JPMorgan Still a Reasonable Long-Term Pick, Despite Opaqueness

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Here we go again. Just when it appeared that the four-year flow of criminal, administrative, and civil lawsuits against the financial industry stemming from abuses last decade had begun to ebb, the new Attorney General of New York State, Eric Schneiderman, has filed suit in New York for reparations for investment fraud on or near 2006 by Bear Stearns brokerage. Of course, the now-defunct powerhouse was acquired in the dark days of 2008 by JPMorgan Chase (NYSE: JPM) at the urging of the Department of the Treasury. This is the first action taken by the joint Federal/state task force announced by the President at the 2012 State of the Union Address.

It almost seems unfair. It’s the same old allegations:Bear Stearns was hawking mortgage backed securities, and focused so much on volume and so little on due diligence that it was selling AAA rated bonds that were really junk. To JPMorgan's credit, it had nothing to do with these sales by Bear Stearns, but that is the price one pays when one company acquires another. What was unique here is that during those trying days in 2008, while JPMorgan was acquiring Bear Stearns for about 3% of its book value, it was doing so with the help of federal regulators.

I wanted to take a brief look at a longer-term view of the enormous ups and downs of the mortgage bond market; for while the past is not proof of the future, it sure can provide good hints. For aid in this lesson, I turn to Man vs. Markets, a recent publication by Paddy Hirsch, best known as a contributor on National Public Radio's Marketplace.

The book is summarized in a recent New York Times Blog. Beginning in the 1970's, bankers from the former Solomon Brothers and other brokerages came up with the notion of “pass through” certificates allowing for the securitization of bundles of plain, ordinary home mortgages. As the trend picked up through the 1980's, banks saw this as a way to jack up their balance sheets and earnings without the risk of writing mortgages and other installment credit instruments.

The momentum for this grew to the extent that by the mid-2000's, incidents like the one at issue with the former Bear Stearns, the Abacus investment scheme by Goldman Sachs (NYSE: GS), and other abuses took place. That, combined with the crushing weight of debt that banks eager to lend and securitize the payment stream allowed themselves to hold, created the conditions that brought down Solomon, Lehman Brothers, Bear Stearns, and hundreds of other financial institutions.

Federal largess saved most of the nation's larger banks. But scarred from the 2007/2008 crisis, credit became very tight, exacerbating the stress in the economy. By the time conditions began to turn in 2009, it was a different world. But many banks that wrote and then almost immediately sold their mortgage notes have been pursued by government agencies like Fannie Mae for misrepresentations as to the quality of the mortgages that the agency bought.

But that is not on behalf of the federal agencies; rather it is on behalf of state treasuries and others who invested in the flood of CDO's, especially in the middle of last decade. Particularly hit have been banks with historically large mortgage operations, such as PNC Financial (NYSE: PNC) and Bank of America. Due to a series of quantitative easing programs by the Federal Reserve, long-term interest rate plunges have hastened millions of people to refinance, giving many mortgage banks great boosts to income in the form of fees.

JPMorgan had until recently the enviable position of not being terribly weighed down by the collapse of the mortgage market, as its peers were. Its burgeoning investment bank helped to buffer earnings swings, and CEO Jamie Dimon was the toast of Wall Street, until early this year when the London trading scandal unfolded. Combined with this multi-billion lawsuit, some must be wondering if Dimon's railings against regulations designed to reign in banks' abuses, such as the Volcker Rule against proprietary trading with depositor money, have come back to bite him.

Looking forward, JPMorgan shareholders don’t seem to care about the recent civil suit, as the share price hardly budged on the announcement. Perhaps one reason they don’t care is that JPMorgan has some $400 billion of excess liquidity; and eventually, when the civil suit is settled, the results will cause a modest dent in one quarter's earnings. This civil suit is also the first of what will likely be many such suits against other banks, so its results do bear watching, as many banks are not as able to weather a substantial civil penalty as effortlessly as JPMorgan will.

What troubles me more than anything else about the recent issues at JPMorgan is that it gives earnings a sense of opaqueness. Without one-time factors, I look for the bank to have earnings for the third quarter of this year at about $1.10 per share. JPMorgan is usually the first of the large banks to report earnings and this quarter it’s scheduled to release earnings on Oct. 12.

I see JPMorgan getting past its legal issues with a settlement of about $1 billion to $1.5 billion. Dimon has stated that “normalized” earnings for the company should be $23 to $24 billion annually. That would still be short of a 1% return on assets, but even then, I don't really know what “normal” means in JPMorgan's context. I do know that management believes there is room for improvement in earnings, and thus in share price. JPMorgan pays a well-covered 3.2% dividend yield, and I believe has a reasonable risk/reward ratio as a long-term holding for most investors.

I have long been a fan of PNC, and see its recent, large acquisitions of BankAtlantic and RBC as supporting asset, loan and earnings growth. Yet this growth has not flowed to the bottom line because of large reserve additions ($350 million in the second quarter alone) needed to cope with agency mortgage repurchase demands. Earnings in 2012 will be a step back from 2011, but if PNC has really put its mortgage purchase issues to rest, 2013 will be a good year. A conservative investor would do well to consider PNC.

Goldman Sachs is seeing signs of life in the domestic economy, especially on the debt and mortgage side of the business. That, a general slackening of litigation, not to mention fine cash flows, should bring earnings for this year to much as $11 per share, or more than twice the 2011 figure. The company's stock has risen about 20% in the past six weeks. But relative to the overall earnings capacity of the international investment bank leader, if economies improve Goldman Sachs’ earnings can grow $20 or more per share. This still underperforming issue is highly volatile, with a beta of 1.61. It might interest highly risk tolerant investors, but it is not for me.


StockCroc1 has no positions in the stocks mentioned above. The Motley Fool owns shares of JPMorgan Chase & Co. and PNC Financial Services. Motley Fool newsletter services recommend Goldman Sachs Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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