If you're a JPMorgan Chase & Co. (NYSE:JPM) shareholder, you might have breathed a heavy sigh of relief when you read the following lines in the company's second-quarter earnings press release Friday:
- Significantly reduced total synthetic credit risk in CIO
- Substantially all remaining synthetic credit positions transferred to the Investment Bank
- CIO synthetic credit group closed down
These statements are supposed to assuage concerns that the bank's profitability could ever again be jeopardized by the 'mishandling' of whale-sized synthetic credit positions. However, there are two very good reasons to believe that shifting the synthetic credit positions to the investment bank and shuttering the CIO's synthetic credit group could have the very opposite effect—the actions could severely impair JPMorgan's profitability. Not only that, the transfer of the synthetic credit portfolio to the investment bank (IB) might be more significant in terms of increasing the IB's risk profile than the firm is letting on.
The first thing to understand is that before it embarked on the ill-fated 'whaling expedition,' the CIO synthetic credit group's portfolio was positive every year from 2007 until 2011, generating billions in gains for the firm.
In other words, the synthetic credit operation and the group as a whole was profitable and very much so. In discussing the shifting of the synthetic credit portfolio to the investment bank, the firm noted:
"Investment bank has the expertise, capacity, trading platforms and market franchise to manage these [synthetic credit] positions."
This is undoubtedly true. In fact, JPMorgan has the biggest credit-swaps dealer in the U.S. Unfortunately for the ill-gotten profit side of the equation, JPMorgan's investment bank tends to mark its positions fairly. Allow me to explain. In an 8k released Friday, JPMorgan announced that it would restate several items from its first-quarter results. The restatement stemmed from the fact that
"...an internal review indicated that the CIO's synthetic credit portfolio had been improperly marked by traders in order hide mounting losses."
Some CIO traders were routinely mismarking CDS positions, a practice that has already prompted criminal investigations. This comes as no surprise, as Bloomberg suggested months ago that the CIO desk's marks differed by as much as hundreds of millions of dollars from those of the investment bank. Now that what remains of the CIO's synthetic credit portfolio will be run by the firm's investment bank, you can bet (especially considering the level of scrutiny now being leveled on the firm) that these positions will be marked as conservatively as absolutely possible, meaning minimal gains if the positions are in the black, and maximum losses if the positions are in the red.
Furthermore, the firm made it a point to say that the transfer of the CIO's synthetic credit portfolio to the investment bank would not create a situation wherein the investment bank's risk profile was dangerously affected:
"[We] expect combined IB & synthetic credit portfolio risks to be within IB's historical VaR & stress risk levels"
If one simply looks at the investment bank's VaR for the past three years, however, the quote above seems to be disingenuous at best. According to the 'executive comments' section of JPMorgan's quarterly report, the transfer of the synthetic credit portfolio raised the investment bank's VaR by a whopping 55%:
"IB VaR as of 7/2/12 (spot) has increased from $74 million to $113 million"
This is quite an abrupt reversal of fortune regarding the level of risk- taking at the firm's investment bank. In 2011, the investment bank's VaR was just $76 million and in 2010, its VaR was $87 million. To be fair, IB's VaR was $164 million in 2009, but the point here is that the trend was definitely towards less risk at the investment bank—until now.
The second reason to believe that closing the CIO's synthetic credit group could substantially reduce the firm's profitability is to simply look at the percentage of JPMorgan's net income historically generated by the CIO unit. In 2009 for instance, the firm had $11.73 billion in net income, of which $4.3 billion came from the CIO desk. Similarly, in 2010, total net income was $17.37 billion, of which the CIO desk accounted for around $3.6 billion. In 2011, net income was $18.9 billion, with the CIO desk contributing $1.34 billion. On average then, the CIO desk has contributed around 20% of JPMorgan's total net income over the past three years.
With the CIO's synthetic credit group gone, one wonders how the unit can possibly continue to make that kind of positive contribution to the firm's results. Ultimately then, the question is: where is that 20% going to come from now? There is no satisfactory answer to that question as of yet. Investors can add this, as well as the 55% increase in risk at the investment banking division to the other concerns about the firm going forward, such as the negative impact of the LIBOR investigation which, by Morgan Stanley's estimates, will cost JPMorgan around $975 million, and the power market manipulation probe. The good news for the sensible—the rally in JPMorgan's shares Friday made put options cheaper. I suggest buying some or shorting the stock.
Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in JPM over the next 72 hours.
Additional disclosure: I am long JPM puts.