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BB&T BANK ANALYSIS REPORT

FINA 280
FINANCIAL INSTITUTION MANAGEMENT & MODELING
William C. Handorf, Ph.D.

June 28, 2008
Washington, DC

Content

1. INTRODUCTION ………………………………………………..…………………3
2. BB&T ……………………….……………………………………………………….4
3. US ECONOMIC OVERVIEW ……………………………………………………12
4. BB&T Bank …………...……………………………………………………………14
5. Conclusion…………………………………………………………………………..41
6. Questions to Management………………………………………………………….42
1. INTRODUCTION

The purpose of this report is to analyze the financial operations and financial conditions of BB&T Bank by evaluating financial, economic and market information available for the period from 2000 to 2008. This paper attempts to address key strengths and weaknesses of the bank from a regulatory, financial, and credit market perspective. In order to make assessments and calculate required ratios, statistics and correlations, we mainly review the Uniform Bank Performance Report (UBPR) of the bank and publicly available financial data. Besides BB&T Bank the paper also attempts to analyze the performance of the holding company, BB&T Corporation (NYSE: BBT).

Section 2 briefly overviews the holding company - BBT - and its financial analysis. Section 3 provides an overview of the US economy as a backdrop to the financial performance of the bank. Section 4 uses the CAMELS methodology (Capital, Asset Quality, Management, Earnings, Liquidity and Sensitivity) to identify the key strengths and weaknesses of the bank. Finally, Section 5 explores the future performance of the bank and then concludes the paper.

2. BB&T Corporation.

BB&T Corporation (BB&T), based in Winston-Salem, North Carolina, and founded in 1872, is the 14th largest U.S. financial services holding company with $136.4 billion in assets (numbers as of March 31, 2008). BB&T operates approximately 1,500 subsidiary financial centers in the Southeast and Mid-Atlantic Region; each bank subsidiary is organized into a group of community banks headed by a regional president.

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The modern BB&T Corporation formed in 1995 through a “merger of equals” with Southern National Bank (at the time, BB&T was the fourth largest bank in North Carolina, Southern National number five). After that merger, the combined BB&T was then the 35th largest bank in the United States. Since then, a flurry of acquisition activity - financial services (asset management, corporate capital investment, insurance, real estate, and consulting) subsidiary and affiliate companies - 47 community banks, 82 insurance agencies, and 31 non-bank entities in the last fifteen years. At the end of February, BB&T raised their quarterly dividend payments 9.5% to 46 cents (from 42 cents a share). Whether or not they keep the dividends at this level will depend on their reaction to Federal Reserve regulators pressuring regional and small banks with balance sheet problems to cut dividends and raise capital. The Fed has made public documents it has sent to multiple banks in the second quarter of 2008 (Millennium Bankshares Corp, Integrity Bancshares Inc., WSB Financial Group Inc.) instructing them not to issue dividends without prior approval from the Fed. An analysis of BB&T’s ability to continue paying dividends and support their dividend growth follows.

The Company's activities are organized into six business segments: Investment Bank, Retail Financial Services, Card Services, Commercial Banking, Treasury & Securities Services and Asset Management The graph below shows breakdown of total income by business segments:

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2.1 Financial Analysis of BB&T Corporation.

In this section we’ll briefly discuss the CAMELS analysis of the holding company.

2.1.1 Capital & Risk Index

The risk index of the bank indicates that there is probability of 0.001% that the Company will below capital, which is higher than the peer group’s indicator of 0.0005%. BB&T’s ROA has been larger but also more volatile compared to the peer group.

| |BB&T |Peer Group |
|Description |Indicator for Dec 31,2002 - Mar 31,2008 |Indicator for Dec 31,2002 - Mar |
| | |31,2008 |
|Tier One Leverage Capital |6.97 |7.95 |
|Mean ROA |1.5386 |1.2323 |
|Sigma ROA |0.1553 |0.1371 |
|Risk Index |22.5924018 |30.50547046 |
|Probability of going under 5% |0.000979592 |0.000537297 |

Credit Rating and Cost of Equity
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BB&T currently has a 4.75% coupon bond which matures October, 1 2012 priced at 97.98 with an ‘A’ rating by Fitch. Comparing the yield on this note to a similar Treasury Note (in our case, a 5 Year Note at 3.15%), the spread in yields is more appropriate of a bond with a low ‘B’ rating, not the ‘A’ rating assigned to the bond or even close to the double-A rating assigned to the corporation’s senior debt.

