JPMorgan’s $2 Billion Mistake: A Buying Opportunity?
In 2008, JPMorgan Chase (JPM) rose out the financial sector’s ashes like a – dare I say – phoenix, as the bank absorbed Bear Stearns and Washington Mutual. At the moment, JPM is the largest bank in the United States, with over $2 trillion in assets between its various branches. Last week, CEO Jamie Dimon held a conference call with shareholders and members of the media to report that his derivatives trading division had made a substantial blunder of $2 billion. While not a significant portion of the company’s overall value, the loss will hurt JPM’s second-quarter earnings, as well as its stock price. Regarding the latter, some tremors in the market have already begun to occur. On Friday, shares of JPM lost 10 percent, while the banking industry declined an average of around 4 percent. To quote a wise man I once knew: “if you could make God bleed, people would cease to believe in him, there will be blood in the water, the sharks will come.” In this case, JPMorgan has been viewed as a banking ‘god’, so it is understandable that investors have been quick to turn on this stock and the industry as a whole.
Perhaps a more important point to be made is that things could get worse for JPMorgan. Reports are that because the trading loss was made in a relatively yet-to-be-understood credit derivatives trade, losses could escalate by another $1 billion over the next few weeks. Critics believe that Dimon – who’s reputation as the most risk-adverse CEO on Wall Street is crumbling – is ultimately responsible for this situation, but it is worth mentioning that if this could happen at JPMorgan, smaller banks are also exposed to this kind of risk. All of this begs the larger question as to when or if lawmakers will pass the famed Volkner rule. For those who don’t know every potential law by heart, the Volkner rule is essentially a risk-prevention measure that would prohibit banks from speculating – aka placing bets – on derivatives. In fact, it was just four short years ago when banks like Lehman Brothers and Bear Stearns failed due to ill-advised speculative plays in the housing market. While JPMorgan’s troubled derivatives were on other asset classes, speculation is still speculation, as they say.
Adding another blow to the bank, Fitch Ratings downgraded JPM from AA- to A+, citing risk management worries, which are obviously justified. For a refresher on bonds and how they are rated, see this article. As investors are not fully aware of a floor where JPMorgan’s losses will stop, the company’s stock could fall further this week. Savvy investors, however, that do not believe the bank’s dominant position in its industry is compromised can use this incident as a nice buying opportunity. With a current Price-to-Earnings ratio of 7.6 times earnings, JPM is undervalued compared to its peers, who have an average P/E of 9.6. Additionally, the company’s Price-to-Cash Flow ratio is 1.3, compared to an industry average of 3.2. Fundamentally, it does not make sense why JPM’s cash flows are so undervalued when the bank currently holds over $100 billion in free cash flow. If anything, a fraction of JPM’s cash hoard could be used to cover this and any future trading losses, though this would still hurt the company’s bottom-line.
On a more sociological note, it will be interesting to see how the public views this misstep, as most bank-haters have been preoccupied with Bank of America (BAC), placing the brunt of their frustrations with the financial sector on the company. Well, JPM just added some fuel to these flames, as protestors can now point to the fact that this bank did not learn the lessons the most recent financial crisis tried to teach us – that no one should be trading assets that they don’t fully understand. Because JPM did not learn this lesson, history may be doomed to repeat itself.
Disclosure: The author has no holdings in the stocks mentioned in this article and has no plans to initiate any positions within the next 72 hours. He does, however, have the intention of rating these stocks on WealthLift.com, a social media website where investment ideas are shared openly and free.