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JPMorgan Investment Bank Avoids Crisis, for Now

After doing its best to prepare the entire world for the worst quarterly revenue result at its investment bank since the depths of the financial crisis, JPMorgan Chase'sinvestment banking unit did better than expected.

The unit earned $6.37 billion in revenue and $1.64 billion in profits during the third quarter. Its trading division drove investment banking results, posting revenue gains that countered estimates tied to drop in trading and deal making environment that snowballed as the third quarter wore on.

JPMorgan reported Wednesday

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that third quarter profit was $1.02 to a share on revenue of $24.4 billion, beating estimates of 91 cents a share and revenue of $23.40 according to Thomson Reuters.

The earnings beat however was a result of a $1.9 billion debt revaluation gain — earnings that are not related to the underlying operations of the investment bank.

In its press release announcing earnings, JPMorgan said, "the DVA gain reflects an adjustment for the widening of the Firm's credit spreads which could reverse in future periods and does not relate to the underlying operations of the company."

According to a Barclays report, JPMorgan's credit default spreads (CDS)nearly doubled from 83-to-162 basis points.

Its investment bank would have posted the lowest net earnings and revenue result since the worst of the financial crisis without the debt-valuation adjustment.

Of the investment bank earnings, JPMorgan CEO Jamie Dimon said in a press release, "The Investment Bank's revenue, excluding the DVA gain, was down substantially; however, we are gratified that the business maintained its number one ranking in global investment banking fees."

Net income from JPMorgan's investment banking operations dropped 20 percent to $1.64 billion from $2.05 billion in the second quarter of 2011. The result was better than the third-quarter results a year ago, when the investment banking unit brought in a profit of $1.29 billion.

Revenue at the investment bank fell 13 percent, to $6.37 billion from $7.31 billion in the second quarter, beating company forecasts. It was also more than revenue of $5.35 billion this time a year ago. The beat was attributed to its fixed income and equity trading businesses.

Expectations were for JPMorgan to earn $1 billion in investment banking fees and roughly $3.77 billion in trading revenue, making overall investment banking revenue forecasts of roughly $4.8 billion the weakest quarterly figure since the 2008 financial crisis when the bank reported an overall loss in the fourth. Without the debt revaluation gain, JPMorgan's underlying investment bank revenue of $4.48 billion was slightly lower than pessimistic estimates.

DVA gains aside, which the company said "could reverse in future periods" the third-quarter results casts into doubt whether the investment bank will grow for the year compared with 2010.

The earnings also show that while revenue contracts, earnings may stay strong. Nine months into the year, revenue is now on track to rise 10 percent and net income is set to rise 18 percent compared with last year — without the DVA gain, revenue would be close to flat for the year.

In a September Barclays Capital financial services conference, JPMorgan investment banking head Jes Staley said that the bank's trading business would fall 30 percent from the second quarter, when it registered a total of $5.39 billion in revenue, and that investment banking revenue would plummet roughly 50 percent to $1 billion.

Staley said, "I think you can safely expect a decline in our markets revenue broadly speaking of roughly 30 percent third quarter to second quarter... whether it's the equity capital markets calendar, whether it's the debt capital markets calendar, whether it's corporations putting a pause on the M&A activity, it's fairly easy to get to a point where our Investment Banking fees in the third quarter should be roughly around $1 billion."

The grim forecast proved to be overly pessimistic for now — and it was a reflection of a quarter when markets and deal volumes deteriorated as the possibility of a return to crisis grew with concerns over government indebtedness and the health of U.S. and European banks.

In a research note after the conference, Barclays Capital analyst Jason Goldberg wrote, "Looking at our expectations for third quarter 2011, we expect all major capital markets revenue categories to decline amid the U.S. debt-ceiling debate/credit downgrade, European financial concerns, falling global equity markets and heightened volatility."

In the third quarter, the S&P 500 index fell 14 percent and the MSCI World Index dropped 17 percent. Meanwhile, the VIX, a gauge of general risk aversion, averaged 31 during the quarter, reflecting an almost doubling of fear from the second quarter's average level of 17.