Based on the assumption that bond premium is 4%, yield for a higher-grade bond (to which category BB&T belongs, according to the ratings in the table above) and using the bond premium model we can calculates the cost of equity.
COE = Corp. Debt + (Rm-Kd)
COE = 6.27% + 4% = 10.27%

Also, we can calculate cost of equity using CAPM model, based risk free rates for various maturities, adjusted beta (adjusted beta assumes the security’s beta will gradually move toward the market average over time) is 0.46 and various assumptions on market premium.
| | | |Market Risk | | |
| | | |Premium Assumption | | |
|Risk-Free Rate |Adjusted Beta |2% |4% |6% |Average |
| | | | | | |
|1-month Rate (1.07%) |0.46 |2.4922 |4.4922 |6.4922 |4.4922 |
|5-year Rate (2.84%) |0.46 |3.3064 |5.3064 |7.3064 |5.3064 |
|10-year Rate (3.68%) |0.46 |3.6928 |5.6928 |7.6928 |5.6928 |
| |Average |3.1638 |5.1638 |7.1638 |5.1638 |

COE = Rf + β (Rm-Rf)

| |2007 |2006 |2005 |
|Net Income |1734000 |1528000 |1653769 |
|Equity |12632000 |11745000 |11129114 |
|ROE |0.13727 |0.130098 |0.1485984 |

The adjusted beta for BB&T, 0.46, is based on a real beta regression estimate of 0.19, greatly lowers the cost of equity estimates to unreasonable levels. A brief look at BB&T’s net income and equity for the end of the last three years shows that even at the highest of estimates for cost of equity, 10.27%, BB&T is creating wealth for it’s investors.

Asset Quality

Asset quality has a direct impact on the financial performance of a financial institution. The average growth rate of assets from the quarter ended December 31, 2002 to March 31, 2008 was 18.8%, with large growth periods occurring in 2007, due to acquisitions of Collateral Real Estate Capital LLC ($10 billion commercial real estate loan portfolio) and increased activity due to the expansionary business cycle.
Currently, BB&T has a lower Net Loss to Average Total LN&LS, as well as lower LN&LS Allowances compared to the peer group. Asset quality remains healthier than peers and focuses on relationship based lending. It should be noted that BB&T has not been immune to the current challenges facing all lenders with mortgage exposure and BB&T continues to see rising deliquencies, foreclosures, and REO.

2.1.3 Management

BB&T’s unique organizational structure where the banking operations are divided into 33 regions (BB&T refers to the banking regions as “community banks”) headed by a regional president provides means client relation are highly decentralized whereas the support and banking information systems are highly centralized. Through this organizational structure and through key strategic acquisitions and mergers, beginning with the Southern National Corporation Merger in 1995, BB&T has created a highly diversified asset mix and market segmentation (50% retail and 50% commercial).
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A look at share prices over the last five years for BB&T compared to some of the banks in its peer group (Comerica, Fifth Third, Keycorp, National City, PNC, Suntrust, and US Bancorp) shows a fairly steady decline for all banks as of the June 2008.
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The credit crunch, liquidity crunch, and down turning stock prices have not kept BB&T out of the mergers/acquisitions news, especially as a takeover target. In the spring/summer of 2004 rumors swirled of a BB&T-Wells Fargo deal. Recently, BB&T is often being mentioned in the same sentence with the Royal Bank of Canada, as the Royal Bank looks to establish a presence in the Southeast United States. Analysts see BB&T as a better U.S. merger target than other regional banks because of its strong brand, asset quality, and the fact that they are less vulnerable to needing to raise capital to offset mortgage losses.

The management of the company has a clear strategy in their every business segments with a clear mission to deliver target ROE. The most current Return on Assets is 1.10%, while Return on Equity is 13.63% which is a clear sign of effective management.

2.1.4 Earnings

For the period of 2004-2007 BB&T shows substantial growth in revenues and net income reflecting the expansionary business cycle. As recently as December 2007 the company’s revenue was $6.25 billion, and Net Income was $1.74 billion. However the March 2008 revenue of $1.47 billion (vs. 1.50 billion in March 2007) and Net Income of $438 million (vs. $439 million in March 2007) indicate that continued earnings and revenue growth may be a challenge in the present economic enviornment. The managed provision for credit losses was in 2007 was $448 million, an increase of $208 million, or 86.7% from the prior year (2006), driven by challenges in residential real estate markets with the largest concentration of credit issues occurring in Atlanta, Georgia and Florida.

2.1.5 Liquidity/Sensitivity

BB&T's available-for-sale portfolio is comprised 100% of total securities at March 31, 2008, this is in the 99th percentile of their peer group. Management believes that the high concentration of securities in the available-for-sale portfolio allows flexibility in the day-to-day management of the overall investment portfolio, consistent with the objectives of optimizing profitability and mitigating interest rate risk. Management has historically emphasized investments with duration of five years or less to provide flexibility in managing the balance sheet in changing interest rate environments.
As of December 2006, JP Morgan Chase & Co. is in the 85th percentile with 17.42 compared to the Peer Group’s statistic of 8.04. Short-term assets can be quickly converted to cash for liquidity purposes, suggesting high liquidity. Likewise its liquid assets are also high, in the 92nd percentile with 52.84 compared to the 22.46 of the peer group.

