JPMorgan Chase: Fortress Under Siege

By Daniel Ferry - June 14, 2012 | Tickers: BAC, C, JPM, WFC | 0 Comments

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JPMorgan Chase (NYSE: JPM) CEO Jamie Dimon testified before the Senate Banking Committee yesterday, apologizing for the company's recent losses but reiterating his claim that “our fortress balance sheet remains intact.”

Shares of JPMorgan Chase have slid by 20 percent since the revelation in April that a London trading desk was losing billions on big, complex transactions. JPMorgan classified the transactions as hedging, while critics -- including Banking Committee member Jeff Merkley -- accuse JPMorgan of labeling any risky strategy a “hedge” as a smokescreen. Regardless of whether you approve of Congress occasionally demanding that public figures come forward and be lectured in a modern-day public shaming, Dimon's comments were revealing. His insights into how big banks approach risk provide food for thought to bulls and bears alike.

For skeptics of the banking sector, it remains worrying that Dimon, often thought to be the best risk manager in the industry, allowed this error. In his comments, Dimon explained that the trading desk responsible for the losses, the Chief Investment Office, had created a synthetic trading strategy that was “poorly conceived and vetted.” The CIO acted autonomously, without strict oversight of senior management, and with the firmwide risk control desk unable to constrain the CIO. Ultimately, Dimon placed the blame on the CIO traders, saying they “did not have the requisite understanding of the risks they took.” Yet, Dimon insisted “[he has] a right to rely on them. Under no event did it look like it would get this bad.” Big banks have often been criticized for maintaining balance sheets too convoluted for investors to understand, but this calls into question whether anyone at the firm has a clear idea of the risks being taken throughout the business.

Losses were relatively small on this failure, but peers like Bank of America (NYSE: BAC) and Citigroup (NYSE: C) have demonstrated during the recession that what appear to be minor losses can prove to be only the tip of the iceberg, as loan portfolios and investment strategies collapse. JPMorgan was thought to be different, but if the CEO doesn't feel responsible for what senior officers are doing, and senior officers are taking risks they don't understand, how can investors have any faith that the balance sheet is in good hands?

And yet, concerns about opaque balance sheets only seem to emerge when banks are trading at a discount. It's not as if JPMorgan Chase's balance sheet was any more transparent three months ago; it was just that nobody was paying attention. For banking bulls, balance sheet concerns therefore present a buying opportunity. If you're willing to accept the risk and uncertainty that comes with not having complete knowledge about a big bank's operations, JPMorgan looks attractive. Compared to its peers, JPMorgan providers a better return on equity and a more conservative debt load than Bank of America or Citigroup, while sporting a much more attractive valuation than Wells Fargo (NYSE: WFC).

In the wake of the losses, Dimon has announced steps to coordinate risk management across the enterprise; if successful this could be a catalyst for higher valuations down the road. And ultimately, Dimon insists, the “fortress balance sheet” and diversified operations performed exactly as they should: cushioning the firm against unexpected losses. JPMorgan expects to report a highly profitable quarter despite the CIO fiasco.

Big banks have always sported vast and complex balance sheets. Personally, I prefer to get my exposure to the banking sector through small regional banks with business models I can understand. But investors who were willing to shoulder the uncertainties, synthetic positions, derivatives, and sub-prime loans of the big banks in the past should recognize that these revelations don't make banks any more risky; if anything they're safer.

The more problems we see, the fewer remain hidden. And a bank recently under scrutiny for poor risk management could be expected to adopt more conservative positions. Living with risk is part of investing, and if your risk portfolio inclines you toward big banks, now is the time to buy.

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