JPMorgan Gets Probed -- Does It Matter?

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

Following a three-day losing streak, U.S. stocks are rebounding this morning, with the S&P 500 (SNPINDEX: ^GSPC  ) and the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) up 0.34% and 0.26%, respectively, at 10 a.m. EDT. Investors must be coming to terms with their "withdrawal fears" with regard to the Fed's bond purchase program.

Big banks' litigation and their bottom lines
After Bank of America (NYSE: BAC  ) , it's JPMorgan's (NYSE: JPM  ) turn in the government's crosshairs. The U.S.' largest bank by assets disclosed yesterday that the Department of Justice has opened a criminal probe into its sale of mortgage-backed securities in the run-up to the financial crisis and that it is "responding to parallel investigations" (civil and criminal) regarding these matters.

The disclosure was contained in the firm's most recent quarterly report, which the bank filed yesterday afternoon. The bank faces so many potential actions from authorities and regulators that it added a new section to cover official requests for information. The "Litigation" section contains nine pages of text in double columns. JPMorgan also lifted its estimate of "reasonably possible" losses due to litigation up to $6.8 billion from $6 billion at the end of the previous quarter.

Meanwhile, on Tuesday, things went a step further for Bank of America (NYSE: BAC  ) as the Department of Justice and the SEC filed lawsuits against the bank concerning the sale of $850 million in mortgage bonds in 2008, alleging it misrepresented the risk of the mortgages that went into the securities. Unusually for this type of litigation, the mortgages in question went to prime, rather than subprime, borrowers.

For shareholders, the question is this: While the government's litigation efforts in these matters are clearly exhaustive, are they material? In aggregate, yes, but they are well provisioned-for. Sure, loss estimates can increase unexpectedly, but JPMorgan's $800 million loss estimate is dwarfed by the $6.5 billion it earned in the second quarter. With regard to Bank of America, the stock lost little more than 1% on Tuesday -- right in line with the performance of the KBW Bank Index (and not dramatically worse than the S&P 500's 0.6% decline).

The credit crisis will have been very costly for banks -- or bank shareholders, to be more precise -- but the mortgage market will remain a source of enormous profits and opportunity for major banks. All the more so if the Obama administration is successful in pushing through its newly unveiled plan to wind down Fannie Mae (NASDAQOTCBB: FNMA  ) and Freddie Mac. After all, not many companies earned more than JPMorgan's $6.1 billion in the second quarter, but Fannie was one of them: The mortgage agency reported a whopping $10.1 billion profit this morning.

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