JPMorgan's 2013 EPS Could Suffer On LIBOR Settlement

| About: JPMorgan Chase (JPM)
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On June 27, Barclays (NYSE:BCS) agreed to pay a total of $450 million to the Department of Justice (DOJ), the Commodity Futures Trading Commission (CFTC), and the British Financial Services Authority (FSA) to settle claims that the bank was involved in manipulating LIBOR, the rate used to set over $550 trillion in loans worldwide.

As is widely known by now, the bank's submitters' turned in false information about interest rates in an effort to benefit the firm's derivatives positions and, during the financial crisis, to portray the firm as healthier than it actually was. By entering into a nonprosecution agreement with the DOJ, Barclays was able to avoid criminal charges. According to The New York Times, similar agreements will likely be reached between the DOJ and the U.S. banks involved in the scandal to avoid the possibility that a criminal conviction could render the banks unable to operate in the U.S.

From there, banks will of course face litigation risk from private lawsuits which, thanks to the any nonprosecution agreements entered into between the banks and the DOJ, will stand a very good chance of success:

Settlements with the Justice Department require an admission of misconduct, not the more typical resolution in civil enforcement actions that come without any acknowledgment of violations. Those admissions can prove to be quite useful to plaintiffs in pursuing their own cases.

The question for investors in financial stocks then, is how much all of this is ultimately going to cost. For JPMorgan (NYSE:JPM) shareholders, the question is especially pertinent given the fact that the firm's 2012 results have already been negatively impacted by a $5 billion derivatives trading loss and could be affected down the road by any potentially negative outcome from the ongoing FERC probe into the firm's involvement in manipulating power markets.

Thanks to Morgan Stanley's (NYSE:MS) research, investors do have some guidance on what the losses might eventually be for JPMorgan. Morgan Stanley identifies three types of risk from the LIBOR probe: regulatory, litigation, and increased uncertainty regarding future operating results. For affected banks as a whole, Morgan Stanley's bear case assumption for regulatory risk is a 5-17% hit to 2012 EPS. To quantify litigation risk, Morgan Stanley assumes:

...every 1bp of LIBOR understatement every day for 4 years represents a $6 billion hit to the LIBOR panel of banks. If the 16 banks listed in the class action lawsuits shared equally, we estimate this would be a ~$400 million hit per bank.

Lastly, Morgan Stanley uses a 'bottoms-up approach' proportional to each bank's derivatives holdings to assess the potential hit to 2013 estimated earnings.

To make a long story short, Morgan Stanley estimates JPMorgan's total litigation settlement expenses to be $975 million, which, if taken over two years, will have a negative 2% impact on the bank's 2013 earnings and a negative 1% impact on the bank's 2014 earnings. While this cost is by no means astronomical, it is nonetheless yet another drag on the bank's results. Combine this with any further losses that may accumulate from the unwinding of the remainder of the ill-fated long position in the CDX IG9, and any potentially damaging settlement related to the power market probe, and there remain significant downside risks for the firm. My suggestion is to either short JPM or go long JPM puts.

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