Should the economy worsen dramatically over the next several years the rescue of Washington Mutual by JPMorgan Chase will be remembered as the event that brought the American financial system to its knees. While the terms garnered by JPMorgan may appear favorable on first review, the deal raises far more questions then it answers in regards to the health of the financial system of the United States. There is a significant possibility that this rescue may have begun the process by which the financial risk of lesser banks is thrown upon the three majors in an attempt to save the entire financial system.
In concentrating the financial risk of our system in JPMorgan, Citigroup & Bank of America there is the acute chance that we will inadvertently kill our rescuers, leaving us no choice but to rely on a federal assumption of banks that are truly to big to fail. Should the economy take a dramatic turn for the worse and unemployment rise dramatically, JPMorgan’s current loss assumptions will prove shortsighted. As we have seen over the last several months when such assumptions are realized by the investment community to be inadequate terrible things happen. JPMorgan with its massive derivative exposure can ill afford the unfortunate series of events that will undoubtedly come about should the losses associated with the Washington Mutual acquisition prove considerably larger then currently expected.
Based on JPMorgan’s current estimates the purchase of Washington Mutual will cost the venerable bank very little, namely a $1.8B dollar payment to the FDIC, an $8B dollar capital raise and a $31B dollar write down of the firm’s newly acquired loan portfolio. While I certainly have no qualms with the first two items, the third appears to be questionable. Below is a table of JPMorgan’s assumed losses on Washington Mutual’s loan portfolio:
| | Projected Remaining Losses as of 9/30/08 ($B) | Estimated Balance as of 9/30/08 |
| Option ARMs | $10.346 | $50.300 |
| Mortgage | 2.183 | 51.100 |
| HE Loans & Lines | 11.739 | 59.500 |
| Subprime | 6.438 | 15.100 |
The home equity (HE) and mortgage loss assumptions are almost laughable in my opinion as they place far too much faith in Washington Mutual’s underwriting capabilities. Unless there is a profound turnaround in the real estate markets out West, I simply do not see how losses on the home equity loans will not be much higher then currently expected. It seems reasonable to me that JPMorgan should have marked the loss assumptions for home equity loans up to such a level so that they match the percentage decline of home prices in the most depressed housing markets.
According to JPMorgan’s own assumptions the company expects losses to expand to $42B should the recession deepen and $54B should the recession become “severe”. These figures would represent an $11B and $23B dollar reduction of capital at the bank on top of the $31B dollar write down that JPMorgan has agreed to take initially. It is important to note that these figures take into account 7.5% and 8.0% unemployment respectively.
Throughout the credit crisis and for that matter throughout its history JPMorgan has been viewed as having a fortress like balance sheet. The Washington Mutual acquisition should put to an end this belief in the impenetrability of JPMorgan’s balance sheet, especially if the economy were to worsen. At the end of September, JPMorgan will have a capital base of $107B and a Tier 1 Capital Ratio of 8.3%. While the company’s capital base will have increased from $99B at the end of June, the Tier 1 Capital Ratio will have fallen dramatically as it stood at 9.2% in June. Such a rapid decline in this key metric is appalling, as it would suggest that JPMorgan is now nothing but a mere mortal.
Should the country enter a “severe” recession, as defined by JPMorgan, the company would find itself with a Tier 1 Capital Ratio that would be quickly approaching 7% (barring additional capital raises). When compared to its peer’s capital ratios, which can be found here, we would see that JPMorgan would have the lowest capital ratio of them all should events unfold in such a manner. The loss of its fortress like balance sheet will likely place the company under considerable strain as it will force it to restrain its derivative and investment bank operations. The future, while still existing for JPMorgan, has gotten bleaker with the acquisition of Washington Mutual. If we were to continue with the “fortress” metaphor, it is as if Jamie Dimon has lowered the drawbridge, raised the gates and proceeded to welcome the Barbarians into Camelot.
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Disclosure: None
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