As no doubt everyone has read or heard, in early May, JPMorgan (JPM) announced a surprise trading loss of “slightly more than $2 bln”, incurred while trying to hedge European sovereign debt exposures. The media attention garnered by this loss has been relentless. The negative coverage is very atypical for this highly successful bank that buttressed its reputation by admirably managing through the credit crisis.
It is likely that CEO Jamie Dimon’s high stature and extremely critical description of the loss contributed to the intensity of the media coverage. The loss was particularly embarrassing since just weeks earlier, during the Q1 conference call, Dimon described a WSJ story about the Chief Investment Office’s (CIO’s) trading activities as a “tempest in a teapot”.
The market reaction was extreme, with the bank’s market capitalization declining by nearly ~US$25 bln (or 17%) in the 5 trading days following the announcement. Given the reaction, we thought we would provide our investors with our perspective. (Note, all figures are in U.S. dollars unless otherwise stated.)
First, JPM is an enormous company. With $2.3 trillion in assets, JPM is almost 3x larger than Royal Bank. Moreover, it has $130 bln in tangible common equity, almost 5x as much as RY, and more than the total tangible common equity of the Big-6 Canadian banks combined. In fact, the balance sheet impact of the after-tax loss (before offsetting gains) is small, representing ~0.1% of JPM’s total assets and ~1.1% of its tangible common equity.
Second, although a pre-tax loss of $2 bln seems like a lot, it is really not that large for JPM. For example, last year, JPM had total trading revenues of ~$20 bln. In addition, the bank announced $1 bln in offsetting gains, making the “all-in” loss (as of May 10th) about $0.18 per share (although many analysts brought their estimates down much more for the possibility that the loss might grow – see comments below).
Last quarter, the bank made over $5 bln or $1.31 per share (core EPS was closer to $1.39). Placing the loss into further context, we estimate normalized quarterly earnings to be in excess of $5.7 bln (or $1.50 per share), for annual normalized earnings of $23 bln per year (or ~$6.00 per share).
That said, the bank went to great pains to suggest the Q2 loss could be as much as $1 bln higher than the announced number (i.e., another $0.18 per share) and that the loss could grow further in 2H12 (it also noted it could decline). Dimon did, however, also indicate that the bank might harvest some of the remaining $7.0 bln in unrealized gains from the same $300 bln portfolio that generated the loss. So, there are some moving parts.
Third, tangible book value will not actually decrease as a result of the announced loss. Even if the trading loss rose to $5 bln and it was all incurred in one quarter and JPM opted not to harvest any additional offsetting unrealized gains, TBV would not decline because pre-tax earnings (net of dividends) would still be meaningfully higher (it was ~$6.5 billion in Q1-12).
So, if the trading loss is not really that significant, why has the bank’s stock price fallen so much?
The outsized decline in the bank’s stock price began from the perceived risk of further losses, but seemed to quickly morph into concerns about heightened regulatory risk. In fact, with the guidelines about the Volcker Rule being decided later this year, the loss could not have come at a worse time for the industry. In a Presidential election year, and given the hyper-political environment in the United States, this loss very clearly emboldens advocates of stricter regulation.
We believe the risk of additional legislation resulting from this loss is unlikely, since the House of Representatives is controlled by the Republicans, who are opposed (and in fact favour a total repeal of Dodd-Frank, including the Volcker Rule). Rather, we believe the probability of implementation of stricter regulations based on already passed legislation (i.e., Dodd-Frank) is clearly higher now, with the Volcker Rule being the most important.
That said, the sustainability, or ultimate impact, of these yet to be finalized regulations will likely depend on the outcome of November’s Presidential election. If the Republicans win the White House (and maintain control of the House), stricter regulations – should they occur – would have a very high probability of being relaxed, if not eliminated entirely.
Fundamental Impact Minor; Political Implications Unknown
The fundamental implications of JPM’s trading losses are not significant and, in our view, transient. It will not impact capital, and the loss – by itself – does not really speak to the overall level of “normalized earnings”, which we estimate to be about $6.00 per share (meaning the bank trades at about 5.2x normalized earnings). And although speculated in the media and advocated by some pundits, we don’t believe this will provide an impetus for breaking up JPMorgan.
However, there could be unknown political implications.
At present, the market appears to be assuming a substantial loss of trading revenues, most likely the result of a particularly punitive interpretation of the Volcker Rule. Although this is certainly possible, we believe it is unlikely that the resultant loss of revenues will be close to what JPM’s current stock price seems to imply, since a $25 bln loss in market capitalization assumes a highly material loss of revenues/earnings.
Rather, we expect this issue will ultimately bear some similarity to many past instances where headline risk or large charges have negatively impacted a U.S. or Canadian bank’s valuation – in every case we can recall, the impact was transient.
Disclosure: Prior to the announced trading loss, no HCP fund had a position, either long or short, in JPMorgan. Post announcement, and its material stock price decline, a position in JPM was added.