Investors Should Be Wary Of JPMorgan Until Risk Management System Is Further Improved

| About: JPMorgan Chase (JPM)

JPMorgan Chase (NYSE:JPM), the largest U.S. bank with respect to assets, surprised analysts when it first announced a $2 billion trading loss in May this year. Later in July, we saw how the disclosed $2 billion trading loss ballooned to $5.8 billion when the company reported its second quarter performance. Besides tarnishing the reputation of JPM's CEO, the flawed trades have cost the bank $17 billion in market value. The problems began when a London-based trader of the JPM Chief Investment Office made outsized bets involving credit default swaps (CDS). Reports suggest that a group of shareholders warned the bank that improvements were required in its risk management systems. However, the top executives rejected these warnings. The management, after it reported its second quarter performance, acknowledged "a material weakness" in their internal control system (risk management systems).

The risk management systems at JPMorgan, as opposed to the rest of the money center banks, are different. Rather than allotting limits to individual traders, the risk management systems at JPMorgan allot trading limits to a group of traders. This unorthodox risk management system allows traders like Bruno Iksil to take large positions. As a result of the trading loss, several investigations are underway to check the bank's internal controls and its risk management systems, and whether JPM traders hid losses. An internal control investigation blamed lax internal control for the considerable trading loss. Pension funds from Sweden, Oregon, Ohio and Arkansas have alleged that they have lost up to $52 million due to the flawed trading at JPMorgan's Chief Investment Office. We changed our buy recommendation and advised our investors to stay away from the stock until a clear picture of the bank's risk management system is revealed.

Where the bank seems to be committed to improving its risk management systems, it also aims to maintain the strategy of allowing a wide variety of potentially risky investments. As part of efforts made to improve the system, the bank recently hired Tim Flynn, the former chairman of KPMG, to its risk panel to strengthen its internal control systems. Flynn is said to have extensive risk management and financial services experience and will be helpful in improving the bank's internal controls. However, the other three members of the risk panel lacked Wall Street experience, with only James Crown having the required experience. However, he too hadn't been employed in the Finance Industry for over 25 years. The remaining members include the president of American Museum of Natural History, Ellen Futter, and the chief executive officer of Honeywell International (NYSE:HON), David Cote. Ellen Futter also sat on the governance committee of the American International Group (NYSE:AIG).

JPMorgan's stock has appreciated 12% since the beginning of the year, and is trading at a discount of 23% to its book value. This is in comparison to a 23% and 46% discount for Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS), respectively. For the coming quarter, analysts have a mean earnings estimate of $1.17 per share and $2 per share for JPMorgan and Goldman Sachs, respectively. This is compared to $1.02 per share and a loss of $0.84 per share a year ago for both banks, respectively. JPM's Tier-1 capital ratio at the end of the second quarter was 11.3%, as opposed to 15% for Goldman Sachs.

We believe that Tim Flynn's appointment alone will not help resolve the broad-level risk management issues at JPMorgan. The risk panel needs to disclose the future of internal controls at the bank, which need to be adopted in the wake of the huge trading loss of May 10, 2012.

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

Business relationship disclosure: The article has been written by Qineqt's Financials Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.