A Look at JPMorgan's (JPM) Massive Losses

Shares of investment bank JPMorgan (JPM: Charts, News) plunged 15% over the past week, after CEO Jamie Dimon revealed that his bank had lost over $2 billion due to a failed hedging strategy. The $2 billion in paper losses do not signal an end to JPMorgan's woes - Dimon disclosed that the bank could lose another $1 billion, due to its reluctance to "rashly" realize the entirety of its losses all at once.

Dimon has also warned that the losses could mount over the year. JPMorgan's practice of portfolio hedging', criticized as a buzz term allowing investment banks to make risky, oversized bets to boost performance, is the primary reason for its massive losses.

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JPMorgan invested in an obscure cluster of indexes tracking the performance of corporate bonds. One of these indexes, the Markit CDX NA IG Series 9, is an arcane portfolio entirely composed of credit default swaps. The credit default swaps, or contracts intended to protect a lender from a defaulting borrower, are pinned to the credit quality of 121 North American investment-grade bond issuers, such as Kraft (KFT: Charts, News) and Wal-Mart (WMT: Charts, News). In short, Dimon was betting that credit markets would strengthen, and riskier loans would be approved - a bullish bet on the financial markets as a whole.

However, due to JPMorgan's size, many rivals have been placing contrarian bets against the bank, hoping to profit from weaknesses in the financial institutions. So far the bears have been winning, and the aforementioned index, which matures in 2017, has been sliding. JPMorgan made similar bets across indexes similar to the Markit CDX NA IG Series 9, which has exacerbated the bank's losses.

A higher value for the Markit CDX NA IG 9 index indicates deteriorating credit quality in the underlying companies. In March, that value was 112; on May 10, it was 128. On May 11, the value jumped to 139. By this Wednesday, that value climbed to 150. Current economic woes in Europe are contributing to a faster breakdown of the index. Ironically, these mysterious indexes were created by JPMorgan and Morgan Stanley (MS: Charts, News) as cutting edge investment vehicles for hedge funds and corporate treasury departments to protect against losses.

Analysts forecast that credit markets will eventually bottom out and slowly improve, which explains Dimon's reluctance to realize all the losses at the same time, instead opting to allow time to heal some of the bank's "self-inflicted wounds". JPMorgan's pain, however, is creating value for hedge funds, which may swoop in to invest in the distressed indexes, alleviating some of the pressure for the bank. Investors looking to invest in JPMorgan should pay attention to these indexes, and not to JPMorgan's stock price. If the value convincingly declines, then JPMorgan stock could rally.

Due to the opaque nature of the loss-causing investments, as well as the bank's reluctance to disclose its trades, experienced analysts are having trouble calculating JPMorgan's true losses. "I've been through this exercise a few times, and I can't make the numbers make sense," commented Michael Johnson, chief market strategist at M.S. Howells. Meanwhile, Oppenheimer & Co. is estimating that JPMorgan's losses could end up close to $5 billion. Traders believe that JPMorgan also invested heavily on another index that would rise if high-yield debt deteriorated. That bet, another bullish one, has also compounded losses for JPMorgan. In other words, JPMorgan was right for the first three months of 2012, when signs of improvement in Europe and Asia freed up credit markets. However, the tables have turned quickly, and it turns out that JPMorgan's high risk bet was the wrong move.

At its depressed price, however, JPMorgan trades at a mere 6 times forward earnings with a 5-year PEG ratio of 1.09. The stock also pays a quarterly dividend of 30 cents per share. Although many analysts and investors are berating Jamie Dimon, few doubt that the bank, with a market cap of 131 billion, will survive and bounce back in years to come.

Other News About JPM
JPM "$2 Billion" Loss Keeps Growing: Report
$2 billion may only be the tip of the iceberg.
JPMorgan Gives Hedging a Black Eye
JPMorgan's hedging practices open up inquiries to other institutional hedging practices. Other Stocks in the News
Mark Zuckerberg and Facebook ring in IPO with all-night hackathon
Facebook pulls off the most eagerly anticipated IPO ever.
Shares in Spain's Bankia plunge on withdrawal reports
More symptoms of a Spanish bank run are surfacing.

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Published on May 18, 2012
By Leo Sun
Leo Sun
Leo Sun is a freelance finance writer and position trader. He focuses on a combination of value and momentum investing, with a strong interest in the trading philosophies of Warren Buffett and Peter Lynch. Leo also has experience writing articles to help small business owners acquire loans and manage their finances. He regularly contributes to the Stock of the Day analysis.

Copyrighted 2020. Content published with author's permission.

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