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Originally published Saturday, November 6, 2010 at 10:02 PM

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Bad WaMu mortgages haunt JPMorgan Chase, Dimon

JPMorgan is now saddled with $74.8 billion in nonperforming home loans inherited from WaMu, a third of the $230.7 billion in mortgages on its books.

Bloomberg News

Jamie Dimon wanted Washington Mutual and he wanted it bad.

The JPMorgan Chase CEO was determined to expand on the West Coast, and Seattle-based WaMu was a prime target. Dimon had a team of auditors poring over WaMu's books in March 2008, at the same moment the Treasury Department was pressing him to acquire struggling investment bank Bear Stearns.

While he initially couldn't make a deal for the Seattle lender, JPMorgan did buy WaMu in September 2008 after it was seized by the Federal Deposit Insurance Corp., which meant the assets came at a bargain price of $1.9 billion. The 2,200 WaMu branches in California, Washington and 12 other states gave JPMorgan's consumer bank 5,410 branches — the second-biggest network in the nation. And it moved Chase to first from third in deposits, with $905 billion after the deal closed.

Dimon got what he wanted — and a lot he didn't want. JPMorgan is saddled with $74.8 billion in nonperforming home loans inherited from WaMu, a third of the $230.7 billion in mortgages on its books.

The WaMu losses are just one of the afflictions besetting the man who, in the midst of the recession two years ago, was dubbed the world's most powerful financial executive by The New York Times and labeled President Obama's "favorite banker."

A lot has gone wrong for Dimon since:

• Both the WaMu mortgages and JPMorgan's own home-equity loans are spilling red ink.

• Dimon's commodities-trading team has suffered a big setback.

• Dimon fought unsuccessfully to derail the Obama administrations new financial regulations and complains the bank will lose about $750 million in profits just as a result of new restrictions on the fees and interest it can charge on credit cards.

• New Basel rules, which will increase capital requirements for banks worldwide, begin in 2013.

• In consumer banking — JPMorgan's biggest revenue source — the bank is pushing against a regulation limiting it to 10 percent of national deposits.

With more than $2 trillion in total assets, JPMorgan is the second-biggest U.S. financial institution by assets, after Bank of America. It's the biggest U.S. credit-card company, with $137.4 billion in outstanding loans, followed by Bank of America and Citigroup.

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• The Securities and Exchange Commission is investigating whether JPMorgan failed to tell investors that an Evanston, Ill.-based hedge fund called Magnetar Capital helped select subprime mortgages for a collateralized debt obligation the bank created.

Yet Dimon's bank is still the brightest star in a dim firmament. While its stock lost 13 percent in the three years between November 2007 and October 2010, investors did far worse buying the shares of its competitors.

Citigroup shares were down 89 percent in the same three years, while Bank of America's return was minus 75 percent and Wells Fargo's stock fell 19 percent.

"Revenue headwinds such as slow loan growth, slim profit margins and higher regulatory costs should continue to hammer bank revenue not only next year but for the decade," says Mike Mayo, an analyst at Credit Agricole Securities in New York. "We think 2011 will be indicative of a year in a decade for banks that has the worst revenue growth since the Depression."

Housing troubles

The debacle in the housing market is still the biggest headache for U.S. banks. Payments on some 8 million U.S. mortgages were delinquent in late September, and almost 7 million of those may end up in foreclosure, says Laurie Goodman, a senior managing director at Austin, Texas-based Amherst Securities Group.

Those projections exclude the 200,000 additional borrowers that become delinquent each month for the first time, she says.

In total, Goodman estimates that 11.5 million homes could be repossessed by banks during the next five years.

Profits are also being squeezed by the Federal Reserve's policy of keeping interest rates persistently low, which had helped boost bank earnings during the worst of the credit crisis, says Matthew O'Connor, an analyst at Deutsche Bank in New York. The Fed's near-zero target rate for interbank overnight lending is compressing banks' net interest margins, the difference between what they pay to borrow money and what they get for loans and securities.

"It's a massive issue," O'Connor says. "As you look out over the next few quarters, it's a potentially very dire situation for the overall industry."

JPMorgan's results for the third quarter confirmed O'Connor's pessimism. Margins fell by 31 basis points to 3.01 percent at JPMorgan from March 31 to Sept. 30. (A basis point is 0.01 percentage point.) Combined with lower lending volumes, the reduced margins translated to a decrease in net interest income of $1.2 billion.

While third-quarter profit rose 23 percent from 2009 to $4.42 billion, the company generated 10.5 percent less revenue, at $23.82 billion. The profit included $1.5 billion the bank took out of its reserves against bad credit-card loans.

"Investors are still trying to figure out where revenue is going to come from when they stop being able to release reserves," says Jason Tyler, a senior vice president at Ariel Investments in Chicago. "That's not clear yet."

There may be more bad news hidden in JPMorgan's books. The bank set aside $30 billion against bad WaMu loans when it acquired the thrift in 2008. Dimon predicted that number could rise by $24 billion if unemployment hit 8 percent.

Unemployment was 9.6 percent in October, yet JPMorgan had only upped its reserves by an additional $3 billion.

