S&P has revised its outlook for JPMorgan to negative from stable, citing the bank’s “unexpected pretax loss of $2 billion.”It affirmed the bank’s A/A-1 rating and A+/A-1 rating for the bank and its subsidiaries, respectively.
“We believe the possibility for broader problems with hedging strategies is not consistent with what we viewed as the company’s sound risk management practices,” the agency said in its release.
“We currently view JPM’s risk position as “adequate” and not”strong” (as our criteria define the terms), partially because of the risk on JPM’s balance sheet, which we believe contributes to the need for elaborate hedging strategies.”
See below for the full announcement.
On May 11, 2012, Standard & Poor’s Ratings Services revised its outlook on JPMorgan Chase & Co. (JPM) and its banking subsidiaries to negative from stable. At the same time, we affirmed our ‘A/A-1’ issuer credit ratings on JPM and our ‘A+/A-1’ issuer credit ratings on its banking subsidiaries.
The outlook revision reflects JPM’s recently announced, unexpected pretax loss of $2 billion in its Chief Investment Office portfolio related to the miscalculation of a hedge consisting of synthetic credit exposures. After reporting a gain of $1 billion from securities sales, the company expects to post an $800 million after tax loss in this division for the second quarter.
Previously, JPM said it expected to report a gain of about $200 million in this division. We believe the possibility for broader problems with hedging strategies is not consistent with what we viewed as the company’s sound risk management practices. We currently view JPM’s risk position as “adequate” and not “strong” (as our criteria define the terms), partially because of the risk on JPM’s balance sheet, which we believe contributes to the need for elaborate hedging strategies. Management’s admission that the hedging strategy was “flawed, complex, poorly reviewed, poorly executed, and poorly monitored” contributes to our negative outlook. We continue to view JPM’s broad lines of businesses and its geographic diversification as positive factors. And we note that losses from the hedging strategy are unlikely to weaken the company’s customer relationships or its core banking businesses.
Based on the announced loss, we now expect JPM to post Standard & Poor’s-adjusted earnings of roughly $17.2 billion in 2012, versus our previous expectation of more than $18.0 billion. Using this projection, and assuming the total payout ratio does not exceed 75%, JPM should be able to increase its risk-adjusted capital (RAC) ratio to slightly more than 7.0% over the next 18-24 months, in line with our adequate score for capital. We will monitor possible developments related to the application of the Volcker rule and its potential impact on industry participants, including JPM.
Although JPM contends that this synthetic credit portfolio was meant to hedge risk, it is possible that losses from the hedging strategy could lead to a more stringent interpretation of the Volcker rule. That, in turn, could affect JPM’s hedging strategies going forward by disallowing certain tactics, adding risk to JPM’s portfolio.
The negative outlook reflects the concerns raised by the miscalculations associated with JPM’s hedging strategy, specifically those applicable to the Chief Investment Office portfolio. The concerns include our uncertainty about other possible risk management weaknesses. We could lower the rating by one notch if: We determine that missteps in risk management are not limited to this synthetic credit portfolio. We determine management is pursuing a more aggressive investment strategy than we originally believed.
We note that the synthetic credit exposure, a position purportedly meant to hedge against tail risk in JPM’s credit portfolio, still holds material risk. As a result, we could determine that JPM’s 2012 earnings will weaken such that the company is unable to build its RAC ratio to more than 7.0% over the next 18-24 months.