The repercussions of JPMorgan’s (NYSE:JPM) hedging bet that went bad seem to be getting bigger by the day. Tuesday morning reports surfaced that JPM may report a $4.2 billion second quarter trading loss from its chief investment office, according to ISI.  Even as the market comes to terms with the fact that the failed hedging strategy has already cost the financial giant $2 billion, news that JPMorgan sold profitable securities worth billions to cover up these losses has sparked another debate about the need for such a measure in the first place.  And the regulatory probe into the issue which has strengthened Volcker Rule supporters is bound to make things difficult for JPMorgan and peers Bank of America (NYSE:BAC) and Citigroup (NYSE:C) in times to come.
We have a price estimate of $48 for JPMorgan’s stock, which we are in the process of reviewing to factor in the effect of the series of events triggered by the trading loss.
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The Loss Cannot Be Undone
Early in May, JPMorgan announced that a large-sized hedging position its London-based investment office entered into has resulted in losses of $2 billion, with a possibility that the loss figure could reach $3 billion in subsequent quarters. Reports this week say it could be up to $4.2 billion. The news took investors by surprise, coming from the bank that is widely recognized as the ideal among diversified banking institutions.
The incident did more than damage JPMorgan’s income statement for the quarter – it considerably damaged the bank’s reputation as the stable financial institution which side-stepped a majority of issues its peers faced during the global economic crisis of 2008 by taking a controlled-risk approach. Questions are now being raised about the bank’s risk management system.
A Cure Worse Than The Disease?
Investors more or less made peace with the fact that JPMorgan’s Q2 2012 figures are in for a $2-billion hit. After all, the financial impact of the poor hedging strategy was largely expected to be one-time.
But JPMorgan’s move to go ahead with the sale of profitable securities worth at least $25 billion to cover up the mess in this quarter’s income statement seems to be another bad decision. And the fact that this sale brought in a profit of about $1 billion means that even the cover up is partial.
There are several reasons why this is a poor call by JPMorgan. Firstly, the reason why all the securities were lapped up quickly by buyers was because they carried high yields. This essentially means that JPMorgan has forfeited an important source of revenue for its trading business – something indispensable given the increasing volatility in global capital markets as the European debt crisis worsens.
Secondly, the sales would have attracted a significant amount of tax – which means the entire monetary benefit of the move would not be passed on to the investors.
JPMorgan should have just gone ahead and contained the losses over this quarter, with more focus on ensuring that its risk management system prevents such incidents in the future.Notes:
- JPMorgan Faces $4.2 Billion Trading Loss, ISI Forecasts, Bloomberg, June 5 2012 [↩]
- Analysis: JPMorgan dips into cookie jar to offset “London Whale” losses, Reuters, May 29 2012 [↩]