from 2007-2011. Management believes that missteps in risk management are isolated to its CIO unit. Since the trading loss was discovered, JPM has put in place various remedies, including a new CIO management team, granular market risk limits within its CIO unit that were not in place before, enhanced governance processes, and new procedures to review models that gauge market losses. JPM's Standard & Poor's adjusted revenue declined by 20.8% in the second quarter (year over year) to $21.6 billion, mostly as a result of the trading loss, but also because of weaker investment banking revenue. Although macroeconomic conditions could stunt capital market activities in the second half of the year, comparisons are favorable on year-over-year basis because of weak results in the second half of 2011. Positively, strong mortgage banking results, because of historically low mortgage rates that lead to high refinance volume, resulted in higher revenue in JPM's Retail Financial Service unit. We don't expect this to continue much longer because the pool of qualified borrowers to refinance is declining. Net interest margin (NIM) declined 14 basis points sequentially to 2.47% as a result of lower interest rates, a change in loan mix, and hedging ineffectiveness. Although midmarket and wholesale lending showed continued growth, we are uncertain whether this trend will continue because of the possibility of an economic slowdown. Consumer credit continued to improve in the second quarter, with sequential net charge-offs down roughly 4.6% to $2.3 billion. Early delinquencies across asset classes improved in the second quarter. We expect net charge-offs to continue to decline through 2013, albeit at a more moderate pace than in previous quarters. JPM's reserve releases were largely in its consumer lending businesses. The ratio of reserves (excluding reserves for purchase-impaired loans) to nonperforming loans is 183%--below the first-quarter level of 194%. Although credit seems to be improving, we are cautious of reserve coverage reductions at this stage in the credit cycle. We believe JPM's direct exposure to Greece, Ireland, Italy, Portugal, and Spain remains manageable but could have a negative ratings impact if the European crisis worsens. JPM's Basel I Tier 1 common ratio of 10.3% at the quarter end was flat sequentially. JPM suspended its share repurchase program. (Beforehand, it had repurchased $1.6 billion of common stock year to date.) The company will not repurchase additional shares until its board completes its CIO review, the company submits a new capital plan, and regulators grant the company permission. We assume that JPM's share repurchase will not commence until 2013 and that the company's combined repurchased shares and dividends will not exceed 75% of earnings. Our outlook on JPM remains negative as we continue to assess whether the risk management missteps are indeed limited to JPM's synthetic credit portfolio and, thus, an isolated case. In addition, we need to ensure that JPM has indeed pared back its more aggressive hedging/investment strategy. We will also review in further detail management's updated stress losses on the remainder of its synthetic credit portfolio. Significantly higher losses than management's estimate could hinder JPM's ability to build its Standard & Poor's risk-adjusted capital ratio to more than 7.0% over the next 18-24 months, which could lead us to lower the ratings. In addition, we will need to assess JPM's new plan to return capital to shareholders, which, if aggressive, could also impede its ability to build capital. Furthermore, although JPM has not been implicated with setting incorrect LIBOR rates, it is our understanding that U.S. regulators are investigating the matter. The issue could potentially lead to significant lawsuits should any wrongdoing be discovered.