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When a steady driver suddenly crashes into a hedge, it's time to run down the safety checklist before proceeding. So it is after JPMorgan Chase's clanging disclosure last week of a $2 billion-plus-on-paper loss in a corporate unit charged with hedging the bank's financial risks.
What just happened? Beyond producing what CEO Jamie Dimon called an "egregious" and "self-inflicted" loss, most of what can be ascertained about the trades in corporate-credit derivatives by the bank's Chief Investment Office is that they were poorly structured, improperly sized, and/or insufficiently monitored.
It was most likely more complex than a simple outright sale or purchase of insurance against corporate creditworthiness, probably involving counterweighted bets across the credit spectrum. Dimon's suggestion that this portfolio could produce additional "volatility" in results in coming quarters means the positions aren't fully unwound.
JPMorgan's Chief Investment Office oversees some $350 billion in assets. It is charged with trying to hedge the structural financial risks (credit, interest rates, currency) that a massive global consumer and commercial bank inherently faces. But there is no way for these aggregate risks to be offset or mitigated precisely.
Among the many debates this incident will energize is how to distinguish prudent hedging from proprietary bets -- a grayer area than partisans on either side of the regulatory divide tend to concede. But it's pretty bankable that the voices favoring a more stringent interpretation of the legal ban on proprietary trading will now be more readily heard. Dimon was the one bank CEO who could legitimately argue publicly that the most aggressive of the contemplated new banking rules would hinder well-run banks' competitive position and weigh on economic growth. He can still make that case, but fewer people of influence will be listening.
Should this loss be seen as a sick or dead coal-mine canary, foretelling broader market contagion? This is quite unlikely. As Nomura analyst Glenn Schorr points out, "While the original premise was to hedge the company in a stress credit environment, we haven't seen credit or volatility blow out this quarter," so the mispositioning was Morgan-specific, and hedge funds and others on the opposite end of the trades were net beneficiaries.
How, and how much, will this hurt JPMorgan? With a $2.3 trillion balance sheet and a quarterly run rate of $6 billion in earnings, a $2 billion mark-to-market loss is easily, if uncomfortably, absorbed, as would be the additional $1 billion in potential costs now being estimated to mop up the trades. The $1.20-per-share annual dividend, the $15 billion share-buyback authorization, the bank's nearly $5 in per-share earnings power, and its solid capital ratios look secure.
The pain is being administered to the "reputational premium" that JPMorgan, Dimon, and the company's stock (ticker: JPM) have (justly, to date) enjoyed over megabank rivals. The narrative of Dimon as the banker who foresaw the excesses that caused the 2008 financial meltdown and girded his company for the shock is diminished slightly, but not fully undermined.
Perhaps it's a trivial observation, but not every CEO would chastise himself and his company in quite the blunt terms Dimon did on his Thursday conference call. It's a fair bet that the Chief Investment Office (which, as the Wall Street Journal's Deal Journal blog noted, has grown far faster than the bank as a whole in recent years) will have its mandate sharpened, shrunken…or both.
What does it all mean for JPMorgan shares? The stock's Friday drop of 9%, to $36.96, was both understandable and probably overdone, vaporizing more than $14 billion in market value. With this decline, the dividend yield is 3.25%, making it just about the highest-yielding large-bank stock around. Tangible book now approaches $35, so a lot of the premium formerly afforded the bank has evaporated. Yet JPMorgan's dominant and broad franchise hasn't gone away.
There is an inherent tension between the desire for banks to be strong and vibrant sources of economic strength and the reformers' resolve to force them in the direction of public financial utilities. Bank critics want them to lend freely to lubricate the economy, but hold more capital against loans to protect depositors; to be large and diverse enough to ensure stability, but not so ambitious as to play too heavily in the global capital markets.
John McDonald of Bernstein Research suggests that the Morgan news "will likely reinforce investor concerns about the opacity of big-bank balance sheets, the predictability of their earnings and the ability of the industry to deliver consistent returns," which should "put pressure on bank-stock multiples."
This is true -- but no more so for Morgan than its peers, despite this sensational and sensationalized misstep.
Comments? E-mail: michael.santoli@barrons.com
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