Unless you have been on another planet for the past few days, you could not have missed reading about the derivatives fiasco at JPMorgan Chase (JPM). Despite extensive coverage, we don't have a clear understanding of what happened and the ramifications for JPMorgan as well as the banking system as a whole. The bank has disclosed a loss of $2 billion on complex derivatives trading strategies that went wrong.
Unlike the trading losses recently at UBS (UBS) and Societe Generale (SCGLY.PK) caused by rogue traders who then manipulated the accounts to hide what they were doing, whatever happened at JPMorgan seems to have happened with the full concurrence of top management, which seemed to have placed too much reliance on their internal controls. In fact, this follows a situation only two years ago when derivative trading went out of control in the bank' s commodities division - specifically a short position on coal that was oversized and risky in comparison to the global market. No exact figures for the losses then were available but informed experts say that they would have been in the hundreds of millions of dollars.
Analysts quickly jumped in to evaluate the effects of the surprise loss on the future performance of the bank. There is no doubt that the news has tarnished the reputation of JPMorgan CEO Jamie Dimon who is widely regarded as arguably the best bank CEO in the world. Despite reports appearing in the media since April about these loss-making trades, Dimon continued to defend the strategy and the executives responsible until he had no choice but to come clean.
At FBR, equity analysts downgraded the shares and, while acknowledging that the core businesses continue to be strong, voiced their concerns about the quality of the credit derivatives portfolio. They also reiterated their belief that though this was a headline risk to the entire banking industry, the problem was confined to JPMorgan. Finally, they recommended shares of competitors such as Wells Fargo (WFC), US Bancorp (USB) and PNC Financial Services (PNC) who followed less complicated and easier to understand business models.
It is likely that more losses may emerge as the position is fully liquidated, but, given the strength of the JPMorgan balance sheet, these losses should be manageable. Other analysts also expressed their desire to revisit the earnings forecasts for 2012 as well as the target price while pointing out that the stock price will continue to be supported by further buybacks as well as the dividend yield, which is in the region of 3%.
Let me try and explain this to you by giving my take on what I think happened and what went wrong. It now appears that the JPMorgan executive who is taking the rap for all this is Ina Drew who is the head of the Chief Investment Office. The office has been phenomenally successful and profitable handling a portfolio of $356 billion and the London office alone where the fiasco took place showed a profit of $5 billion for 2010.
You must remember that the bank was attracting large quantities of new deposits because of its reputation as a secure bank and was unable for various reasons to lend out these deposits as profitable loans. My guess is that these deposits must have found their way to the Chief Investment Office to be profitably deployed in hedging. Because hedging instruments are liquid and easily tradeable unlike loans, which have to be held to maturity, the focus shifted to trading activity.
The exact details are not available but there is no such thing as a perfect hedge and you have to live with the consequences of the market turning against you, which is always the main risk in speculation. It also appears that the markets and media were aware of the size of these trades and other traders could have made money by being the counterparty to the JPMorgan trades.
I have no reason these trades were anything other than genuine hedges for assets in the JPMorgan portfolio and it is difficult to judge them unless we have the full picture of both sides of the trades. For instance, the bank may have been worried about the catastrophic effects of a meltdown in the eurozone and moved to protect itself. Hedges are put into place as insurance against enormous losses and it is quite possible that the hedge will lose money while the asset that it protects makes money. We will just have to wait for further details to emerge.
Unlike Bank of America (BAC), which has made a series of major mistakes and still survives, Dimon has done an exceptional job leading JPMorgan Chase through its various tribulations and building what is the strongest bank in America. I personally believe that this mistake should not mar his reputation and he continues to be the best possible person to serve as CEO. If anything, I am sure that he will learn from this mistake and strengthen the internal controls so that the bank can continue to profit from complex strategies that less formidable rivals may not be able to emulate. I am sure that JPMorgan Chase will continue to stay ahead of the pack.
I would consider the recent drop in the price of JPMorgan Chase as an excellent buying opportunity based on fundamentals and the dividend yield except for one factor. I do not believe that any investor should invest without a clear picture of the future prospects. I am by no means implying that the future prospects for the bank are anything but bright, but this stock is not going anywhere in a hurry. I would wait for the air to clear and hold on to any existing positions. If anything, a clearer picture could make this an even more attractive buy. Given JPMorgan's financial strength, I predict that the stock will climb back up to the $40 level by late 2012.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.