Monday, October 21, 2013 - JPMorgan's Deal

JPMorgan's Deal

by Sinclair Noe

DOW – 7 = 15, 392
SPX + 0.16 = 1744
NAS + 5 = 3920
10 YR YLD + .02 = 2.61%
OIL – 1.63 = 99.48
GOLD - .80 = 1317.60
SILV + .28 = 22.34

Apparently, over the weekend, JPMorgan Chase reached a $13 billion settlement with the Department of Justice and the New York Attorney General over the sale of mortgage backed securities back in the days of the housing bubble. We're still waiting for details, but it looks like the tentative deal would resolve charges that JPMorgan misrepresented the quality of loans that had been packaged as mortgage backed securities, including mortgage backed securities packaged by Bear Stearns and Washington Mutual, the two failed institutions acquired by JPMorgan in 2008.

And one of the unique features of this settlement is that it does not end a criminal investigation of the bank. Prosecutors did not want to end the criminal probe before they were sure of its findings. The investigation could take another several months. Ending the criminal probe was a long shot and the bank was not interested in holding up all the other settlements to wait for that. Civil cases require a lower burden of proof than criminal cases, and can often be wrapped up quicker than parallel criminal proceedings. In other words, they knew they could lose; so they took a deal.

Now, $13 billion sounds like a lot of money, and it is for you or me, but not so much for JPMorgan. Still, the bank's legal problems are not going away. JPMorgan has set aside a total of $23 billion to pay for legal issues, and faces more than a dozen probes globally.

The fine of $13 billion is roughly half of what JPMorgan pulled down in 2012 and only about 1.5x what the bank paid its executives through the first nine months of this year. Shares are up over 70% since 2008, trouncing the returns of its banking peers. JPMorgan shares are flat on the day and actually up more than 3% since the company reported its first quarterly lost under Dimon last week after taking a huge hit on legal fees and fines.

The settlement is composed of $4 billion to settle claims that it lied to Fannie Mae and Freddie Mac about the quality of mortgage securities is sold them, $4 billion in consumer relief (which never seems to provide much relief) and $5 billion in penalties. The $4 billion in consumer relief spread among "Americans" more than five years after the fact is less than it may seem. And don't forget that the bank will likely write-off the fines, taking a tax break on any payment and relief.

The Justice Department and JPMorgan are reportedly still haggling over the degree to which the bank has to admit to misbehavior or failure to follow its compliance policies. Additionally, Holder and other enforcement agencies may use the JPMorgan case as precedent to expand their investigation into Wall Street malfeasance, among other things extending the statute of limitations from five to ten years.

Beyond mortgage-related probes, federal prosecutors are looking into whether JPMorgan broke laws in its handling of derivatives bets known as the "London Whale trades" that cost the bank more than $6 billion in trading losses, and more than $1 billion in regulatory fines so far. Also, regulators are examining whether the bank gave jobs to children of executives at Chinese-owned companies to secure business in China. And don't forget the Libor rate rigging scandal; plus, about a dozen more investigations globally. A billion here a billion there and pretty soon you're talking about real money; a legal fund of $23 billion might not be enough.

JPMorgan CEO Dimon has argued to the Justice Department that much of the conduct at issue stems from two firms the bank acquired with the encouragement of the US government during the height of the crisis, Bear Stearns and Washington Mutual. It is unfair to penalize the bank for alleged sins that took place before it owned the two banks, Dimon has complained. He has also said that the investigation will make JPMorgan reluctant to buy troubled institutions again. But Dimon's whining doesn't match recent statements.

In the last couple of annual reports from JPMorgan, Dimon brags that the bank absorbed Bear Stearns and Washington Mutual without hurting its capital levels. That is at least partly because JPMorgan bought both banks at fire-sale prices. The bank bought Washington Mutual essentially for free, paying $1.9 billion for a bank that had $40 billion in shareholders' equity just before the deal, and then turned around and booked an immediate $2 billion profit.

