Things just keep taking a wrong turn for the investment banking industry. After announcing a $2 billion loss due to a derivatives bet gone awry, JP Morgan (JPM) is now facing an FBI investigation on whether its officers engaged in any criminal activity related to the loss.
Meanwhile, JP Morgan's rival, Morgan Stanley (MS), is facing an investigation from both the SEC and FINRA, and also the U.S. Senate, regarding whether it selectively disclosed information to its clients in the lead-up to Facebook's (FB) Initial Public Offering.
That news came even as reports emerged that Morgan Stanley's co-underwriters, JP Morgan and Goldman Sachs (GS) had actually been helping clients, such as hedge funds, sell Facebook shares short amidst the stock's precipitous decline not long after listing. Where it gets worrisome for investors in financial stocks is that these occurrences inevitably provide ammunition for those seeking to reform Wall Street, whether its because of fears about "Too Big To Fail" or the "Fight for the Little Guy."
That's all well and good - but the fact of the matter is that companies like JP Morgan thrive on the $1.2 quadrillion derivatives market and, during lean times for trading financial assets, rely on fees from investment banking activities such as underwriting and advisory areas, not coincidentally, that are coming under ever-greater scrutiny.
Indeed, investment banking (25%) accounts for a fourth of JP Morgan's revenues. During boom periods of significant financial innovation and high stock market returns, investment banking can easily double its overall contribution to revenues. A look at the price action of JP Morgan, Morgan Stanley, Barclays (BCS), Bank of America (BAC) and Goldman Sachs is instructive. It shows that these financial institutions enjoyed their best stock price action 5 years ago, that is, before the mortgage market collapsed in late 2007 and the financial crisis ensued in late 2008.
To put it in a different context: boom profits from trading and structuring products for clients are Wall Street's equivalent of the incredible smartphone and tablet revenues in the technology sector. Investors should ask themselves: "would Apple (AAPL), Google (GOOG) or Amazon (AMZN) enjoy their current lofty valuations if, for whatever reason, they were suddenly shut out of the mobility market?"
Probably not, and that's the rub for Wall Street: investment banking is its "mobility" play.
So, how would JP Morgan fare?
To answer this, let's take a look at its breakdown of profits. As mentioned, JP Morgan close to a fourth of its income from investment banking, which broadly includes not only activities that are commonly associated with investment banking, such as advisory and deal underwriting, but also trading, structuring and derivatives.
That said, it shouldn't come as a surprise that the $2 billion cash derivatives loss that it reported was less than 0.5% of JP Morgan's cash reserves; derivatives trading, insofar as it contributes to investment banking, may be an integral part of JP Morgan, but it's still not its biggest part. In that sense, JP Morgan isn't quite like a hedge fund; a nominal loss of that magnitude would result in a significant diminution of the average large hedge fund's assets, if not an outright dissolution.
By far, the biggest portions of JP Morgan's revenues are from Retail Financial Services (i.e. typical bank deposit-taking) at 30%, investment banking at 25% and credit cards services at 16%. Those 3 areas account for 72% of its revenues. Another four revenue sources, private equity, treasury and securities services, commercial banking and asset management, combine for around 28%.
Consequently, even if JP Morgan were to see its investment banking unit contract reduced by half to 12.5%, it would still have 87.5% of its revenue streams available, all else being equal. Unfortunately, there wouldn't be much revenue "excitement" from the other 87.5%, but there would be solid, if unspectacular, opportunities. In particular, Moody's expects pre-tax profits from credit cards to rise by 35% in 2012, even as charge-offs decline to about 5% from double-digits in the prior years.
Meanwhile, to briefly touch on JP Morgan's revenue areas outside of investment banking and credit cards:
- Retail Banking. Profits should remain sluggish as deposit growth slows amidst rising consumer confidence resulting from the slowly expanding economy depresses saving. Meanwhile, mortgage-refinancing activity has been buoyed by persistently low interest rates.
- Commercial Banking. Profits from Commercial and Industrial lending are unlikely to expand significantly with corporations in the U.S. still holding onto record levels of cash.
- Asset Management. Asset Management should contribute healthy, if unspectacular, profits - particularly with equities markets generally buoyant this year.
- Private Equity. The private equity market is still in the doldrums, with uncertainty regarding the investment cycle and fewer large deals to excite investors despite the excitement over Facebook's listing.
- Treasury and Securities Services. This area should see respectable growth with positive price activity in the equities market supporting healthy treasury flow from U.S. corporations seeking to deploy their large hordes of cash to limit its negative carry.
Given this, it's easy to see that a JP Morgan, without a significant contribution from investment banking, is more like Hewlett-Packard (HPQ) than Apple: it's the leader or dominant in older businesses like PCs, printing and services that are growing only moderately and doesn't have a footprint in exciting areas like mobile.
There are clear parallels between Hewlett-Packard and JP Morgan, which derives large portions of its business from low to mid-growth businesses, like commercial and retail banking and credit cards. Without investment banking, it just doesn't have a foothold in high-growth businesses. Consequently, it shouldn't surprise anyone that JP Morgan took huge bets on risky derivatives trades.
JP Morgan is standing at the precipice. If its recent derivatives losses, coupled with its peers' questionable actions in the primary market, spur drastic changes to regulations that limit what JP Morgan can do in the investment banking arena, it will lose its major growth driver. Given the uncertain environment going forward, I believe that JP Morgan could underperform the broad market and possibly fall to $20 per share.