JP Morgan Chase & Co. is very careful managing its interest rate risk. It holds 4033.34% of interest rate contracts as a percentage of its total assets compared to 59.23% for the peer group. The holding company is actively managing its interest rate risk compared to its peers.

2.1.6 Credit ratings
|June 9, 2007 |
|JPMorgan Chase & Co |
| |
|Moody's |
|S&P |
|Fitch |
| |
|Outlook |
|Stable |
|Stable |
|Stable |
| |
|Commercial paper |
|P-1 |
|A-1+ |
|F-1+ |
| |
|Senior unsecured |
|AA2 |
|AA- |
|AA- |
| |
|Subordinate |
|AA3 |
|A+ |
|A+ |
| |
|Preferred stock |
|A1 |
|A |
|A+ |
| |
| |
|JPMorgan Chase Bank |
| |
|Moody's |
|S&P |
|Fitch |
| |
|Short-term deposits/debt |
|P-1 |
|A-1+ |
|F-1+ |
| |
|Long-term deposits/debt |
|AAA |
|AA |
|AA- |
| |

Above are the financial ratings for JP Morgan Chase & Co., the holding company and JP Morgan Chase Bank quoted by the different rating agencies.

Both have generally acceptable credit ratings of upper medium quality which is considered investment grade. Based on these ratings JP Morgan must receive the best rates to borrow funds and must easily be able to raise funds by issuing new debt.

7. US ECONOMIC OVERVIEW

Banking profits are fueled by the macroeconomic environment. People can’t buy houses if they don’t have jobs (and they can’t make their existing payments, either), and people are less likely to buy houses when the costs involved in buying those houses are too high. We look at two factors that explain this behavior: the unemployment rate and the yield curve.

A quick glance at the graph below shows that unemployment has fallen from a high of 6.3% in June 2003 to a low of 4.4% in October 2006; however, the graph doesn’t tell the whole story.
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Unemployment Rates

Some economists look at more than just the rate, but look at job creation and destruction, as well as job creation required to meet population growth. Is the unemployment rate dropping because of a bustling economy and thousands of new hires, or is the unemployment rate dropping because thousands of workers are leaving the job market (those leaving the job market are no longer counted). As of April 1, payrolls have actually contracted by 232,000 since December, and, more importantly, private-sector jobs are down 300,000 since November (officials sometimes point to the beginning of a recession at the employment peak followed by a consistent downturn – which is what the current jobs trend is pointing to). A simple linear regression of unemployment rates as a predictor of BB&T’s interest income over the last 22 quarters provides a statistically significant relationship (beta coefficient for unemployment was -0.63 – as unemployment rises, interest income drops).

Economists (and bloggers) debate whether the current yield curve points toward a recession or otherwise. Longer maturity US Treasuries are most sensitive to inflation price pressure. As recent inflation estimates climb and retail sales figures stagnate or fall, the spread between 10-year and 2-year notes to continue to narrow.

The TED Spread is the difference between the 3-Month T-Bill interest rates and LIBOR and is generally viewed as a measure of liquidity and flow of dollars into and out of the United States, as well as a measure of credit risk. When the Fed cuts interest rates , the 3-Month T-Bill should also move lower, but LIBOR is determined by an average of what banks are willing to lend, and when LIBOR does not move in the same manner as the 3-Month T-Bill, credit markets are said to be pessimistic. When the TED Spread rises, risk is said to be rising, as investors move their funds to safer investments, and a trend rising TED is usually seen as an indicator of a downturn in the U.S. stock markets. The spread reached its lowest recent level in February 2007; however, it rose again to 200 basis points in March. The current level is less than 100 bps and falling, a sign of increasing liquidity? Maybe not… Analysts also view the lower spread as merely a sign of higher TBill rates and not necessarily lower LIBOR rates. The LIBOR-OIS spread, the spread between LIBOR and the overnight indexed swap rate, is still high (0.66% compared to a 0.11% average).
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Yield Curve as of March 31, 2008

In 1996, Federal Reserve economists Arturo Estrella and Frederic S. Mishkin published a paper examining the spread between the 3-Month T-bill and the 10-Year T-Note and the probability a recession would occur one year later. In 2006, Estrella and Mary S. Trubin refreshed the analysis and interpretation of a model of the yield curve as an indicator of economic downturn. An inversion occurs when short-term interest rates rise above long-term interest rates, and one has occurred in the year prior to each of the last six economic recessions. Not all economists view the yield curve as a valid predictor of recessions; pointing to other reasons for an inversion, such as the market segmentation term structure theory; that is, an inversion would merely occur when businesses require short-term funds in greater demand than long-term funds, and that there is no substitution between the two financing options.

