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Hold the cheering that JPMorgan Chase lost only $5.8 billion on its London whale trade--the global investment banking model is completely broken
07/17/2012 8:30 am EST
Frankly, I find the jump in JPMorgan Chase stock deeply disturbing. It’s yet one more sign, if you need one, of exactly how cynical Wall Street has become and of how corrupt the world’s banking system is.
I can explain the rally in JPM Morgan shares. It’s the logic of that explanation that I find so profoundly troubling. Especially in the context of the global financial crisis (remember Lehman Brothers, Countrywide Financial (acquired by Bank of America (BAC) for $4.1 billion in 2008, and American International Group (AIG) rescued with $85 billion in loans by the Federal Reserve and the U.S. Treasury) and following so closely on the heels of news that Barclays (BCS) and other global banks had rigged the LIBOR interest rate benchmark.
So many investors I know have thrown up their hands in disgust and now either won’t invest in the financial markets at all because they think they’re corrupt and rigged or invest cynically with their fingers figuratively holding their noses at the stench. Who can blame them? Not I certainly.
Think about the two logics that explain the 6% gain in shares of JPMorgan Chase.
First, there’s the argument that the $5.8 billion loss from the complex—and disastrous—London Whale trade put on by a trader in London operating out of the bank’s chief investment office shouldn’t count because it’s a one-time problem.
This is the position taken by JPMorgan Chase CEO Jamie Dimon who said, in announcing the bank’s second quarter earnings that the results showed “really good underlying performance.”
Kind of hard to see, actually. Even if you look past that huge loss.
Reported earnings for the second quarter came in at $1.21 a share, a drop from the $1.27 a share reported for the second quarter of 2011. Revenue fell by 16.5% from the second quarter of 2011.
Further breaking down the income statement, revenue from fixed income and equity markets dropped to $4.54 billion in the quarter from $5.36 billion in the second quarter of 2011.
The bank did much better in bread and butter banking than it did on the investment banking and trading side. Revenue from retail banking, which includes home loans and checking, rose to $7.9 billion in the quarter from $7.1 billion in the second quarter of 2011. Income for this unit climbed to $2.3 billion from $383 million. Mortgage fees and related revenue rose to $1.6 billion from $595 million. Net income climbed to $931 million from $286 million in the second quarter of 2011.
But even in JPMorgan Chase’s banking business, though, there were signs of trouble on the horizon. Net interest margin, the difference between what the bank makes on its loans and what it pays to raise cash in the financial markets, dropped to 2.47% from 2.72% in the second quarter of last year.
All this good news only matters, in reality, if you agree with Wall Street accounting. There was the assumption that the brutal $4.4 pretax loss on the London Whale trading position was actually a one-time event. And the bookkeeping that offset much of that loss with a $1 billion pretax gin in the securities in the chief investment office portfolio, a $2.1 billion pretax benefit from a reduction in loan loss reserves, a $800 million gain from debit valuation adjustments and a few other items.
If you exclude all these accounting adjustments, JPMorgan Chase earned 67 cents a share. Well below the 76 cents a share projected by Wall Street analysts.
Wall Street has played fast and lose with bank earnings since the financial crisis, dismissing some losses as one-time events and counting some gains that I’d call one-time as part of a bank’s regular revenue stream. That’s exactly what Wall Street analysts and the stock market seem to have done again this quarter with JPMorgan Chase.
And to me that seems profoundly wrong. If the financial crisis has taught us anything, it’s that the big global investment banks have made risky trading with their own money—the sort of activity that resulted in $5.8 billion and counting in losses from the London Whale position—a core part of their business model. Goldman Sachs (GS) does it. Citigroup (C) does it. Bank of America does it. The gains and losses from those activities may be lumpy and may swing from plus to minus with any quarter, but they can’t be discounted as just one-time events. The big global investment banks are engaged in activity like this everyday. To say that JPMorgan Chase’s core banking business is doing fine—and to ask investors to somehow consider trading losses as outside the core—profoundly misrepresents the risk of the current investment banking model.
Second, there’s the related logic that says that a loss like the $5.8 billion London Whale loss is just an accident, bad luck, the result of a rogue trader, or whatever. Again I think that’s a total misrepresentation of the core problems at global investment banks.
