JP Morgan, margins and speculation: James Saft

Wed Jan 16, 2013 4:03pm EST

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(Reuters) - The risk controls may have changed but many of the preconditions for JP Morgan's epic speculative loss remain - for all too-big-to-fail banks.

JPM on Wednesday released both its fourth-quarter earnings and a 129-page report into the details of its $6.2 billion loss in its London-based Chief Investment Office. The two documents are a good pair, demonstrating why banks are likely to fall into the same pattern of taking on principal risk to make up for the declining profitability of core banking. here here

It is impossible to understand why JP Morgan found itself so far out on a limb without reckoning with two facts: it, and other banks, are awash in deposits, but face dwindling profits from loans.

Both phenomena can be traced to government policy. Deposits have poured into the largest banks at least in part because of the, correct, perception that they are too big to be allowed to ever go under. Declining net-interest margins, the gap between what a bank charges on a loan and what it pays for funds, is a natural offshoot of the very low interest rate environment, a sort of perverse outcome engineered by the Federal Reserve's zero interest rate policy.

The upshot of all of this is that banks, especially the largest, are sitting on huge amounts of cash but aren't making all that much on their loans. That piles on pressure to make money elsewhere, arguably one of the key forces behind the CIO debacle. The first thing to understand is that the CIO office exists exactly because of this imbalance between deposits and lending - its purpose, as described by the bank, is to ensure liquidity and make a "reasonable" return. In 2011 that reasonable return equated to revenues of $3.3 billion and profits of $411 million, making it a powerful and much admired force in the bank.

In 2012 the CIO was charged with reducing so-called risk-weighted assets, a measure the bank wanted to take because upcoming regulations will place greater strictures on RWA levels. When push came to shove, however, Ina Drew, head of the CIO, blanched at the losses cutting back on risk implied and instead instructed her team to "be more sensitive to the profit-and-loss impact of their trading."

The rest is history, history ending with a large and embarrassing loss and entailing failure of management, of models and of risk controls.

JP Morgan may, or may not, have put in new policies which will address these shortcomings. They certainly say they have. What is a lot less clear is whether a bank, given lots of government-enabled cash to play with and a malfunctioning central business model, will be able to abstain in future from trading escapades.

SHRINKING NET INTEREST MARGINS

JP Morgan reported a 53 percent increase in profits, with standout areas including surging revenue from fees for investment banking and for originating home mortgages.

Deposits are up 6 percent in the year and the loan to deposit ratio has shrunk to 61 percent, among the lowest in the world and indicating the bank is putting proportionally less of its money to work. JP Morgan's loan-to-deposit ratio was at 75 percent as recently as 2010.

At the same time those loans the bank is making are less profitable. The bank's net interest margin fell again in the quarter, to 2.85 percent, continuing a steady and depressing decline. At the end of 2010 it was 3.51 percent and 3.91 percent for all of 2009.

This is not just JP Morgan's problem. Bank of New York Mellon saw its shares tumble 2.8 pct on Wednesday after it announced a surge in revenues but a worrying decline in margins. Net interest margin at BNY Mellon dwindled to 1.09 percent in the fourth quarter, down from 1.27 percent in the same quarter of 2011.

It was the same story last week with Wells Fargo, which reported strong earnings but saw its shares sell off based largely on poor and declining margins. NIM at Wells fell to 3.56 percent from 3.89 percent a year ago and 3.66 percent in the third quarter.

The three banks together form quite a trend.

So what happens from here? My guess is that so long as the banks are awash in cash and can't do very well out of lending there will continue to be leaks, through which that money, seeking higher returns, takes on risks not adequately controlled by managers and regulators.

If mergers or private equity take off it could be channeled into financings which don't make much themselves but which are intended to help capture investment banking fees. If housing blossoms that would be another prime candidate.

Of course long-term rates could also rise, taking net margins along for the ride. That, however, could do damage to bank balance sheets, which carry plenty of interest rate risk. An economic recovery would help too, as loan demand would pick up.

If not, look for other speculative leaks out of our largest banks.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

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