Using the spread between the 3-Month T-Bill rate and the 10-Year T-Note, the probability of a recession one year in the future can be calculated using the following formula:
Recession Probability = NORMCDF(-0.6045 – 0.7374(10 Year Rate – 3 Month Rate)
The histogram below depicts the probabilities calculated over the past 5 years. Despite the recent drop in estimated probabilities, most economists (even Warren Buffet thinks the U.S. is in a recession) would state that the high probabilities accurately predicted a recession that began either late 2007 or the first quarter of 2008.
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Regressing the probability of a recession as a predictor of BB&T’s income shows a statistically significant relationship. However, this relationship could be due more to ten year interest rates dropping than to the public’s perception of a upcoming recession.

Inflation concerns have taken a more prominent role in the Feds most recent policy statements, with higher food and energy prices cutting into the wallets of U.S. consumers. If the Fed uses even stronger language to address inflation in the release on June 25, Wall Street will certainly react with an eye toward rising interest rates.

8. JP Morgan Chase Bank

In this section the strengths of JPMorgan Chase will be analyzed from a regulatory, financial and credit perspective based on CAMELS. The main source of information is UBPR and Supervisory Review report for the holding company.

1. CAMELS Analysis

1. Capital & Risk Index

Our main measurement method of capital risk of the bank is calculation of risk index. We calculated risk index for the last five and three years. Based on calculated risk index we can see that the probability that Tier I capital will go below 5% is very low. At the same time risk index decreases from five year analysis to three year analysis, which means that the Bank’s capital position became worse.

Tier one leverage capital ratio of JPMorgan Chase bank by the end of year 2006 is 5.94%, which is lower than the same number for peer group (8.16%). Compared to 2005 tier one capital ratio of the bank decreased from 6.14% for 2005 to 5.94% for 2006, which is also negative indicator for our Bank.

| |For 2002-2006 |For 2004-2006 |
|Risk index |Bank |Peer group |Bank |Peer group |
|Equity ratio, 2006 |5.94% |8.16% |5.94% |8.16% |
|Mean ROA |0.53% |1.28% |0.54% |1.27% |
|Sigma ROA |0.003132411 |0.000270185 |0.003208323 |0.000360555 |
|Risk index |4.686485588 |164.183726 |4.602612928 |122.8660935 |
|Normal probability of going below 5% |0.00014% |0.00000% |0.00021% |0.00000% |
|Non-normal probability of going below|2.2765% |0.0019% |2.3603% |0.0033% |
|5% | | | | |

Although, based on risk index analysis, the probability that capital position of JPMorgan Chase will go below the general requirements is very low, equity indicator of peer group are significantly better. We conclude that Bank has moderate capital position, and management should put more attention to the equity ratio of the Bank.

Regulators’ perspective

From the regulators’ point of view JPMorgan Chase bank is well capitalized. Since, by the end of 2006 the Bank had Total Risk-Based Ratio of 11.44%, which is higher than 10% the level required by regulatory agencies. Also, Tier 1 Risk Based Ratio for the Bank was 8.18% and Total Risk-Based Ratio was 5.94% at the end of 2006, while regulators required 6% and 5% correspondingly.

| |Total Risk-Based Ratio |Tier 1(Core) Risk-Based|Tier 1 (Core) Leverage |Capital-Related Action |
| | |Ratio |Ratio | |
|Well-Capitalized |10% or above |6% or above |5% or above |Not subject to capital |
| | | | |directive or capital |
| | | | |related cease and |
| | | | |desist order |
|Adequately Capitalized |8% or above |4% or above |4% or above | |
|Undercapitalized |Under 8% |Under 4% |Under 4% | |
|Significantly Undercapitalized |Under 6% |Under 3% |Under 3% | |
|Critically Undercapitalized |Ratio of tangible equity to adjusted total assets of 2% or less |
| | |
| | |

As a result, JPMorgan Chase meets the requirements of the regulatory agencies to satisfy the level of well capitalized bank. At the same time, if we compare JPMorgan Chase with its peer group, we can find that our Bank has lower ratios for risk based capital, which implies higher risk of JPMorgan Chase.

