How JPMorgan Just Lost A Huge Source Of Profits, Now A Terrible Investment

Jul.14.12 | About: JPMorgan Chase (JPM)

I don't think many are recognizing the long-term significance of JPMorgan's (NYSE:JPM) Chief Investment Office (CIO) blowup. Zerohedge broke a huge story Friday, explaining that the CIO has been responsible for 31% of net income in 2009, 19% in 2010, and 10% in 2011.

Take a look for yourself:

Click to enlarge image.Click to enlarge

Well, there goes a huge portion of JPMorgan's earnings power, and yet the stock was up an absurd 6%.

The CIO's role is (or supposed to be) a legitimate hedging operation. Hedges don't make money unless your other positions were wrong. Getting the picture? The CIO is essentially supposed to lose money.

With this kind of story taking center stage, JPMorgan's CIO simply cannot take the risks it has historically taken. Every large trade will be under the scrutiny of regulators, and management will be sure to stay well away from large risks.

It's also fair to question the actual execution of the office. The now famous "hedge" of selling credit default swaps during the first quarter, right after the ECB's LTRO seemingly removed all risks from the macroeconomy, is laughable. For a professional institution to sell credit insurance at multiyear-low values in response to some cheap liquidity injections is astonishing. Calling JPMorgan out isn't Monday morning quarterbacking either; the structural risks to the macroeconomy are well publicized, and nothing fundamentally changed as a result of LTRO. I'd add that most individual investors weren't fooled by the cash injections and subsequent market melt-up.

Of course, the trade didn't come up as being risky in JPMorgan's value-at-risk model, since LTRO essentially vacuumed out all technical risk from the marketplace. But where was the oversight? Did Jamie Dimon himself really think credit risk had been substantially lowered?

Perhaps risk evaluation was irrelevant. What is far more likely is that risk evaluation isn't taken particularly seriously by any of the TBTF prop trading offices (yes, the CIO is -- or at least was -- a prop trader), and a blowup like this was simply bound to happen. As Iksil began to bully the market, skewing the IG9 CDS index well past its fair value, JPMorgan simply didn't have enough market participants to play with anymore. And when market risk spiked as investors begin to re-recognize the structural deficit issues that almost every developed nation has, CDS prices rose markedly.

This doesn't happen to hedging offices. Hedge funds, sure, but not risk management offices. It's unacceptable behavior from a philosophical standpoint, considering JPMorgan's implicit taxpayer backing. It's terrifying from an investment standpoint since long-term net income is going to be negatively impacted severely, and because Dimon's ability to recognize investment risks is clearly in question.

Conclusions

Investing in JPMorgan, Bank of America (NYSE:BAC), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), or the like is simply irresponsible. First of all, these institutions are starved for revenue growth and are willing to take exceptional risks to achieve it. Second, they may now be forced to scale down risk-taking in response to JPMorgan's regulatory spotlight, further harming bottom lines. With net interest margins at record lows, regulatory scrutiny increasing, and a slowing global economy, an investment in the big banks makes absolutely no sense from a risk-adjusted standpoint.

This is not isolated to JPMorgan. The next big blowup is on the horizon. Every new spike in economic distress will bring more bad trades and positionings to the forefront. Some of these firms have trillions in derivative risks, much of it related to European sovereigns or banking institutions. These banks like to note their "net exposure," or hedged risk, but these calculations are dependent on, one, the models used for net calculations and, two, the assumption that there is no counterparty risk. The failure of a major institution, not such an unlikely scenario in an economic crisis, would break the entire netting and all of a sudden that net exposure becomes "gross," or total risk.

This has been apparent since the financial crisis. Why anyone feels comfortable tying their capital up long term with TBTF (too big to fail) banks never ceases to amaze me.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.