JPMorgan Chase & Co (JPM) has had a most interesting year. It had its highest profits ever ($21.3 billion in net income) along with a huge 6.2 billion dollar loss in the "London Whale" debacle. That debacle drew massive and unwanted international attention to how the company managed its trader network. The scandal also cut into CEO Jamie Dimon's bottom line when the board hit him with a 50% pay cut over it. His dual roles of CEO and COO also came into question. He seems to have survived a shareholder vote this month with both of his roles left intact. 2012 marked very strong results across all of JPMorgan's units.
Of late, JPM has had analysts looking at its overall position with a critical eye. The Motley Fool recently ran a piece titled "Why You Shouldn't Invest in JPMorgan". In the article, the authors took the position that there is considerable downside risk in the stock. They acknowledge that "Compared with the other banks traded on U.S. exchanges, JPMorgan has average profitability that becomes larger if you take into account leverage; superior growth rates (zero) that resulted from avoiding the worst of the financial crisis; and a somewhat weaker balance sheet."
They go on to note that, "And like its Wall Street peers, JPMorgan faces considerable risks. Its most recent 10-K devotes more than 12,000 words to a dizzying array of risk factors such as regulatory risk, market risk, credit risk, liquidity risk, legal risk, and operational risk. Recently, The New York Times reported that the bank is being investigated by at least eight federal agencies in addition to investigations by federal prosecutors and the FBI."
An investor may not find such a landscape especially troubling, thinking that JPM remains in the too-big-to-fail category. If one considers that the JPM balance sheet is about one-ninth of the entire US economy that may be a fair assumption.
But the risk involved in the stock remains potentially huge. Consider how much the bank has paid to deal with regulatory and legal challenges. Graham Fisher's Joshua Rosner outlined the size of the problem in a March, 2013 note. He thinks that "there are real risks of further regulatory or legislative changes to required leverage and capital ratios, and that the FDIC's "single point of entry" approach to the orderly liquidation authority may result in new long-term debt issuance requirements at the holding company. Furthermore, other business risks appear under-appreciated, such as those associated with interest-rate risk management and also the collateral management of derivatives." JPM has also paid $16 billion in litigation expenses since 2009. Excluding these expenses, the Company has paid more than $8.5 billion in settlements since 2009 for various regulatory and legal problems. These settlement costs, which include a small number of recent settlements of older issues, represent almost 12% of the net income generated between 2009-2012.
In January 2013, the Federal Reserve issued two fairly narrow Consent Orders to JPMorgan. The first one was related to violations of the Bank Secrecy Act and anti-money laundering requirements, the second to the losses in the Chief Investment Office. Rosner notes that "neither of these orders appears to have resulted from any meaningful investigation and neither addressed the many other recent failures of the Company's internal controls." This CO may have been related to an August 2011 civil settlement by the bank with the US Treasury. Among those items in the settlement are violations of Cuban Assets Control Regulations ("CACR"), Weapons of Mass Destruction Proliferators Sanctions Regulations ("WMDPSR"), Executive Order 13382, "Blocking Property of Weapons of MassDestruction Proliferators and Their Supporters", the Global Terrorism Sanctions Regulations ("GTSR"),the Iranian Transactions Regulations ("ITR"), he Sudanese Sanctions Regulations ("SSR"),the Former Liberian Regime of Charles Taylor Sanctions Regulations ("FLRCTSR") and the Reporting, Procedures, and Penalties Regulations ("RPPR") Other issues were addressed by the CO unrelated to the OFAC settlement including violations of AML/BSA regulations related to its role in the recent Vatican Bank scandal, a drug cartel money-laundering scheme, and possible link the Madoff bankruptcy.
The whale situation (also known as the Synthetic Credit Portfolio), shows that problems in risk management problems existed in the CIO office, and were known to the most senior management of the bank. This calls into question the accuracy of the firm's filings and compliance with Title III of the Sarbanes-Oxley Act. If the controls in place were generating massive profits, management may not have had any impetus to change them. The list of JPM's regulatory violations over the past five years is long, diverse and appears to cross legal and regulatory jurisdictions. Many of these infractions are for repeated violations of specific control failures, which the Company had previously agreed to remedy.
There are other kinds of regulatory problems for JPM as well. The Commodity Futures Trading Commission (CFTC) has shown that JPM's funds and customer funds were being intermingled. In September 2009, the CFTC sanctioned JPMorgan for failing to properly segregate customer funds and for failing to report these "under-segregations" on a timely basis. According to the CFTC, JPM failed to segregate $725 million of its own money from a $9.6 billion account.
Other agencies have made moves against the bank. On June 21, 2011, the Securities and Exchange Commission brought a securities fraud action against JPM for misleading investors related to the structuring and marketing of a synthetic CDO called "Squared CDO 2007-1", for allowing a hedge fund, Magnetar, to play a "significant role" in selecting the securities included in the CDO's portfolio as well as Magnetar shorting securities with a notional value of over half the CDO portfolio.
The investor looking at JPM has to consider its history of problems balanced against its operational performance. Yes, it is huge and makes a lot of money so far that has kept the bank far ahead of any substantial legal burials. But JPM's history shows that there may not be sufficient oversight at the highest levels to guide the bank though stormy waters or perhaps that the bank itself is just so massive that it may not be able to avoid these kinds of issues. Either way it's an interesting story to watch and I'm sure more will unfold as time goes on. I'd consider it a safer bet if the majority of their compliance problems were solved and the true extent of their derivatives obligations were divulged.