The Materiality of JP Morgan's Trading Loss is Overblown
RJ is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
As media outlets continue to hyperbolize the $2 billion trading loss at JP Morgan (NYSE: JPM), we thought it important to put this loss in perspective not only with respect to JP Morgan’s fortress balance sheet, but also as it relates to the confidence in the global financial system in general.
For starters, JP Morgan passed the Federal Reserve’s recent stress test with flying colors, and we’d argue the conditions presented in such a stress-test exercise were extreme. Second, JP Morgan’s capital position was excellent at the end of its most recently-reported quarter, with the bank posting a Basel III Tier I common ratio of 8.4% and Basel I Tier I common of $128 billion (10.4%). We don’t think such a lapse of judgment as it relates to the recent “hedging loss” should disrupt the view that consumer credit quality across the board continues to improve. In fact, the downward trajectory in allowances for loan losses and net charge-off rates across the domestic banking system’s aggregate portfolio has not changed since JP Morgan reported improved first-quarter results in mid-April (a few weeks ago). We view improving credit health as core to our thesis of having diversified financial exposure in the portfolio of our Best Ideas Newsletter. And to put it bluntly, diversifying across the financial spectrum also alleviates pain caused by any one bank – in this case, JP Morgan – while capturing higher valuations as European sovereign debt issues are inevitably put to bed (as it relates to the impact on domestic financial institutions).
Though such a trading loss will surely tarnish CEO Jamie Dimon’s near-pristine reputation and make it difficult for JP Morgan to turn a profit in the current quarter, we fully expect market confidence to be rattled a bit. After all, Jamie Dimon has been the poster child for the big banks on how to best avoid huge financial losses (as it did successfully during the recent financial crisis), and such a candid admission of this blunder will send shockwaves within the bank’s executive suite and prompt Congress to put even more financial regulation on the table. Three executives at JP Morgan have already been singled out for the bank’s $2 billion misstep, and we’d expect all three to resign in coming days. Increased financial regulation beyond what can be considered necessary would be a major negative for the big banks and global capital formation specifically.
But let’s keep this trading loss in perspective. The bailout of the big banks was nearly $800 billion during the financial crisis, so this is far from the conditions that set the financial crisis in motion a few years ago. The housing meltdown is far greater than any minor hedging hiccup. And with JP Morgan being one of the largest money-center institutions in the world, a $2 billion hit is but a blip to profitability and the growth of its capital base. For example, in its first quarter alone, JP Morgan earned $5.4 billion, a level that will absorb the majority if not all of the potential losses (current and foreseen) related to its recent misstep.
All things considered, this hedging mistake is an isolated loss at JP Morgan, and the size of the loss barely breaks the threshold of materiality. We don’t expect this loss to have implications on the other big banks, and the market’s reaction to the news is severly overblown, in our view. JP Morgan has shed nearly $10 billion in market cap in recent trading sessions, significantly more than the expected loss itself. However, we fully accept the notion that banks operate on confidence, and any damage to it will certainly make operations more difficult. By extension, we wouldn’t be surprised to see the recent multi-day sell off continue into the next few weeks as investors take some risk off the table, marking what we’d describe as a healthy pullback following a multi-month advance.
We reiterate that such a trading loss will not spark 2008 again, but the 30%+ cash position in the portfolio of our Best Ideas Newsletter that we had been building for some time speaks to our more cautious stance. Our Valuentum Buying Index, which captures valuation extremes (both to the upside and downside), has largely given us a leg up as it prompted us to raise cash before the market's recent fall. However, we won't hesitate to put this cash to work in undervalued names that score high on our Valuentum Buying Index when the time comes.
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