Well-Positioned JPMorgan Chase Still Stymied

NEW YORK ( TheStreet) -- Five years after the Lehman Brothers bankruptcy, JPMorgan Chase ( JPM) CEO James Dimon has quite a bit to be proud of, but the nation's biggest bank is facing a major political and regulatory onslaught at a late stage of the banking industry's recovery.

"The big U.S. banks have been taking turns in the hot seat," according to Gimme Credit analyst Kathleen Shanley, who wrote in a note on Aug. 21 that "Bank of America dominated the headlines for several years, given its hefty exposure to mortgage-related issues. But now the baton has been passed to JPMorgan, where the legal department is working overtime."

While investors should expect to see a continuing flow of negative headlines for at least another year, JPMorgan has been quite a profit machine over the past three years. With the stock trading at a very low valuation historically and to its peers right now, long-term investors with the patience to sit tight for several years could make a killing.

Before reviewing JPMorgan Chase's success in taking advantage of opportunities presented by the credit crisis, it's appropriate to consider what the company is facing right now.

Most investors realize that the forces behind JPMorgan Chase's stock underperforming its peers are the mounting political and regulatory challenges the company faces, at a much later stage in the banking industry's recovery than may have been expected a few years ago. The bank in its second-quarter 10-Q filing said it was facing six separate investigations by the Department of Justice, along with four investigations by the Securities and Exchange Commission and three by the Commodity Futures Trading Commission.

Sanjay Sanghoee -- a former banker, political and business commentator and author of the novel Killing Wall Street -- says that despite JPMorgan's strong operating track record in the wake of the financial crisis, "James Dimon should resign now, because he has a responsibility to the company. Being the largest bank, there needs to be a distinction between the company and the leadership. For good or bad, Dimon has become a lightning rod for government investigations and a symbol of poor corporate governance."

"I believe JPMorgan Chase needs a fresh perspective and a fresh face to reassure the markets that there will be some changes at the bank, including better risk management, internal accountability and more oversight to make sure they are not violating laws or their ethical obligations to the public," Sanghoee adds.

When asked why JPMorgan has become federal authorities' favorite target five years after the peak of the credit crisis, Sanghoee says "JPMorgan is not being singled out for this, although they may have been spared the government's first salvo. In terms of the subprime mortgage crisis, JPMorgan seems to have been the least investigated or inspected to date. I am surprised it has taken so long for the regulators to get to JPM."

Considering how the federal agencies time their leaks to the media, there are dozens of negative headlines ahead for JPMorgan.

Recent leaks have led to reports that the Federal Housing Finance Agency -- which regulates Fannie Mae ( FNMA) and Freddie Mac ( FMCC) -- is seeking a $6 billion settlement of mortgage repurchase claims against the bank.

According to a recent New York Times DealBook report, which cited unnamed sources, JPMorgan is facing $80 million in fines from the Consumer Financial Protection Bureau and the Office of the Comptroller of the Currency, over the sale of "credit protection" products to credit card customers.

The Wall Street Journal recently cited unnamed sources when reporting that JPMorgan could be fined between $500 million to $600 million by a group of federal regulators over the "London Whale" fiasco. Of course, that type of fine would beg the question -- haven't JPMorgan's shareholders suffered enough from the $6.2 billion in "London Whale" losses?

The bank last month agreed to pay $410 million in penalties and "disgorgement to ratepayers" to settle the Federal Energy Regulatory Commission's charges of energy market manipulation.

Those figures really add up, and could put quite a dent in JPMorgan's earnings this year and/or next year.

Wall Street Meltdown: Five Years Later:

The silliest investigation of JPMorgan Chase leaked by the Justice Department is the selective application of the Foreign Corrupt Practices Act of 1977. DealBook cited unnamed sources in its report on Aug. 19 that reported "Federal authorities have opened a bribery investigation into whether JPMorgan chase hired the children of powerful Chinese officials to help the bank win lucrative business."

According to the report, "in one instance, the bank hired the son of a former Chinese banking regulator who is now the chairman of the China Everbright Group." Following the hiring, JPMorgan "secured multiple coveted assignments from the Chinese conglomerate," the report said.

DealBook was careful to say that "legal experts note that there is nothing inherently illicit about hiring well-connected people"

Well, that's how it's done in all over the world in most industries, so why not in China? JPMorgan would be quite foolish to refuse considering a well-qualified job applicant, just because their parents are well connected.

In reaction to the obvious point that the Foreign Corrupt Practices Act was being selectively applied to JPMorgan Chase, there were subsequent reports that the Justice Department was investigating other banks' foreign hiring practices. But there were no reports of any non-banks being investigated.

Following the reports of the bribery investigation, Shanley wrote in a note to clients on Aug. 19 that her firm was maintaining its "buy" opinion of JPMorgan. "Given its capacity to generate earnings, we continue to believe that JPM will be able to maintain its overall credit strength even considering the ongoing regulatory scrutiny of its activities," she wrote.

A Good Crisis

JPMorgan certainly made the best of the financial crisis, first in March 2008 acquiring Bear Stearns for roughly $10 a share, or roughly $1.2 billion. That was up from its earlier offer of $2 a share, after shareholders of the investment bank cried foul. Bear Stearns had suffered a liquidity crisis, which was the end result of a series of events that began in July 2007, when the bank said two of its subprime mortgage hedge funds had lost nearly all of their value.

Following the collapse of Lehman Brothers and agreement by Bank of America ( BAC) to acquire Merrill Lynch, Washington Mutual was shuttered by regulators on Sept. 25, 2008. In a deal personally facilitated by Sheila Bair, who then chaired the Federal Deposit Insurance Corp., JPMorgan Chase acquired the banking operations of Washington Mutual for $1.9 billion. Washington Mutual was the largest U.S. bank ever to fail, with total assets of $307 billion and $188 billion in deposits.

