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JPMorgan (NYSE:JPM), considered to be the largest bank in the U.S., is having a tough year. First the bank faced a trading loss of $2 billion, which swelled to around $6 billion, and now the bank is faced with a lawsuit over the sale of fraudulent mortgage-backed securities. In the sale of securities, the bank ignored defects pointed out by its own review system. Both incidents are prime examples of a lack of adherence to the internal control systems developed at JPM. Even though the bank has a robust capital base, and the stock has attractive valuations compared to most of its peers in the industry, we recommend our investors to stay away from the stock until the management gives clear disclosures on its internal control systems.

On October 1, 2012, America's biggest bank, JPMorgan, was sued by New York Attorney General Eric Schneiderman for creating fraudulent mortgage-backed securities during the U.S. housing bubble. The issue started from Bear Stearns, which packaged and sold securities during the period. Since the ailing company was acquired by JPMorgan in 2008, JPM is said to be legally responsible for the sale of its fraudulent securities. It is alleged that during the U.S. housing bubble, Bear Stearns did not carefully evaluate the quality of the securities, and even ignored defects detected by company reviews. JPM is further accused of not having reformed its practices till now. Investors lost over $22.5 billion due to the purchase of these mortgage-related securities.

This is a first of many similar lawsuits to follow that will implicate other money center banks for their involvement in the financial meltdown. The U.S. president had appointed a committee to check the wrongdoings that led to the U.S. financial meltdown.

Improper evaluation of the mortgage-related securities reflects the lack of internal controls. The lawsuit is a last nail in the coffin for JPMorgan this year, which is already being investigated for a $6 billion trading loss this year. The bank has not yet settled the entire position, and it is feared that the loss could swell, affecting the bottom line in the coming quarters. As noted earlier, the bank had admitted to having a material weakness in its internal control systems. JPM has a policy to allot limits to a group of traders, whereas, the rest of the banks allot risk taking limits to individual traders. This led to outsized trades by one of the traders, in the office of the chief investment officer.

The bank posted a revenue figure that exceeded its consensus expectations by around 5%; however, the bottom line remained below expectations, largely, due to the trading loss that ballooned to $4.4 billion, at the end of the second quarter of the current year. At the end of 2Q 2012, the bank had a Tier 1 capital ratio of 11.3% and a total capital ratio of 14%. Both are well above the regulatory requirements of 6% and 10% for Tier 1 capital ratio and total capital ratio, respectively.

Surprise History

The bank has shown better than expected performance over the last five quarters, with the exception of the last quarter of the last year. On average, the bank demonstrated a 15.2% surprise by surpassing the consensus mean estimate for earnings per share, whereas, the turnover exceeded expectations by about 1% for each of the last five quarters. The most recent quarter's earnings alone exceeded estimates by around 49%, while revenues topped estimates by 1%.

Credit Suisse's Upgrade

JPM is among the few banks that Credit Suisse has upgraded to an outperform rating. On October 2, 2012, in a report to its investors, Credit Suisse noted that improvement in asset quality and loan growth will remain the key drivers for growth in JPMorgan in the coming quarters. Further, Credit Suisse has a positive outlook for the U.S. private sector economy.

Outlook

During the second quarter of the current year, the bank originated mortgages worth $131 billion; two fold when compared to the originations of the previous year. The surge in mortgage originations led to a 17% increase in quarterly profits. The U.S. housing markets have bottomed, and we believe the markets have started recovering. The Case-Shiller Home Price Index: National, a prime indicator of the activity in the U.S. housing markets, is at the level of 127.32, 1.14% above the level at the end of the first quarter of the current year. JPM is set to benefit from this recovery in the U.S. markets in the coming quarters.

Valuations

JPMorgan, with YTD performance of 23%, is cheaper compared to most of its peers in the U.S. banking sector. It trades at a discount of 25% to its book value compared to 17% for Goldman Sachs (NYSE:GS).

We are advising our readers to stay away from JPM until we get more clarity on the internal control systems.

Source: JPMorgan: Stay Away Until Management Gives Clarity On Internal Control Systems