At the time of the deals, JPMorgan estimated that Bear Stearns and Washington Mutual combined would add about $3.5 billion to net income annually. If correct, that would add up to about $16 billion in extra profit since 2008, trumping the $13 billion in fines. But the truth is that JPMorgan has likely pocketed much more than that. Remember the Fed took almost all of the toxic assets, and they left the good stuff. The result is that JPMorgan booked an extra $6 billion in net interest income in 2008 alone.

The government has said it is taking the nature of the WaMu and Bear Stearns acquisitions into account. It is unclear how the fines the bank is expected to pay reflect that. Some legal experts not involved with the talks say that JPMorgan does not have much of an argument when it comes to avoiding civil liability for Bear's and WaMu's mortgage abuses.

The line of argument misses another important point. And it typifies the heads-I-win, tails-you-lose mentality that gets so many Americans angry at Wall Street. When you buy a company, or a piece of property, you don’t just acquire the assets. You acquire the liabilities—the contracts, the leases, the bank debt, the environmental problems. The price you pay isn’t just for the good stuff. You conduct due diligence, and you adjust the price accordingly. JPMorgan execs claimed they were well aware of problems at Bear Stearns, and they were eager buyers; the original offering price on Bear Stearns was $2 per share, but when rival banks showed interest, JPMorgan upped their offer to $10 per share; they also negotiated to have the Federal Reserve cover possible losses from about $30 billion in risky Bear Stearns assets.

And only about 70% of the garbage mortgage backed securities behind the current settlement can be placed at the feet of Bear Stearns and WaMu; 30% of the securities in question came directly from JPMorgan. The fact is that all these bankers were packaging the worst of the mortgages into MBS and selling them to government-sponsored entities such as Fannie Mae and Freddie Mac, as well as large institutional buyers like pension funds; and the banks were claiming the mortgage-backed securities were good, when they knew they were not. That was standard operating procedure for the banks.

The banksters broke the law and they got away with it, and it's been going on for a long time, and even with this weekend announcement of a tentative settlement, they continue to get away with it. The banksters have been considered too big to jail. Lanny Breuer of the DOJ refused to prosecute banksters, probably because he knew he would soon be going back to representing them in the private sector. Attorney General Eric Holder has expressed concerns about the economic consequences of criminal prosecution of big banks or big bank execs. And even with the news that they are keeping the criminal investigations open while reaching a civil settlement, it doesn't mean there will be criminal charges.

How is it possible to have billions of dollars in civil settlements and nobody broke the law along the way? It isn't. And we will never get rid of the illegality in banking until we see someone or several facing criminal charges. Having gotten away for many years with relatively tiny, slap-on-the-wrist fines that were in most cases less than the profits made on the crimes they committed, and fines where they were not required to admit wrong-doing but still got exemption from any future legal action, and fines that they can write-off and deduct from corporate taxes; well, a big $13 billion fine with no criminal side settlement is a different ballgame entirely. If you want to change reckless behavior, the kind of behavior that cost the country more than $15 trillion, and nearly destroyed the global financial system then maybe the punishment should be tougher than the justice meted out to some kid with a joint in his backpack.

So, why the change in attitude toward getting tough with the banksters? And why would Jamie Dimon accept a fairly large civil penalty, without clearing the deck of potential criminal charges? If these were really legacy issues only related to Bear Stearns and WaMu, it is unlikely Dimon would accept a deal quite so easily. You have to consider the possibility that there are still skeletons in the closet, there are still violations, criminal violations that could not only bring down the banks but also multiple bank executives. For a long time, the bankers played hard ball. Now, Jamie Dimon seems to be doing little more than whining. And you also have to consider that if the banksters were involved in illegal activities in 2008, they didn't get religion and clean up their wicked ways. The bad practices have continued and continue to this day.

Right now, the government has leverage, and likely not just against JPMorgan. There’s going to be more of this to come and maybe the JPMorgan settlement will be the template for other banks that were big players in the mortgage-backed securities market, including Citigroup, Deutsche Bank and Royal Bank of Scotland.

Indeed, The Financial Times reports Monday that Bank of America is in talks to pay a $6 billion settlement to the Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac; that’s even larger than the $4 billion JPMorgan is earmarked to pay the FHFA, according to numerous reports.