Thursday, April 5, 2012

How sizable are the losses JP Morgan is hiding on and off its balance sheet?

With the adoption of the Japanese model for handling a bank solvency led financial crisis, policymakers have suspended mark-to-market accounting and implemented regulatory forbearance.  In essence, with their regulators' blessing, banks are hiding losses on and off their balance sheets.

Periodically, a bank CEO will remind everyone that the losses are still there.  For example, RBS' Stephen Hester confessed to hiding losses.

In his 2012 annual letter, JP Morgan CEO Jamie Dimon made a point of telling everyone exactly how much the losses hidden on and off JP Morgan's balance sheet are costing each year.
Your company earned a record $19.0 billion in 2011... 
On an absolute and static basis, we believe that our earnings should be $23 billion–$24 billion. 
The main reason for the difference between what we are earning and what we should be earning continues to be high costs and losses in mortgage and mortgage-related issues. 
While these losses are increasingly less severe, they will still persist at elevated levels for a while longer.
The losses are costing between $4 and $5 billion annually.

Naturally, Mr. Dimon is deliberately vague about how many more years it will take to run the losses through the income statement.  This is a function of the fact that he doesn't know the degree to which he can socialize the losses.

For example, the Obama Administration is actively trying to lower the losses in the second mortgage portfolio by forcing Fannie, Freddie (aka, the taxpayer) and the private mortgage investors to absorb losses on the first mortgages instead.

In theory, if the first mortgage holders take a big enough write-down, the borrower will be able to pay both the modified first mortgage and the second mortgage held by JP Morgan.  Hence, JP Morgan would suffer no losses.

The fact that second mortgages are supposed to be written down to zero before first mortgages are modified is what makes it hard to estimate the degree to which the losses can be socialized.

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