"WaMu was a top-to-bottom subprime lender," says Paul Miller, a bank analyst at FBR Capital Markets in Arlington, Va. And its branch network outside California is not worth much, he says. "They were very expensive branches, not well placed."

The company told analysts last month the WaMu mortgage portfolio could cost $3 billion more if losses continued at current rates. Dimon says he doesn't expect profits to be dented much by the foreclosure scandal.

"It will cost us some money to go back and make sure it's done right," he told analysts on the Oct. 13 earnings conference call. "It will delay some foreclosures. But the whole mortgage issue costs us so much money now, to me it will be incremental."

He said no one had been evicted who shouldn't have been.

JPMorgan is the third-largest mortgage servicer in the U.S., with 13 percent of the market as of June 30, according to industry newsletter Inside Mortgage Finance.

On the same day Dimon made his statement, attorneys general in all 50 states announced a joint investigation into whether banks and loan servicers used false documents and signatures to foreclose on hundreds of thousands of homeowners.

In September, lawyers for defaulting borrowers disclosed that a mortgage executive at Chase Home Finance in Florida said in a May 17 deposition that she was among eight managers who together signed about 18,000 affidavits a month attesting to facts in foreclosure cases without personally checking loan records.

JPMorgan said Oct. 13 it was reviewing the documents for 115,000 loans. Nancy Bush, an analyst at Annandale, N.J.-based NAB Research, says JPMorgan can't rid itself of the foreclosure mess so easily.

"Dimon was putting a happy face on this issue," she says. "He'll review 115,000 foreclosures now in process. But what about the rest that have already occurred?"

Brian Battle, vice president of trading at Performance Trust Capital Partners in Chicago, says the bank's foreclosure flaws are just becoming apparent.

"That can be a big long-term problem, very expensive," he says. "The whole can of worms is wide open."

Strong performance

Even as Dimon swims through a sea of trouble, he can brag that JPMorgan remains the strongest big bank in the nation. It's the only major bank to have turned a profit in every quarter since the crisis erupted in late 2007.

Per-share earnings have grown 14-fold since hitting a six-year low of 7 cents in the fourth quarter of 2008. They were $1.01 in the third quarter.

The bank has generated $29.9 billion in profit since taking over Bear Stearns in March 2008 — an acquisition that has been a huge boon to JPMorgan's investment banking franchise.

When JPMorgan acquired Bear Stearns and WaMu, Dimon "had the strongest balance sheet in the industry," says Robert Willumstad, a former Citigroup chief operating officer who has known Dimon since the 1980s. "That's the exact position you want to be in: You want to be the strongest player in the marketplace when the government turns to you and says: 'We've got a problem. Can you take it off our hands?' "

Dimon's surpassing skill is his ability to hold down costs, efficiently integrate new acquisitions and minimize risk, Willumstad says. During his four years as CEO of Chicago-based Bank One, from 2000 to 2004, Dimon engineered a dramatic turnaround that took the bank from a $511 million loss in 2000 to a $3.5 billion profit in 2003.

When Bank One merged with JPMorgan in 2004 in a $58 billion deal, CEO William Harrison named Dimon president and chief operating officer. Dimon overhauled management, shuttered lagging businesses and instituted monthly management reviews in local branches.

Dimon was named JPMorgan CEO on Dec. 31, 2005. He largely avoided investing in the subprime housing loans that crippled Bear Stearns and Merrill Lynch — at least until he bought WaMu

Since 2006, JPMorgan has generated $59.7 billion in profit at a compounded annual growth rate of 22 percent.

JPMorgan's acquisition of Bear Stearns, the fifth-largest U.S. securities firm at the time, has gone far smoother than that of WaMu.

The bank ended up paying roughly $1.5 billion in stock to close the deal. The Federal Reserve Bank of New York agreed to take $30 billion of the struggling investment bank's mortgage-backed securities, collateralized debt obligations and other illiquid assets. JPMorgan assumed the first $1 billion in losses.

JPMorgan got billions of dollars in new investment-banking revenue and a prime-brokerage business serving hedge-fund clients out of the deal. The acquisition boosted 2008 second- quarter profits by $500 million.

JPMorgan's investment bank carried the bank's earnings through 2008 and 2009. Fees and trading revenue began to falter in 2010 due to the persistently weak economy and high unemployment.

Dimon, like his counterparts at other banks, is waiting impatiently for the housing crisis to ease so the bank can rid itself of its huge portfolio of bad loans. In addition to the WaMu writedowns, the bank faces an avalanche of litigation over allegedly predatory and fraudulent WaMu mortgages and has set aside a total $3.5 billion in reserves to cover the cost of mounting lawsuits.

Dimon blames the continuing home-loan losses on house prices that keep falling, unemployment that remains high and an economy that's recovering at a snail's pace. He predicted in April 2008 that home prices would fall a maximum 9 percent over the rest of that year; they fell by 16.5 percent.

Meanwhile, the company set aside $34.5 billion in reserves against potential losses on its mortgage, credit-card and auto loans in 2009, up from $20.4 billion the year before.

"It is just going to take a little bit of time before the mortgage losses are run off and things normalize," Dimon told investors in September.

That means Dimon has more time to mull the question of whether buying Washington Mutual was that rarest of events in his professional life: a bad deal.

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