| |2006 |2005 |2004 |2003 |2002 |
|Risk based capital |Bank |Peer group |Bank |Peer group |
|2006 |Bank |0.1144 |0.0818 |0.0594 |
|2005 |Bank |0.1113 |0.0806 |0.0614 |
|2004 |Bank |0.1171 |0.0828 |0.0601 |
|2003 |Bank |0.1043 |0.0805 |0.0557 |
|2002 |Bank |0.1112 |0.0819 |0.0525 |
| |Mean |0.11166 |0.08152 |0.05782 |
| |Stdev |0.004785708 |0.000967988 |0.003650616 |
| |Risk index |4.254334045 |31.21940808 |4.525263203 |
| |Normal distribution probability |0.0010484% |0.0000000% |0.0003016% |
| |Non normal distribution |2.7625% |0.0513% |2.4416% |
| |probability | | | |

In addition we calculated the percentage of non-earning assets that are financed by depositors. The formula is: (non-earning assets – total risk based capital + net income) / total deposits. In case calculated number is positive, it means that bank finances some of its non earnings assets such as cash, real estate, premises, etc with depositors’ funds. JPMorgan’s numbers are positive during last five years decreasing from 11.1% in 2002 to 7.1% in 2006. Thus regulators can require bank to increase its capital or decrease non earning assets.

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Investors’ perspective

From the investors’ point of view lower capital ratios of JPMorgan compared to its peer group are resulted in higher ROE and higher gains. From the graph below we can see that changes in risk weighted assets are strongly followed by change in Tier 1 capital.

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The level of total risk based capital allows increasing risk weighted assets by 14% without going below the level of well capitalized financial institution based on requirements of regulators. It provides JPMorgan with a good potential of growth and as a result higher ROE.

In collusion concerning capital adequacy of JPMorgan we would like to note that although capital position of the Bank satisfies regulators’ requirements, management should put more attention to its bank equity ratios. Since, in case of worse scenario the Bank may have problems.

2. Asset Quality

Total earning assets represent 89% from total assets. The major categories of assets of JP Morgan Chase are loans not held for sale that consist 33% from total assets, while peer group has 61.79%. Also, trading account assets represent 23.26% from total assets, while peer groups parameter is 0.29%, and federal funds sold and resales represent 22.08% and peer group –1.95%. As we can see structure of JPMorgan’s assets differ significantly from the peer group’s one. If we compare with peer group, we can see that activities of JPMorgan Chase are more relied on trading activates and less on lending. IT can result in better liquidity position, but lower returns from the loans and leasing.

Composition of earning assets:

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The structure of loan portfolio can be presented as in pie chart below.
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As we can see the JPMorgan’s loan portfolio significantly differs from its’ peer group. The Bank provides more loans to individuals, has more commercial and industrial loans and higher share of credit card loans and foreign office loans and leases. In general, credit card loans and loans to individuals are treated as high risk and high return investments. Thus we can expect JPMorgan Chase will have higher allowances and losses from bad debt expenses.

Assets growth

16% increase in assets during 2006 was due to increase in federal funds loans and resale, trading account assets and increase in real estate loans. Such rapid grouth in 2006 can result in lower quality assets, which will be checked in our paper further.
JPMorgan Chase had significant increase by 53.87% in total assets in 2004, because of merging with Bank One of Chicago.

Loan and Lease and Securities Analysis

The quality of loans of JPMorgan Chase are lower than the peer groups’ one, because the ratio non-current loans and leases to gross loans and lease in 2006 was 0.91, while its peer group had 0.51. Higher the ratio of the bank indicates lower quality of loans. The fact that spread between peer group and bank does not decrease indicates that the quality of loans did not improve during the last years.

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Other ratios analyzed: 1) loans and lease allowance to total loans and lease, 2) net loss to average total loans and leases – supports our statement that quality of bank’s assets is low compared to its peer group.

Loans and lease allowance to total loans and lease of the decreases during the last several years. However, this indicator for the peer group is better, thus we can conclude that based on that ratio loan quality of JPMorgan is comparatively low.
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If we analyze the ratio of net loss to average total loans and leases we can reveal that losses from loans were decreasing, but compared to the peer group the losses from loans of JPMorgan were higher. It indicates the low quality of the Bank’s loan portfolio.

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The major loan losses in 2006 came from credit card loans (2.97%), while peer group had only 1.98%. Loans to individuals had 1.52%, which significantly higher than peer group’s indicator of 0.65%. From real estate loans JPMorgan had higher losses of 0.12% than the peer group’s 0.05%. We can conclude that JPMorganChase has risky loan portfolio.

|ANALYSIS RATIOS |2006 |2005 |2004 |
|NET LOSSES BY TYPE OF LN&LS |BANK |PG 1 |BANK |PG 1 |BANK |PG 1 |
|CREDIT CARD PLANS |2.97 |1.98 |4.01 |2.08 |2.19 |3.04 |
|LOANS TO INDIVIDUALS |1.52 |0.65 |2.03 |0.92 |1.79 |1.01 |
|COMMERCIAL AND INDUSTRIAL LOANS |0.16 |0.28 |0.01 |0.28 |0.58 |0.43 |
|REAL ESTATE LOANS |0.12 |0.05 |0.1 |0.05 |0.08 |0.08 |

Yields

High losses on loans can be a result of high yield on those loans. Thus, we will analyze returns on JPMorgan’s loan portfolio.

