Is JPMorgan the New Lehman?

Let me say this from the outset: I'm not suggesting that JPMorgan Chase (NYSE: JPM) will share Lehman's ignominious fate. However, if you're confident that you have a solid grasp on the risks relating to JPMorgan's activities, you're fooling yourself. With a balance sheet that exceeds $2 trillion (or approximately 14% of U.S. GDP), it's difficult enough for an insider to get a handle on the bank's risk. For an outside shareholder, it's impossible. Here's why and why it may not matter.

First, let's discuss some similarities with Lehman. The fascinating report by Lehman's bankruptcy examiner (released last month) described the bank's so-called 'Repo 105' transactions, in which it monetized securities and took them off the balance sheet in time for end-of-quarter reporting. By treating the transactions as outright sales, rather than loans -- even though it was contractually obligated to repurchase the securities -- the bank was able to conceal its true leverage from credit rating agencies and investors. This chicanery was symptomatic of a broken culture that ultimately scuppered the firm.

Et tu, JPMorgan?
It turns out that JPMorgan booked repo transactions as sales between 2001 and 2004 -- to the tune of $20 billion in 2004. Goldman Sachs (NYSE: GS), Morgan Stanley (NYSE: MS), and Merrill Lynch, a unit of Bank of America (NYSE: BAC), all deny booking any repos as sales.

There are nevertheless fundamental differences in spirit and transparency between JPMorgan's transactions and Lehman's. JPMorgan disclosed the impact of the transactions on its balance sheet in its annual reports. There is no suggestion that JPMorgan engaged in this practice to deceive third parties; the bank releases average balance sheet figures over the full reporting period, so end-of-period window-dressing shouldn't trick anyone -- in theory.

In practice, JPMorgan, B of A's Merrill Lynch, Goldman, Morgan Stanley, and other major banks have all been masking their risk over the past five quarters by reducing their repo funding levels at the end of the quarter by an average of 42%, according to an April 12 Wall Street Journal article.

Plenty of murky assets
Furthermore, on some measures, JPMorgan looks like the riskiest bank in its peer group. Perhaps you remember level 3 assets: They gave banks and investors terrible headaches during the credit crisis, because they trade so infrequently and are thus extremely difficult to value. The following table ranks the major banks at the end of 2009 in terms of the value of level 3 derivatives on their balance sheet:

*At Dec. 31, 2009. Source: Company SEC filings.

JPMorgan and Lehman on par?
Among these seven global banks, JPMorgan appears to have the largest exposure to level 3 derivatives: 2.3% of total assets -- equivalent to over a quarter of total shareholders' equity. Total level 3 assets represent 6.4% of total assets, almost exactly the same fraction as at Lehman Brothers at the end of May 2008 (6.5%) -- less than four months before the bank went bankrupt. Still, one shouldn't read too much into that: There are fundamental differences between the two firms that can't be captured in a ratio.

Take Lehman's CEO, Dick Fuld, for example. Some anecdotes, including the time Fuld gave his co-head of global equities a dressing-down for, well, dressing down for an off-site event, depict a rigid, controlling personality. Put that together with a closed cadre of handpicked senior managers, and you have an ideal environment in which to extinguish any spark of constructive dissent. By contrast, according to the author of Last Man Standing: The Ascent of Jamie Dimon and JPMorgan Chase, "When you worked for [JPMorgan Chase CEO] Jamie Dimon, he expected you to speak your mind. If you didn't, he'd just as soon replace you."

If you don't know the bank, know the banker
If you don't "know the bank" -- and investors should accept they can't properly know any large bank -- but you still want to invest in bank shares, you should make a careful assessment of the quality of the bank's management and culture, both of which are easier to gauge than the quality of its assets. On that measure, JPMorgan Chase rates very highly; Jamie Dimon  is arguably one of the best large bank CEOs in the world. My guess is that over the medium to long term, this qualitative factor will remain a good predictor of operating performance.