Once-mighty JP Morgan on the rack after disastrous fees-for-loans foray

JP Morgan's dream of emulating Citigroup turned to nightmare when the bubble burst

In the mid-1990s, Bill Harrison, chief executive of Chase Manhattan, started to dream of taking his hugely successful commercial bank and using it to bulldoze his way into investment banking, not stopping before he broke into the bulge bracket that contained Merrill Lynch, Goldman Sachs and Morgan Stanley.

By September 2000, Mr Harrison believed he had made that dream a reality. Having eyed up his smaller rival, JP Morgan, for years, Mr Harrison managed to woo it away from other suitors Deutsche Bank and Goldman Sachs, eventually paying $30bn (£20bn) for the prize.

Even at the time, the price looked generous. But Mr Harrison and his team had seen what a success Citigroup had made of welding a plodding commercial bank with an investment bank earning handsome fees, and did not want to be left behind in the rush to "universal banking".

Today, JP Morgan Chase looks more like a Frankenstein than the finely tuned athlete it aspired to be. In the dash for fees and growth it overburdened itself with high-risk lending, and with the wonders of the technology bubble now but a distant memory, the bank is struggling to stay afloat.

Last week JP Morgan issued a profit warning that underlined its parlous state. Quite apart from a $1.4bn provision for bad debts, it was forced to warn of serious problems in its own share trading business. JP Morgan guided the market that its trading profits has swung from $1.3bn in the second quarter to $100m in July and August.

The latest piece of bad news has prompted rival investment banks to sharpen their knives for a possible carving up of the giant bank, with speculation growing that if there is a major banking casualty in the current economic downturn, JP Morgan would be the most likely candidate.

One senior banker at a rival company says: "In every cycle, there is an example of someone who pushes the boat out a lot further than others and finds themselves in trouble when the storm hits." In this downturn, JP Morgan is the most at sea, he says.

The crisis has already claimed heads. Geoffrey Boisi, head of the investment bank, was given his marching orders earlier this year. He was replaced by the well respected David Coulter, now widely tipped as a possible future chief executive for JP Morgan.

Unsurprisingly, JP Morgan believes the fears have been blown out of proportion, and strongly refutes the suggestion that it is at risk of being overwhelmed by its liabilities.

Klaus Diederichs, head of JP Morgan's European investment banking business, said: "We have very diversified earnings and overall the company is on solid ground."

Mr Diederichs points out that JP Morgan is hardly alone in feeling the pinch. Only Goldman Sachs seems to have bucked the trend of falling revenues. Mr Diederichs said July this year was "the worst month in market conditions in my 22 years' investment banking experience".

Even the rest of the investment banking community concede that JP Morgan's capital position is strong. It has $723bn of assets and a much stronger tier one capital ratio than a number of rivals, which makes it likely to survive the downturn.

The bank can also point to significant market share gains in investment banking since the merger in 2000. A survey by Dealogic released earlier this week shows JP Morgan has grabbed the top slot in European mergers and acquisition work, up from its position as number 10 at the end of 2001, and globally it has moved from number five to number three.

Even so, the bank stands accused of paying too high a price in the scramble for market share. Critics say it was too ready to hand out massive loans during the New Economy boom in exchange for fat corporate advisor fees, and too many recipients of loans have ended up in trouble or receivership.

JP Morgan's clients include most of the high-profile financial crashes of the last year, including Enron – for which it is also under investigation in the US over its role in helping the failed energy company to set up off-balance sheet vehicles.

JP Morgan's telecoms loans are thought to stand at $8bn and it is a substantial holder of bankrupt credit lines – a type of finance which is not supposed to be used by a company unless it is in trouble.

The bank's exposure to so many of these disaster zones partly reflects the fact that JP Morgan is the world's largest syndicated lender, making it more likely than most to crop up at the scene of financial accidents. Its headline risk also belies the fact that it syndicates out most of its loans, making its write-offs lower than those of many of its peers.

Most have lost faith in JP Morgan's model for growth. David Hussey, a banks analyst at Barclays Private Clients, said: "Its model worked well in the bubble period but the bad debts have discredited it."

Mr Diederichs observed that hindsight is a wonderful thing, saying: "The world looked totally different two years ago. At that time, many of our telecom clients were among the most respected investment-grade companies in the market."

JP Morgan insists it wasn't its policy to hand out high-risk loans in return for investment banking fees – a practice the US government is investigating.

Even so, alternative investment banking strategies now look like they were better advised or more fortunate. Others may not have so profligate in using their balance sheets for the purpose of winning advisory work, relying instead on existing relationships in their historically strong fields of mergers and acquisitions and broking to keep revenues from dwindling to nothing. They may also have been better at refinancing the high-risk loans they did take on.

Citigroup – the model JP Morgan tried to emulate – also had a lighter touch to tapping its mammoth balance sheet, instead relying on the expertise of staff at its Schroder Salomon Smith Barney subsidiary to develop investment banking.

The problem for JP Morgan seems to have been that Chase Manhattan – America's second-largest commercial bank – thought it was buying a business that had considerable expertise in investment banking.

But the reality was that JP Morgan was also largely a commercial bank. Before the main merger, Chase had also bought Robert Fleming, a family controlled City merchant bank, which brought asset management expertise but little track record in deal making.

One senior investment banker said: "You cannot turn a team of corporate lenders into mergers and acquisitions specialists over night."

The challenge facing JP Morgan is where to go. "Does it put investment banking on hold and bring down costs or does it throw more money at it by trying to pick off teams from other banks?" one source said. Another theory is that it cannot be long before the bank, whose shares are now trading below the book value of its assets, might be taken out by a predator, with HSBC thought to be the most likely candidate.

Nonetheless, JP Morgan is under pressure to slash its dividend to preserve capital. Whether Mr Harrison can survive such a cut remains to be seen.