First we will analyze loan portfolio of JPMorgan Chase, since it represents the biggest (39.8% for 2006) part from earning assets. The yield on total JPMorgan Chase’s loans and leases during the last years is lower than the peer group’s one. Especially gap increases in 2004, and the reason for that can be merging with Bank One Chicago. Although the gap decreases during recent years, low yield on loans and high allowance and losses on those loans indicates low quality of loan management of the Bank.

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In the table presented below we can see the returns for the major types of the Banks’ loans and leases. As we can see, Bank’s yield on its main types of loans is mainly lower than the peer group’s ones. Only commercial and industrial loans of JPMorgan Chase have higher yield than the peer group’s one.

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Earnings coverage of net loss of JPMorgan Chase in December 31, 2006 was 8.59, which was significantly lower than the peer groups’ coverage of 30.79. Although the Bank’s coverage ratio increases during last years, it is significantly lower than the peer group’s and indicates low quality of loans portfolio.

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Securities
As we can see from the graph below Bank does better with investment securities. Historically return on investment securities of the Bank is higher than the peer group’s.
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Bank’s operations with securities bring higher yield than the peer group’s one. That proves that JPMorgan Chase is more concentrated on securities trading. That partially compensates low yields on loans and leases.

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Loans and lease portfolio of the Bank has lower yield and quality than peer group. It indicates that loan portfolio management is weak in JPMorgan Chase. At the same time, yields on securities are higher, which partially compensates poor performance of loans and leases of the Bank.
Off Balance Sheet Items

The amount of derivative items of JPMorgan Chase on December 31, 2006 was USD 60,693 billion, which is 51.4 times the total asset. During the last years, notional amount of derivatives significantly increased.

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The structure of derivative contracts is presented in the table below.

|[pic] |[pic] |

JPMorgan Chase is one of the largest derivative traders in US. The notional amount of its total derivatives by the end of 2006 was 51 times the total assets. More than 99% of derivatives are held for trading. The major type of derivatives is interest rates (89%) and swaps represent 67.5% from total derivatives.

3. Management

From management side of view one of the most significant events in JPMorgan Chase Bank was the merging with Bank One in 2004. Bank One was the large bank, operating in consumer banking sphere. JP Morgan Chase press release on January 14, 2004 announced that JP Morgan Chase and Bank One had agreed to merge in a "strategic business combination establishing the second largest banking franchise in the United States, based on core deposits." The combined company is expected to have assets of "1.1 trillion, a strong capital base, over 2,300 branches in seventeen states and top-tier position in retail banking and lending, credit cards, investment banking, asset management and etc. From management point of view it is always difficult to keep the operating (non-interest) costs in appropriate level, especially for such a large nationwide bank as JPMorgan Chase. Management has to emphasize, monitor, and control the risk related with bank’s operations. In this part we will observe and analyze key financial figures that are belonging to non-interest bearing part of balance sheet.

The starting point in our analysis of management performance is Return on Assets (ROA). As we can see from the UBPR data, JPMorgan’s ROA is less than that of peer group. But we can see positive trend starting from year 2004. It means that management started to make more effort to improve bank’s profitability. It might some connection with the new CEO James Dimon. He joined the JPMorgan Chase Bank after merging with Bank One (he was CEO in Bank One). Usually when new people come to companies they tend to make more effort, and takes into account mistakes and faults of preceding management. In the graph below you can see ROA of JPMorgan and peer group during 2002-2006.
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JPMorgan Chase Bank’s management has been able to manage their non-interest expenses (G&A costs, rent of office space, etc) little worth than a peer group. This trend was started in 2005 (2.8 vs 2.54), and continued in 2006 (3.01 vs 2.7). In 2004, 2003, 2002 non-interest expenses were smaller than that in peer group: 2.66 vs 2.89, 2.62 vs 2.95, 3.03 vs 3.05, respectively. Total overhead expenses (or non-interest expenses) were the same throughout the 2002-2004 period, but in 2005 and 2006 they were higher than that in peer group. Form that, we can conclude that structural changes happened in 2004, after merging with Bank One, were dramatically affected to JPMorgan’s total overhead expenses. But we believe that this will not continue in future years, because of the bank’s ability to use their economies of scale (due to large size) and management experience (that they gained during 2004-2005 years). In below graph you can see the non-interest expenses trend from year 2002 to 2006.

