Why JP Morgan is Still a Good Buy
Maxwell is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
JP Morgan Chase (NYSE: JPM) controversially announced a $2 Billion derivatives loss at the end of last week, sending shockwaves throughout Washington and Wall Street and prompting the resignation of some executives.
By the standards of Wall Street, a $2 billion loss is not a huge amount; it represented just 0.5% of JP Morgan’s Cash and Cash Equivalents and, even with the loss, JP Morgan remains within the required Basel 3 Capital Requirement of 8% at 8.2%.
To give a better appreciation of how relatively small this loss is, just on the basis of its cash and cash equivalents alone, JP Morgan could have invested just a third of its cash and equivalents in 5-year US Treasuries yielding 1.5% and earned enough to cover the losses.
Moreover, JP Morgan’s Net Available-For-Sale Financial Assets portfolio was $8 Billion above water through the end of March 2012. As Jamie Dimon explained to investors, JP Morgan may have to register a $1 Billion quarterly trading loss, but even with this, JP Morgan should remain on solid footing.
If anything, given the climate of the times and the way that whispers on Wall Street propagate, JP Morgan management probably thought it best to come clean with the loss before rumors of trading losses trigger a vicious cycle of short-selling and counterparty risk-aversion.
The real impact of JP Morgan’s losses is that it increased regulatory scrutiny on all of Wall Street, not just JP Morgan, as evidenced by the stock price action on Goldman Sachs (NYSE: GS), Bank of America (BAC), Morgan Stanley (NYSE: MS), and Citigroup (C) in the wake of JP Morgan’s announcement.
Compounding matters for JP Morgan, the losses have also prompted the FBI to begin a preliminary investigation with the intent of determining whether criminal charges will be filed against its executives.
Circumstances are different for each bank but the fact that trading- and market-making revenues account for anywhere from 25% to 70% of profits at the biggest banks is why they’ve resisted the implementation of the Volcker Rule. Regardless of the political discourse in the wake of JP Morgan’s disclosure, the fact of the matter is that Wall Street still has two years in which to comply with the Volcker Rule and that means that banks, including JP Morgan, can continue reaping the benefits of the strong equities market in the near-term.
In the past, whenever trading profits have been weak, Wall Street relied on profits from activities such as Underwriting and Advisory to bolster its bottom line. Fortunately for JP Morgan, while Investment Banking fees for the industry have been tepid thus far in 2012, it remains the leader in this area and has seen growth on a quarterly basis.
Moreover, while JP Morgan may not necessarily be the recipient of windfall fees from the highly anticipated IPO of Facebook (NASDAQ: FB), making the market in Facebook shares could help bolster its trading profits and offset a portion of its derivatives losses. Indeed, making the market on Facebook may be especially lucrative now that demand for its IPO has pushed Facebook to increase its share offering.
Meanwhile, unlike Goldman Sachs and Morgan Stanley, which derive large portions of their incomes from Trading and Investment Banking, JP Morgan also has a large retail banking operation from which to draw cheap deposits – and it was for this reason that JP Morgan emerged from the Financial Crisis of 2008 relatively healthy. Indeed, with the U.S. Economy slowly gaining traction, mortgage activity has started to pick up, which should begin to benefit banks with large retail and consumer operations – like JP Morgan – in the coming quarters.
Of course, the real danger to Wall Street is if, like in 2008, JP Morgan’s loss is only the tip of the iceberg. Estimates vary, but it’s safe to say that most of the large Wall Street Banks have significant exposures to Europe, where recent developments in Greece have sent a panic across markets.
Interestingly, JP Morgan’s losses came from its synthetic credit portfolio; the nature of credit derivatives is such that buyers of Credit Default Swaps do not need to actually own the debt they’re hedging, essentially allowing them to place unlimited bets on whether a sovereign nation may be defaulting on its debt. In some cases, an actual default doesn’t even need to occur – a “default event” can be defined in very narrow terms to suit the parties involved – so much so that defaults can be based on the level of credit spreads rather than the occurrence of an actual default. What this ultimately means is that banks may have even larger notional exposures to Europe than what estimates suggest – especially if their proprietary traders stretch their trading limits or hold onto their positions in the hopes of riding-out the volatility and returning their position to profitability. This is apparently what JP Morgan’s “London Whale” was doing.
All that said, I believe its recent losses have pushed JP Morgan to unwind – or at least net-out – any negative credit exposure it may have. At the very least, it has pushed other Wall Street firms to examine their books for similar cracks and make the appropriate adjustments. Unlike in 2008, this is not as difficult as it sounds: in the intervening years, banks have had ample time to build their reserves and the Fed’s accommodative policy stance means there is plenty of liquidity with which to mean margin and collateral calls.
Conclusion
I see the recent action in JP Morgan’s stock price as an opening to buy a stock that was headed for a good year before the disclosure happened. The bottom line is that, despite the negative publicity brought on by the disclosure, JP Morgan retains a strong portfolio of businesses that should allow it to balance weaknesses that occur in one business unit.
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