FOOL ON THE HILL
JP Morgan Chases Credibility

There's been a common thread in this past year of scandals and meltdowns -- JP Morgan Chase seems to be in the middle of the mess, every time. The cost to its shareholders has been severe -- more than $40 billion in market cap evaporated this year. Some may be tempted to pick up this old-line name with the 7% dividend yield. We don't think that's a good idea at all.

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By Bill Mann (TMF Otter)
September 27, 2002

For years, the Dow Jones Industrial component with the highest dividend yield was Philip Morris (NYSE: MO). During the depths of the legal threats against its very existence, Flip Mo' had dividend yields approaching 9%. Even today, it stands at above 6. Not so long ago, though, JP Morgan Chase (NYSE: JPM) surpassed Philip Morris as the company with the highest dividend yield -- in this case, over 7%.

It's a distinction the bank certainly does not want.

There is a nice calculus for companies that offer dividends. In some ways, dividends help people take on more equity risk because they're being compensated in cash by a check from the company. Look at it this way: You have two companies offering similar risks. Both have dropped more than 80% in stock price from their highs. One offers a dividend; the other does not. That company's dividend yield (meaning the percentage of current share price of the combined dividends paid over the preceding year) is now 5%. Which company do you buy?

OK, OK -- if you answered anything other than "not enough information," you fail the test. But dividends do play a significant role in stabilizing markets. A company with shares spiraling downward looks to the world like a disaster, while the same company maintaining a dividend can look ever-so-much like an opportunity.

The trouble with JP Morgan is not simply its warning last week that earnings are down and non-performing assets are up. The trouble is much bigger, and bears risk for much more than just the shareholders of JP Morgan. So, if you're looking at that dividend and saying, "This is one of the oldest, most trusted names in America...," then I suggest you turn the other way. JP Morgan has legal risks, credit risks, and it also happens to be the largest dealer in the world of derivatives, with a notional value of nearly $26 trillion, according to the U.S. Office of Comptroller Currency. That is double the amount of the U.S. GDP for 2001.

Most of the derivative exposure is with companies that maintain low credit risk, and further of the entire notional value, JP Morgan estimates it has exposure to 5%. Still, that's $1.3 trillion. These positions aren't exactly liquid, and that's what's dangerous. When a company has to unwind its positions and finds no buyers, it can cause a catastrophe. That's what happened with Long Term Capital Management in 1998, when its complicated models failed to predict what would happen when everyone rushed for the exit at the same time. Given the size of JP Morgan's portfolio, a big roiling problem could cause turmoil throughout the financial markets.

Where complicated = stupid
So, what are derivatives? They're basically bets on the direction of all things financial. There are simple derivatives, like a bet that interest rates will rise by X% over the next two years, and there are complicated ones that seem to have no real connection with actual events. These are designed to reduce risk.

If you see an event that could cost your company $50 million, such as the Japanese yen going to 100 to 1 U.S. dollar, you might buy a derivative contract, for, say, $5 million. This contract will let you pay $20 million if, at any point over the next three years, the yen reaches 100:1. If it doesn't reach that level, the contract costs you $5 million. If it does, you must pay the $20 million, meaning the cost of the contract was actually $25 million. At the same time, you didn't lose the $50 million you would've lost had you not bought the contract and the yen reached 100:1. If you think this is a simplification, you're right. Here's a 162-page Deloitte & Touche report on accounting for derivatives under FAS 133.

JP Morgan sells derivatives -- a ton of them. They have these stupendous models that are supposed to pair off uncorrelated events; so, in theory, the risk to JP Morgan is zero. It's nice, in theory, but these models only operate under the expected distribution of events. As Long Term Capital Management taught us, the unexpected happens. And in this past July and August, the enormous stress on the stock market meant that almost everything was moving the same way -- down. JP Morgan's trading revenues dropped by 90% as a result.

As you can imagine, these contracts are awfully tough to value. Also, they don't fit on balance sheets very well. Ask Enron. These complex trading strategies work under many circumstances, but when they fail to control risk, they fail in spectacular fashion. According to some experts, we can expect the same to happen to JP Morgan over and over until the stock market comes out of the doldrums.

As the assets crumble
So the deal now is that, at a market capitalization of $38 billion, JP Morgan is trading below its book value. This is a sign the market expects a company to destroy equity in operations, not grow it. This is precisely what has taken place as every single big financial disaster this year seems to have JP Morgan sitting in the middle: Enron, WorldCom, Adelphia, Global Crossing, Argentina, Kmart, Brazil. And in the most recent installment, JP Morgan wrote down $1.4 billion in non-performing assets, blaming bad loans to the battered telecommunications sector. Even so, JP Morgan maintains a reported $8 billion exposure to telecoms. Which loans did JP Morgan write down? They don't say.

There is a basic truism about banks. It is nearly impossible for an outsider to determine what credit risks the banks face until it is too late. There is an old adage: "No loan ever looks bad on the day it is signed." Just so, one of the scariest things for an investor to see is a bank that is trying too hard, being too aggressive. In the boom years, it seems that JP Morgan was among the most aggressive in lending money to telecom and cable companies, a great strategy when everything high tech was going up. When the weather turned, it seems JP Morgan was the company farthest out at sea. JP Morgan just had its credit rating downgraded to A+, which is still high. Any further credit rating downgrades could, however, put it in a spiral of non-compliance.

If the suit fits
As if these threats were not opaque enough, there is also the risk of lawsuits and myriad other legal action against the company. Most notably, JP Morgan has caught the Enron flu, due to its role helping the defunct energy trader structure its off balance sheet vehicles, the same ones that helped tank the company. It has been named in several suits, and is also being investigated by the Feds for its role in Enron's hide-the-debt schemes. If the courts allow the suits, the exposure JP Morgan faces could be enormous, since it is one of two deep pockets left after the collapse of Enron and auditors Arthur Andersen.

As a result of the firestorm surrounding JP Morgan's involvement in these many blowups, CEO Bill Harrison went on the offensive, stating in a recent Wall Street Journal article, "After every bubble, there is a search for scapegoats. To say that (banks) contributed to or even condoned fraud, when the evidence indicates that they have been among the parties most damaged, only adds insult to injury."

Quatsch. When current Treasury Secretary Paul O'Neill first took over as CEO of Alcoa (NYSE: AA), he said that bank after bank came to him with plans to dress up his company's balance sheet with such transactions, each one netting millions for the bank. The Enron model was lauded throughout the investment-banking realm as one to be emulated. And all of these deals -- all of them -- were designed to hide risk from the owners of these companies, the shareholders. JP Morgan may not be found guilty of fraud in any of these instances in a court of law, but they knew precisely what they were doing. And on the off chance that they didn't, then JP Morgan isn't run by crooks -- it's run by morons.

All of this is to say the following: JP Morgan flew awfully close to the sun during the height of the technology boom, and now it has plummeted back to earth. It is the classic story of a bank that tried too hard and unwittingly took on risks it didn't know it had. When bad loans are chewing up assets and derivatives (on factors that seemed to have no correlation) suddenly move down in tandem, you have the makings of a problem. Add to that a management that wants to deflect blame rather than address the obvious problems, and you have a recipe for disaster.

Fool on!
Bill Mann, TMFOtter on the Fool discussion boards

Bill Mann is in Washington, D.C., counterprotesting at the IMF. His sign? "I love pork." We'll keep you posted. Bill owns none of the companies mentioned in this article. The Motley Fool has a disclosure policy.