These banks are indeed too big to manage. And they have fully embraced a culture of risk-taking at the same time that they’ve refused to admit that they can’t manage the risk to keep it within bounds or make sure that it doesn’t spiral into a culture of deception.
Notice that the defense that the CEOs at JPMorgan Chase and Barclays have both offered in the London Whale and LIBOR scandals blows the accident defense out of the water. (I’m pretty sure that isn’t what either bank intended.)
At JPMorgan Chase Dimon has told investors and Congress that he didn’t know that the chief investment office was out of control until the London Whale trade blew up on the bank. JPMorgan Chase admitted to investors this quarter that it had a material weakness of internal controls. Some traders, the bank said, mis-stated or mis-priced positions in order to avoid showing the full extent of their losses. And it wasn’t just in the second quarter of 2012. Last week the bank moved to restate earnings for the first quarter of 2012 as well. Some former traders at the bank have disputed this position, saying that the controls in place made it impossible for a few traders to significantly misprice positions—unless the risk control system itself was compromised.
The chief investment office team, the bank’s internal investigation said created a portfolio of derivative positions that “grew to a perilous size with numerous embedded risks that the team didn’t understand and were not equipped to manage.”
“Didn’t understand?” “Were not equipped to manage?” And nobody noticed?
Either Jamie Dimon and the rest of the management team at JPMorgan Chase isn’t anything like as competent as Wall Street has said it is—which would be a serious indictment of banking analysts and conventional wisdom on the Street—or they are indeed pretty smart men and women who have failed at the impossible task of running a very risky business at an investment banking behemoth that is simply unmanageable. That’s a much scarier proposition.
And it gets even scarier when you consider the story line that shows the once conservatively run chief investment office gradually becoming accustomed to taking on more and more risk as the managers of that unit worked to turn it into a major profit center for the bank. I don’t think this is an isolated occurrence. Many banking managements apparently no longer think that traditional low-risk bread and butter banking can generate the level of returns that a bank needs to earn.
Want to see what the pressure for higher returns produces when it is combined with management that isn’t up to the job of running an impossibly complex global investment bank. Take a look at the still unfolding LIBOR scandal.
So far Barclays has agreed to pay a $450 million fine to settle charges that the bank manipulated the LIBOR (London Interbank Offered Rate) benchmark interest rate used to price everything from mortgages to home equity loans to derivative contracts used for hedging risk by corporations and governments so that it would look more financially solid to regulators, credit-rating agencies and investors.
How far back does the manipulation go? The Bank of England and the New York Fed, to name just two parties, seem to have tumbled to the manipulation as early as 2008. Barclay’s internal documents push the beginning of the manipulation back to 2005.
But the inaction by regulators for four to seven years isn’t actually the most distressing part of the LIBOR scandal. LIBOR is calculated everyday by the British Bankers’ Association as the average interest rate at which 16 big international banks based in London can borrow from each other.
It’s just about impossible to imagine, therefore, that Barclays could have manipulated the LIBOR rate without the active or at least passive involvement of other big global banks. That is certainly the message of a memo that Barclays management sent out to the bank’s staff after Barclays’ settlement with U.S. and U.K. regulators. “As other banks settle with authorities, and their details become public, and various government inquiries shed more light, our situation will eventually be put in perspective,” the memo says.
In other words Barclays won’t seem quite so culpable because further investigation will reveal that everybody does it. Who’s everybody? The New York Times reports that UBS is under investigation but I’m sure the LIBOR scandal won’t stop there.
I don’t see any way to argue convincingly that the LIBOR scandal was just an accident or even that it was just a management failure at a single bank. Replacing Robert Diamond with a better CEO isn’t going to fix the problem because the problem is at the heart of the current incarnation of a global investment bank: too big to manage and too addicted to risk.
And if that’s indeed the case, there’s also no way that the JPMorgan Chase London Whale disaster is just a one-time event. It’s central to the way the bank does business.
And it’s about time that the financial markets started treating it that way.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
Jim Jubak's column has run on MSN Money since 1997. He is the author of the book "The Jubak Picks," based on his market- beating Jubak's Picks portfolio, the writer of the Jubak's Picks blog and the senior markets editor at MoneyShow.com. Click here to find Jubak's most recent articles, blog posts and stock picks. Get a free 60-day trial subscription to his premium investment letter JAM by using this code: MSN60 when you register here. [http://jubakam.com/wp-login.php?action=register