3 Ways JPMorgan Chase Needs to Come Clean: Analyst

NEW YORK ( TheStreet) -- Morgan Stanley analyst Betsy Graseck says investors could see "an upside surprise" in the shares of JPMorgan Chase ( JPM) as the company makes additional discloses about "the composition of the $2B loss in the first 6 weeks of 2Q12."

JPMorgan's shares closed at $33.68 Friday, declining 17% since they closed at $40.44 on May 10, just before CEO James Dimon disclosed an estimated $2 billion in second-quarter hedge trading losses.

Bank regulators, along with the U.S. Justice Department, the Securities and Exchange Commission have announced investigations of the hedging activity JPMorgan's Chief Investment Office (CIO) and/or the company's disclosure of the losses, and even the Federal Bureau of Investigation has been reported to open an investigation into the matter.

Graseck says that the "key to getting investors back into JPM is answers to 3 questions," beginning on Wednesday, when Dimon will testify before the Senate Banking Committee.

Graseck's first question -- which she expects to see answered at Wednesday's hearing -- is "who knew what and when," saying it is "critical to understand who in the organization" knew of accounting changes related to the losses, along with "the extent of the positions in question and trading strategy employed," and "the size of the losses...and when they knew it." The analyst said that "if senior management outside the CIO office were aware of these 3 items," she "wouldn't be surprised to see senior management turnover which would be negative for the stock."

The analyst says her firm is "assuming senior management was not aware of such details at the time 1q12 earnings were reported," and gradually gained an understanding of the losses in late April, leading up to Dimon's May 10 conference call.

Graseck's second question -- which she expects JPMorgan to answer in its second-quarter earnings release -- is for "more specific details on the components of the trade, size of the trade, strategy employed and how that strategy was executed over time." At Wednesday's hearing, she expects "to hear some discussion around the types of trades engaged in by the CIO," along with a debate on what "risk" means, since a current yield for "5-year treasuries at 71 bp" represents "significant risk for bank portfolio if/when rates rise."

When JPMorgan Chase reports its second-quarter results in July, Graseck expects her third question to be answered, with "more detail on the latest mark to market of the position, size, max loss and color on how analysts can potentially better forecast the ultimate loss." The analyst also wants to know how "reducing risk in the CIO office" might affect JPMorgan's net interest margin.

Graseck said that "our current back of the envelope estimate gets us to a $7B loss" so far during the second quarter, although she admitted that "this is a very simplistic approach as we're solely looking at changes in IG9 2012 spreads relative to IG9 2017 spreads," adding that ".many on the Street are using this approach and assuming IG9 is the biggest piece of JPM's trade."

IG9 is the 10-year Markit CDX North America Investment Grade Index Series 9, which tracks credit default swap spreads, allowing investors to trade on the likelihood of defaults among a group of 125 companies.

Graseck said that her firm's rough estimate "is too simplistic for a very complex trade where outsiders cannot see the entire position," and that she expects "the company to deliver more detail and clarity on the 2q12 earnings call."

Graseck continues to rate JPMorgan Chase "Overweight," with a $54 price target, and on Monday left her 2012 earnings estimate of $4.35 a share and her 2013 EPS estimate of $5.62 a share unchanged, while lowering her 2014 EPS estimate by a dime to $6.55.

The analyst thinks "JPM can take share in European deleveraging, benefit from faster housing reserve bleed, return capital to shareholders, and has room to become more efficient -- all driving upward EPS revisions," adding that "we like JPM's growing market share, efficiency focus, share gain from Europe, and declining mortgage foreclosure costs in 2013, all of which should lead to rising return on equity ."

JPMorgan's shares returned 3% year-to-date through Friday's market close, following a 20% decline during 2011. Based on a 30-cent quarterly payout, the shares have a dividend yield of 3.56%.

The shares trade for 1.1 times their tangible book value, according to Thomson Reuters Bank Insight, and for six times the consensus 2013 EPS estimate of $5.33, among analysts polled by Thomson Reuters. The consensus 2012 EPS estimate is $4.33.

Interested in more JPMorgan Chase? See TheStreet Ratings' report card for this stock.

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-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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