Our Take on J.P. Morgan's Fourth Quarter

 J.P. Morgan Chase (JPM) reported net income of $19 billion, or $4.48 per share, for 2011, slightly below our expectations on the revenue front, and reflecting the adverse impact of a $567 million pretax loss from debit valuation adjustments, which we exclude from our forecasts. However, our long-term expectations are essentially unchanged. We're maintaining our fair value estimate for its shares.

Although balance sheet assets declined during the quarter, loans increased by 3.9%, with demand for both commercial and consumer credit appearing to grow. We think this development is not only a positive for J.P. Morgan, but also for the banking industry and the U.S. economy. Credit expansion should eventually result in not only a larger balance sheet, but also a wider net interest margin.

Given Europe's well-documented problems, the investment bank segment posted only $726 million in net income, down more than 50% from the final quarter of the previous year. This is not a surprise to us. In addition to the aforementioned DVA charge, investment banking fees, debt and equity underwriting fees, advisory fees, and trading revenue all experienced declines. Most of these line items are volatile, and these results are not unexpected given the prevailing uncertainty in the business environment. We expect these businesses to eventually post rebounds.

Credit quality continues to slowly improve. Net charge-offs were only $2.9 billion in the fourth quarter, while the bank recorded only $2.2 billion in provisions for credit losses. The bank will not be releasing reserves indefinitely, and this minor earnings tailwind should taper off soon. However, we don't expect credit losses to rise much, even in the event of a double-dip recession. More than four years since a recession officially began in December 2007, banks have turned over their balance sheets to a large extent, replacing aggressively underwritten loans with higher-quality assets. In addition to the company's allowance for loan losses, it is quite well-capitalized, in our view, with an estimated Basel III Tier 1 common ratio of 7.9% at year-end.

In contrast to many of its peers, which are cutting staff, J.P. Morgan is actively investing in its business. Head count posted an 8% year-over-year increase, as the bank added employees both to increase business--the bank opened 260 new branches during the year--and deal with mortgage defaults. Eventually, expenses such as the $390 million in repurchase losses will decline, but we are not currently forecasting a significant decline in total noninterest expenses.

A flat market in 2011 did little for the asset management segment, which suffered from lower performance fees and valuations. As in other segments, lower variable compensation was offset by a larger head count, as J.P. Morgan added private bankers and other personnel.

J.P. Morgan Chase's quarterly and full-year results were driven to a large extent by its long-term strategy. Management's actions--including another $950 million in stock repurchases in the fourth quarter--clearly indicate that the bank is willing to sacrifice short-term performance for long-term value creation. This strategy could backfire in the event of a prolonged deflationary environment, but if the future is anything like the past, J.P. Morgan is likely to remain in the best competitive position of its large bank peers.

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