This was a beautiful deal for JPMorgan as well as the FDIC. For starters, "Claims by equity, subordinated and senior debt holders were not acquired," to use the FDIC's words, meaning the failed bank's holding company was left with those claims. Meanwhile, JPMorgan acquired over 2,200 branches and expanded its branch presence to 23 states from 17 states, becoming the nation's largest bank by deposits, with the second-largest branch network, after Bank of America.

For the FDIC, the deal worked out very well because there were no losses to any of Washington Mutual's depositors, at a time when the basic FDIC deposit insurance limit was $100,000. Some depositors had lost money from bank failures leading up to Washington Mutual's closure. Another very significant advantage to the FDIC is that it provided no loss-sharing coverage on the assets acquired by JPMorgan.

Following Washington Mutual's failure, it became standard for the FDIC to cover 80% of losses on assets acquired as part of failed-bank purchases. The FDIC also raised the basic deposit insurance coverage to $250,000 and put in place its Temporary Liquidity Guarantee Program, which temporarily removed deposit insurance coverage limits on most business checking accounts, while guaranteeing banks' newly issued senior secured debt.

At the time of the acquisition, JPMorgan estimated it would mark down Washington Mutual's loan portfolio by $31 billion. The company in the third quarter of 2008 raised $11.5 billion in common equity and reported a $1.2 billion charge to increase loan loss reserves as a result of the Washington Mutual acquisition, but also booked a $581 million gain on the acquisition of the failed bank's operations.

For the fourth quarter of 2008, JPMorgan Chase reported a slew of significant items, including a $4.1 billion provision for loan loss reserves, $2.9 billion in markdowns in its investment bank, and $1.1 billion after-tax benefit from "merger related items."

In October 2008, JPMorgan was among the first nine large banks to receive government bailout funds through the Troubled Assets Relief Program, or TARP. The company received $25 billion in bailout money.

The company in February 2009 cut its quarterly dividend on common shares to 5 cents a share from 38 cents, "to retain an additional $5 billion in common equity per year," and then in June 2009 raised $5 billion in common equity, after which it fully repaid the TARP money.

JPMorgan began raising the quarterly dividend on common shares to 25 cents in April 2011. The dividend during the second quarter was raised back to its old level of 38 cents a share.

The company set earnings records during 2010, 2011 and even in 2012, when it earned $21.3 billion, or $5.20 a share, despite the losses of at least $6.2 billion from the "London Whale" hedge trading debacle.

Solid Performance In the Wake of the Crisis

Looking back, only Wells Fargo ( WFC) among the "big four" U.S. banks has outperformed JPMorgan Chase in the wake of the crisis:
  • From 2008 through 2012, Wells Fargo's return on average assets (ROA) ranged from 0.44% to 1.41%, according to Thomson Reuters Bank Insight. Its return on average tangible common equity (ROTCE) over the same period ranged from 7.15% to 16.32%. Leaving out the "bad year" of 2008, Wells Fargo's lowest ROA over the period was 0.97% in 2009 and its lowest ROTCE was 14.89% in 2010.
  • JPMorgan Chase's ROA over the past five full years ranged from 0.31% to 0.94%, while its ROTCE ranged from 6.55% to 14.92%. Leaving out 2008, the company's minimum ROA was 0.58% in 2009 and its minimum ROTCE was 10.66%, also in 2009.
  • Citigroup's (C) ROA over the past five full years ranged from a negative 1.28% to 0.57%, while its ROTCE ranged from a negative 37.4% to a positive 8.61%. When leaving aside the "worst year" of 2008, the company's lowest ROA was a negative 0.08% in 2009 and its lowest ROTCE was a negative 1.5%, also during 2009.
  • Bank of America's ROA has ranged from -0.09% to 0.26% over the past five years, while its ROTCE has ranged from -1.62% to 5.59%. The negative figures are both from 2010, when the company booked a $12.4 billion goodwill impairment charge, set aside $6.8 billion to cover mortgage repurchases losses and also recorded $2.6 billion in litigation expenses.

Stock Valuation and Opportunity

Despite having pretty much sailed through the credit crisis, JPMorgan Chase is the cheapest of the "big four," on a forward price-to-earnings bases. The bank's shares closed at $50.53 Friday and traded for 8.3 times the consensus 2014 earnings estimate of $6.11, among analysts polled by Thomson Reuters.

Citigroup's shares closed at $48.33 Friday and traded for 8.9 times the consensus 2014 EPS estimate of $5.6. Wells Fargo closed at $41.08 and traded for 10.2 times the consensus 2014 EPS estimate of $4.02.

The most expensive of the group is Bank of America, with shares closing at $14.12 Friday and trading for 10.4 times the consensus 2014 EPS estimate of $1.36.

The continuing flow of sometimes brutal headlines aside, JPMorgan's historically cheap valuation, even after three years of record earnings, speaks for itself. The investigations and lawsuits can't go on forever, and the company has several strong businesses that will keep bringing in massive revenue.

Even Bank of America has been able to rehabilitate its reputation.

It also pays to keep in mind that even the valuation for the currently high-flying Bank of America is historically cheap. The largest U.S. banks were easily trading for 20 times earnings before the real estate bubble burst.

If JPMorgan's P/E ratio was to rise to the level of Bank of America's, investors would be looking at a gain of 26%. And over the very long term, with solid operating earnings and capital, leading to rising dividends and share buybacks, investors may look back in five years and realize they had seen a golden opportunity.

JPM Chart JPM data by YCharts

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

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

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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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