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In particular, their occupancy expenses (as a percentage of average assets) were also higher than that in peer group. This trend was observed for all 5 years of our observation. It can be explained that JPMorgan care about their image, and therefore they were spending more money on occupancy expenses than other banks in peer group. One more explanation might be huge merging &acquisition process JPMorgan went trough last years. In below graph you can see the occupancy expenses trend from year 2002 to 2006.

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One more key figure in management part of our analysis is personnel expenses. From the UBPR report we can see that in beginning period of our timeframe (in 2002-2004) personnel expenses were lower than in peer group banks. In 2005 JPMorgan’s personnel expenses were almost the same as in peer group (1.31 vs 1.32 respectively). But in 2006 JPMorgan’s expenses on personnel was higher than in peer group (1.35 vs 1.26). Again, one of the reasons may be merging with another huge bank Bank One – it might require some additional expenses for staff training and other HR related costs). Also, one more interesting fact is that average personnel expense per employee in JPMorgan was higher than that in peer group. We can observe it from year 2002 to 2006. It means that average salary of JPMorgan employee is higher than in other banks in peer group. It leads to more efficient work among JPMorgan staff and better achievements in banks operations. In below graph you can see the personnel expenses trend from year 2002 to 2006.
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One of the key measurements of management performance is amount of “bad credits”. We analyzed the net loss to average total loans & leases, and we found that this indicator is almost twice worth than in peer group banks. It means that JPMorgan faced more losses due to low-quality credit assessment (even though JPMorgan’s personnel expenses are more than in peer group). In graph below you can see the trend of net loss to average total loans & leases.

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The last key figure that we will analyze is efficiency ratio. An increase in efficiency ratio means the bank is losing a larger percentage of its income to expenses. If it is getting lower, it is good for the bank and its shareholders. The efficiency ratio gives us a measure of how effectively a bank is operating. In JPMorgan Chase Bank the efficiency ratio was not good in comparison with the peer group banks. Only in recent years (2005 and 2006) the efficiency ratio was close to peer group index. We can find answer to this from the key financial figure – assets per employee. From UBPR report we observed that assets per employee were higher than in peer group from 2002 to 2005, but smaller in 2006. It might be a reason of efficiency ratio’s trend. Below you can see graphically the trends for efficiency ratio and assets per employee. Of course, there might be a million of reasons of so low efficiency ratio. But analyzing from management part of view, we can propose this key figure (assets/employee) as a main reason.

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From the graph we can see that JPMorgan started to decrease quantity of assets per employee, and their average salaries are higher that that in peer group. Therefore, we believe that in long-term the efficiency ratio will stabilize and might be better than that in peer group banks.

4.1.4 Earnings

We start our analysis of JPMorgan Chase Bank’s earnings from analyzing net income as a percentage of average assets. From UBPR report we can see that peer group performance of income/assets ratio is stable over the 5 year period (2002-2006) ranging from 1.23 to 1.29. While JPMorgan’s earnings is jumping up & down from year to year. Moreover, this key financial figure is less than that in peer group. But in last 2 years we can see upward trend of increasing profitability performance. But still it is lower than peer group performance. The items that mostly hurt the bank was provision of loan & leases losses (especially in recent two years), realized gains/losses securities (recent two years), and non-interest expenses (recent two years). Only thing that helped earnings, was non-interest income – this financial figure was better than that in peer group during the whole 5 year period. In the table below you can see the partly composition of income statement from UBPR report.

|EARNINGS AND PROFITABILITY |
|JP Morgan Chase Bank |Interest Earning & | |Portion > 1 Year | |Computed < 1 |
| |Receiving Assets and | | | |Year |
| |Liabilities | | | | |
|Assets |89.72 | |22.56 | |67.16 |
|Liabilities |(71.28) | |(1.74) | |(69.54) |
|GAP | | | | |(2.38) |
|Peer Group | | | | | |
|Assets |91.92 | |46.55 | |45.37 |
|Liabilities |(81.66) | |(6.40) | |(75.26) |
|GAP | | | | |(29.89) |

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During the 2002 to 2004 period when the interest rates declined to its 20 year low point, the peer group was affected positively compared to JP Morgan Chase Bank because of their negative interest rate gap. But during the 2004 to 2006 period interest rates were increasing therefore the peer group was affected negatively compared to JP Morgan Chase Bank because of their negative interest rate gap.

In the current economic environment the market expects the interest rates to be relatively stable; therefore JP Morgan Chase Bank’s policy of keeping its interest rate gap close to 0 is consistent with the economic outlook.