Currently the VIX is above 40, indicating that since the quarter ended, worries of a crisis haven't subsided entirely. The market's volatility has been even worse for banks. In the third quarter the KBW Bank Index fell more than 25 percent.

JPMorgan reported Wednesday

JPMorgan's earnings also rebut analyst's forecasts that the investment bank would contribute the smallest share of revenue to the overall bank since the fourth quarter of 2008, a time when global capital markets were nearly frozen.

JPMorgan reported Wednesday

Jamie Dimon
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Jamie Dimon

According to median estimates compiled by Thomson Reuters analysts expected JPMorgan to earn $23.4 billion in revenue, making management's forecast of $4.77 billion in investment banking revenue, roughly 20 percent of overall forecasted revenue the smallest revenue contribution by the investment bank since it nearly pushed the overall bank to a loss in the fourth quarter of 2008.

It's also a reversal of the trend of stalling investment banking revenue for now, which accounts for between a quarter and a third of JPMorgan's overall revenue and has, in post-crisis quarters, supplied up to 75 percent of overall profits to the second largest bank in the U.S.

For JPMorgan's investment bank, which has shown quarter-over-quarter declines in revenue in six of the last seven quarters, it dampens expectations earlier in the year that 2011 would be better than 2010. In the first two quarters of the year, revenue increased 16 percent and net income increased 49 percent.

Falling revenue and an increase in profits were driven by expense savings, mainly pay. Compensation expense as a percentage of revenue fell to 29 percent, from 35 percent in the second quarter and 38 percent a year earlier — overall the investment bank paid employees $1.85 billion.

Barclays Capital's Goldberg wrote in his note, "As revenues decline, we would expect a commensurate decrease in expenses. Using JPM as an example, if trading revenues fall 30 percent and investment banking declines 47 percent, and it maintained a 35percent to 40 percent comp ratio, comp expense could decline 25 percent to 35 percent."

Investment banking fee revenue fell 46 percent to $1.04 billion, after growing 23 percent and 37 percent in the first and second quarters respectively when compared with 2010. In the second quarter, the investment bank posted its best quarter since earning $2.24 billion in that period two years prior.

According to Dealogic, global investment banking revenue was $13.5 billion in the third quarter, the lowest level since the first quarter of 2009 and down nearly 40 percent from second quarter levels of $21.4 billion.

The third quarter results still showed that JPMorgan led all banks in investment banking fees, taking an 8.4 percent overall market share. Results showed that through the first nine months of the year, it led all banks in fees earned from debt issuance and was second in equity capital market, merger and acquisition, and loans fees earned.

Total fixed income, currency, and commodity trading revenue fell to $3.33 billion below $4.28 billion earned in the prior quarter, but more than $3.12 billion this time last year. Meanwhile, equity trading increased to $1.42 billion from $1.22 billion in the second quarter and $1.14 billion at this point in 2010. Overall, FICC trading revenue is up 6 percent and equity trading is up 11 percent nine months into the year, when compared to 2010.

JPMorgan's shaky investment banking earnings numbers may be a harbinger of things to come as Morgan Stanley, Goldman Sachs, Citigroup and Bank of America all report earnings in coming weeks. For other banks, falling revenue from operations may be erased by gains from their widening credit spreads.

"Third-quarter 2011 has been a very difficult quarter for market making across the Street, particularly in FICC trading... We are currently forecasting the median bank's FICC revenues to decline 14 percent and equity trading revenues to increase 17 percent from the second quarter of 2011," wrote analysts at KBW in a Sept. 26 note.

In a separate note written following JPMorgan's muted outlook for investment banking, Mike Mayo of CLSA wrote, "We think these lower activity levels will carry forward until the global economic and market outlooks improve."

If debt revaluation gains based on gains related to widening bank credit spreads are readjusted to losses, management and analyst pessimism for investment banking revenue may be realized in coming quarters.

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