For years, we were told that Jamie Dimon, CEO of JPMorgan Chase & Co (JPM), was the best banker in the world. I'm starting to doubt that claim. Clearly, he steered JPM admirably through the financial crisis by making the wise decision to mostly avoid subprime mortgages, but since the crisis, the bank has been plagued by operational missteps like the London Whale trading loss and constant legal scrutiny. Frankly, part of me wonders whether Dimon was more lucky than good in avoiding the subprime mess; after all, he tried to buy Washington Mutual, a king of subprime mortgages, in March 2008. Fortunately, WaMu rebuffed JPM, saving the company over $10 billion in losses, and JPM was able to buy their good assets on the cheap after the bank was seized by the FDIC. If Dimon really saw the problems in subprime mortgages, why would he have offered over $5 a share for Washington Mutual that spring?
Whatever your personal view of Dimon, it is clear Washington has soured on him as JPMorgan has become ground zero for those seeking restitution from major financial institutions. Currently, the Justice Department is conducting six investigations, the SEC 4, and CFTC 3. Meanwhile, the Federal Reserve, Congress, the OCC, and British regulators are probing the bank for possible offenses. Virtually, every aspect of the bank is under siege, from the CIO office to mortgage securitization to its energy trading unit. In its last quarterly filing, the bank said it may be under-reserved for legal losses by upwards of $6.8 billion. However, just today, it was learned that the Justice Department is seeking $6 billion in damages from RMBS it bought from JPM. This would amount to a 90% redemption of losses, similar to what USB (USB) agreed to pay in July.
So far this year, the bank has already paid out over $1 billion in fines and settlements and is about to pay another $500 in fines over the London Whale mess. Adding in this new $6 billion RMBS lawsuit, I think JPM's $6.8 billion legal loss guidance is not big enough. Further, several of these ongoing investigations are likely to result in new lawsuits, pushing that total even higher. In all likelihood, the bank will be paying out an additional $12 billion in lawsuits over the next 3 years.
As an investor do you want to own the bank with a legal bulls-eye on its back when others are receiving little legal scrutiny? Further, these lawsuits can hamper a bank's performance. Time management would be spending running the bank is diverted to fending off lawsuits, possibly weakening results. Moreover, clients may not want to do business with a bank under so much scrutiny, taking their business to one of JPM's competitors. Already, the bank's overseas business is facing operational difficulties due to these lawsuits according to several reports.
In a market with many cheap financial institutions, is JPM worth the headache, especially as it has clearly lose its "best-in-breed" luster? JPM's troubles remind me of the legal challenges Bank of America (BAC) face. From the summer of 2009 through April 2013, the bank was engulfed with lawsuits, mainly thanks to its Countrywide acquisition. With its recent MBIA (MBI) settlement, BAC's legal problems are seemingly in the rear view mirror. Look though how its stock performed during this period of legal wrangling:
Essentially, the stock did nothing, trading flat while the S&P 500 doubled. During this whole period, investors could point to its cheap valuation (notably its discount to book), but there remained little buying appetite. However, the stock has rallied 20% since the MBIA settlement. Clearly without a legal overhang, investors are compelled by its cheap valuation, but with legal issues, they would rather just avoid the name. Now, some bulls are pointing to its recent 10% decline as proof JPM is pricing in legal difficulties, but the stock has still wildly outperformed the S&P 500 over the past year.
As you can see, JPM still has room to fall on a relative basis. Thanks to its excessive legal losses, the stock is also not as inexpensive as it seems. When you factor in additional losses, book value is $49.30 while tangible book is roughly $37. At its current price of $50.60, JPM trades at a slight premium to book and 35% premium to tangible book. For comparison, Bank of America and Citigroup (C) both trade at discounts to tangible book, let alone total book value. With its legal issues, I question whether JPM still deserves this premium.
Legal issues could cut 5% of JPM's capital base, pushing its Basel III ratio back below 9%, still good but not as robust as earlier, while its leverage ratio will increase, drawing the ire of regulators. These legal challenges will likely also limit how much of a dividend increase and share buyback the Federal Reserve permits. Safe to say, its payout growth will likely lag those its competitors.
Given JPM's legal headaches and still comparatively rich valuation, it appears poised to trade sideways for some time just as Bank of America did. When there are plenty of strong banks to own, it is unwise to own the one that the government is attacking, justly or not. With Dimon losing some credibility and lawsuits piling up by the day, owners of JPM will just grow frustrated. It doesn't pay to fight the government, and I don't think JPMorgan will be an exception. With book value poised to decline as legal losses pile up, I would sell JPM; Jamie Dimon clearly isn't what he was cracked up to be. JPM no longer deserves a best-in-breed premium. Just sell JPM and focus on other high quality banks without the legal problems to earn solid returns.