JP Morgan Chase Bank should follow Fed’s policy closely, because they could have benefited from the changing interest rate environments from 2002 to 2004 and 2004 to 2006 by altering the composition of its assets and liabilities.

Correlation Analysis

|JP Morgan Chase Bank |3-Month Treasury Bill | 10-Year Treasury Note |
|Interest Income |0.9162 |0.8915 |
|Interest Expense |0.9449 |0.9246 |
|Net Interest Income |0.5656 |0.5331 |
|Peer Group | | |
|Interest Income |0.8605 |0.8418 |
|Interest Expense |0.9483 |0.9292 |
|Net Interest Income |(0.2614) |(0.2516) |

The above table shows the correlation between each interest income, interest expense and net interest income to a short-term (3-Month Treasury Bill) and long-term (10-Year Treasury note) rate respectively. The results are based on the 5 most recent annual data as of Dec 2006 .
As expected, interest income and interest expense are both positively correlated to both the short-term and long term-interest rate for both JP Morgan Chase Bank and Peer Group. However net interest income is positively correlated to short-term and long term-rates for JP Morgan Chase Bank and negatively correlated to short term and long term rates for the peer group. This is consistent with the gap analysis that shows that JP Morgan Chase Bank is positively gapped and peer group is negatively gapped during the last 5 years.

Repricing Risk

Repricing risk refers to the risk that arises from timing differences or mismatches in the maturity and interest rate changes of a bank’s assets and liabilities. We can define JP Morgan Chase Bank’s repricing risk as the difference between its short term liabilities and Long term assets.

|JP Morgan Chase Bank |2002 |2003 |2004 |2005 |2006 |
|Liabilities < 1 Year |63.31 |63.07 |64.39 |64.31 |69.54 |
|Assets > 1 Year |22.15 |24.51 |24.24 |19.97 |22.56 |
|Difference |41.16 |38.56 |40.15 |44.34 |46.98 |
|Peer Group | | | | | |
|Liabilities < 1 Year |69.21 |69.91 |70.5 |71.35 |75.26 |
|Assets > 1 Year |47.26 |49.32 |48.25 |47.48 |46.55 |
|Difference |21.95 |20.59 |22.25 |23.87 |28.71 |

From the above table we can see that JP Morgan Chase bank’s short-term liabilities are much higher than its medium to long term assets, indicating a high repricing risk. Compared to its peer group, JP Morgan Chase bank has a much higher repricing risk during the period under consideration.

Shock Analysis

This is an analysis of the impact on net interest income given a 1% increase in interest rates under the assumptions of parallel shift of yield curve and no options.

|Gap as % of Total Assets |-2.38% |
|Gap($) |-28 billion |
|Annual Net Interest Income Change |-.28 billion |

Approximately JP Morgan Chase Bank’s net interest income would decrease by $ 280 million given a 1% increase in interest rates. ROA would decrease from .87% to .85%

Overall JP Morgan Chase Bank seems to be effectively managing its sensitivity to interest rate changes. Interest rates in near future are expected to rise or remain stable. This creates a positive outlook for net interest income in this period for JP Morgan Chase Bank.

5. Conclusion

JP Morgan Chase’s management is creating economic value for their shareholders as is seen from a Price/Book Value ratio greater than 1. This is supported by the higher return on equity over its cost of equity. However in the last 2 years the ROE of JP Morgan Chase is significantly lower than its peers. At the same time it worth to note that quality of loans and leases of the Bank is low, while its yield is also low.

JP Morgan Chase’s credit rating is considered investment grade and stable outlook has been noted across the three rating agencies. It has a good reputation although it has lower capital ratios compared to its peers. Returns on Assets have been well below its peers mainly due to lower net interest income and higher non-interest expense.

The bank outperformed the peer group in most of the liquidity ratios (except core dependence ratio) suggesting that it is in a strong position from a liquidity standpoint. In relation to the interest rate risk, the bank would be rated as a Minimal risk due to its almost zero asset/liability gap.

2006 was a good year for the company with higher income level and a significant improvement in ROE. This has kept the stock price rising and it is expected to outperform the market in 2007.
6. Questions to Management

1. How can the management explain the lower net income compared to its peer group? 2. JP Morgan Chase has a higher dependence on Non Core Deposits, thus reducing bank’s liquidity. What would be the bank’s strategy in case of a rating downgrade when the non core deposits are likely to flee? 3. How can the management explain the high non interest expense and efficiency ratios? 4. What’s the rationale behind keeping the asset/liability gap close to zero? Why doesn’t the management manage its asset/liability gap so as to benefit from the movement of interest rates?

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