JP Morgan’s Dimon: Prime Mortgages Look “Terrible”

While second quarter earnings Thursday from JP Morgan Chase & Co. (JPM: 38.30 +3.12%) beat analyst expectations and helped set the stage for another rally in stocks ahead of market open, executives at the company sounded a strong warning bell over growing trouble in the nation’s mortgage market.

JP Morgan said that net income for the second quarter was $2 billion, or 54 cents a share, a drop of 53 percent from year-ago totals; analysts had been expecting 44 cents per share, according to a Bloomberg News report.

The firm recorded markdowns of $1.1 billion related to leveraged lending and mortgage-related positions; it also absorbed $540 million net loss on the late May merger with Bear Stearns.

While investors took heart in the second major financial company to report better-than-expected earnings — Wells Fargo & Co. (WFC: 29.84 +3.22%) set the stage for a market rally on Wednesday by beating analyst estimates — JP Morgan’s no-nonsense CEO Jamie Dimon was clearly trying to temper investors’ newfound enthusiasm with a dose of market reality.

“Our expectation is for the economic environment to continue to be weak – and to likely get weaker – and for the capital markets to remain under stress,” he said in a press statement. “We remain conscious that since substantial risks still remain on our balance sheet, these factors will likely affect our business for the remainder of the year or longer.”

Parsing mortgages
Part of that weak economic outlook can clearly be attributed to mortgages. In a surprisingly short conference call with analysts, Dimon suggested that losses in JP Morgan’s prime mortgage book could triple in the foreseeable future as the credit mess moves out of subprime and into Alt-A and jumbo loans.

“Prime looks terrible,” he told analysts on the call. “And we’re sorry, and there’s nothing else we can say.”

The company currently holds $34.4 billion of jumbo mortgages, along with $2.5 billion of Alt-A mortgages. Net charge-offs among prime loans in the second quarter rose to $104 million, more than double the $50 million recorded just one quarter earlier. JP Morgan jumped in headlong into jumbos and Alt-A mortgages during 2007 — obviously an ill-timed bet, given where the market has headed.

“We were wrong, we obviously wish we hadn’t done it,” Dimon told analysts. “We’re very early in the loss curve.”

Home equity loans are also proving to be problematic; JP Morgan holds $95.1 billion in the category, and saw net charge-offs rise to $511 million in Q2 from $447 one quarter earlier. High CLTV seconds in particular are “performing poorly,” according to the company’s investor presentation.

Chief financial officer Michael Cavanagh suggested that roughly 10 percent of the seconds on JP Morgan’s books are currently underwater — meaning that the borrower owes more on their combined mortgages than their home is worth.

“That could be headed to 20 [percent],” he said on the earnings call. “We can’t predict how homeowners will react when they go into negative equity.

“We’re assuming they won’t act well, but it’s possible things aren’t as bad as we expect.”

Subprime losses aren’t going away, either, thanks to housing price declines; net charge-offs in Q2 reached $192 million, up from $26 million one year earlier and $149 million in Q1. 30-day delinquencies also continued to post increases, suggesting that more losses are yet in the offing.

Total provisions for credit losses — including mortgages — hit $3.46 billion during Q2, more than double year-ago totals, although a $969 million drop from first quarter’s provision charges.

Despite headwinds in mortgage credit quality, the company’s mortgage banking operations turned in a solid second quarter. Mortgage loan originations were $56.1 billion, up 27 percent from the prior year and 19 percent from the prior quarter; total third-party mortgage loans serviced were $659.1 billion, an increase of $86.7 billion, or 15 percent.

Shares in JP Morgan were at $40.58, up nearly 13 percent, when this story was published.

Related links: JPM Q2 earnings statement, and financial supplement.

Disclosure: The author held no direct positions in JPM when this story was written, although indirect holdings may exist via mutual fund investments. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.