Chart of the Day – JPM’s Blubbery Fall From Grace

by Enis June 12, 2012 7:38 am • Commentary

Jamie Dimon will give testimony on the floor of the Senate tomorrow, in what has seemingly become an annual exercise of parading bank executives in front of Congress.  If you’re unfamiliar with the JPM CIO’s multibillion dollar trading loss, you can read our initial commentary after the announcement of the losses last month, as well as today’s WSJ article with more detail about what executives knew about the trades.

I consider the financial sector in the U.S. my area of special expertise.  I first moved from covering the energy and materials sectors to cover the financials sector as a trader in the summer of 2008.  I gave myself a crash course in reading financial company balance sheets.  Within a couple months, I was listening to practically every conference call, detailing each bank’s individual risk to the subprime crisis.

I couldn’t tell who was worse, the bank executives who lied or obscured the facts, or the analysts who believed the executives.  It was a frequent song-and-dance on those conference calls, where the numbers on the balance sheet didn’t match the story the bank executives told. But since financial companies are so complex, with massive balance sheets (larger than $2 billion in the case of JPM), the bank executives almost always had the final word, no matter your own suspicions.  Yet, the numbers just didn’t add up.

What’s been more surprising though, is that this game has continued even after the financial crisis in 2008 and 2009.  I won’t bore you with the details, but as someone who pored over these financial statements as my full-time job, I can tell you that American banks still frequently obscure the nature of their risks to the housing market.  They hide counterparty exposure to European banks, and use derivatives transactions to improve their outward appearances while maintaining their large, risky positions.

Incredibly, even during Jamie Dimon’s mea culpa on the conference call disclosing the Whale’s losses in May, he played the same game, leaving many of the analysts on the call confused as usual.  He did not want to say, we lost $2 billion and still have the largest CDS position in history on our books, so we might lose many more billions.  But that was the truth.

My mini-rant aside, what do my personal anecdotes mean for the sector?  To me, it’s obvious that in a world where the 10 year Treasury yield is 1.6%, banks are struggling to generate meaningful returns, and they’ve resorted to trading groups like JPM’s CIO group to maintain their earnings power.  It’s why the financials sector has not been able to hold on to any rally since May 2009 (in fact, the banks trade lower than where they did 3 years ago).  Astute investors see any earnings pop as ephemeral, with little change in the underlying structural issues.

For JPM, this story implies that the future loss of earnings power from reining in the CIO group is still likely being underestimated.  And today’s chart is an illustration of what happens when Congress decides to rein in your risk.  It is a comparison of the price action of GS during the 5 months surrounding the GS Abacus ordeal in 2010 (white line), vs. the last 5 months of price action in JPM in 2012 (orange line), with the respective event announcements circled in red:

As Dan mentioned in his justification for his JPM put spread shortly after the news broke, the JPM situation is similar to the GS Abacus situation, Senate inquiries and all.  We expected the price action to follow a similar pattern, and it has indeed.  I think the long-term path will be similar as well, as GS now trades 30% below where it did AFTER the steep fall, as its earnings power from proprietary trading has been steadily eroded.

Over the next year, I will look to JPM as a good shorting vehicle on any market pops, as I expect the Whale ordeal to have the same long-term impact.  No matter what the bank’s executives tell me…