JP
Morgan announced yesterday that its Chief Investment Office had incurred a loss
of $2 billion on derivative trading undertaken for the purpose of hedging its
loan portfolio. This loss in turn had
been partially offset by $1 billion of realized gains in regular trading. JPM’s Jamie Dimon further warned that the CIO
loss could rise or fall substantially until the derivative positions were
undone.
As
a shareholder, I was surprised by the announcement and I am not happy. In the charged regulatory and political
climate of Washington, we can expect all kinds of theater; Congress has already
announced hearings on the matter; the SEC and the New York State Attorney have
announced inquiries. While the stock has
fallen 9% already, it could fall further.
There
some troubling aspects to this loss: (1)
how could these derivative positions lose so much money in so little time? (2)
market rumors of excessive position building seem to have preceded JPM’s top
management awareness of the magnitude of the problem, (3) how could anyone
believe that building a position, big enough so as to be illiquid, be a good
way to hedge a portfolio? (4) if indeed the short hedges lost money, there
should have been a commensurate gain on the asset side JPM balance sheet.
Beyond
the above questions, there are some more fundamental issues: (1) is this
incident evidence that JPM has become too big to manage, even for as
detailed-oriented a manager as Mr. Dimon, or is this proof that even the best
falter sometimes? (2) there have been reports, unconfirmed so far, that those
responsible for hedging at CIO had recently been expected to show a profit as
well; (3) old-time bankers like me remember when the kind of derivatives JPM
used didn’t exist, yet banks tried to protect against portfolio losses by
having ample capital and building general loan loss reserves in good times; shouldn’t
regulators and banks take another look at these remedies?
I
will close with two observations: having
pulled through the crisis unscathed, JPM has not been bashful about its
prowess. Its CEO can come across as
arrogant at times, and I can see how many officers at the bank, by
assimilation, could consider themselves as the new masters of the banking
universe; hubris can be as dangerous, in its own way, as lack of
competence. Although it is purely a
personal speculation of mine, I believe that the huge cost of litigation and
regulation is pushing banks to make up for lost profits in every nook and cranny,
in the case of JPM in what used to be a hedging activity. Ironically, Congress and state attorney
generals have some paternity in the JPM loss.
Clearly,
JPM has built huge derivatives positions that it can’t easily close. Market participants will quickly figure out which
these are, if they don’t know already, and bid against JPM. This is why Mr. Dimon warned about volatility
and his determination to use his balance sheet not to be forced into untimely
liquidation. Consequently, it is prudent,
in the absence of detailed information which is unlikely to be aired publicly,
to assume that JPM could incur a bigger loss than the above gross $2 billion.
Even
if the gross loss number were doubled to $4 billion, or about $1.05/share , pre-tax,
the tangible book value at the end of the year is likely to be close to $36 [1]
per share. I would think that buying
below that level would represent an interesting opportunity. After all, the bank is well diversified, has
plenty of capital and, despite this embarrassing loss, well managed.
[1]
$34.5 tangible book at 3/31 + $4.7 of earning - $2.1 of net loss - $1.2 of
dividends. Book value would rise to $49.1. I have assumed no net share buyback for the
rest of the year.
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