Morningstar's Jim Sinegal says the escalating costs of past misdeeds at J.P. Morgan and its predecessors have forced Morningstar analysts to reconsider their position on the bank's management team.
J.P. Morgan Chase (JPM) reported a net loss of $400 million, or $0.17 per share, for the third quarter of 2013, as the company experienced $9.2 billion in legal expenses. We do not intend to significantly alter our fair value estimate, but we plan to reduce our stewardship rating for the company from Exemplary to Standard.
Although we once considered the "London Whale" incident a one-time risk management failure, the escalating costs of past misdeeds at J.P. Morgan and its predecessors, as well as the firm's deteriorating relationships with regulators and other government agencies, forced us to reconsider our position. Our previous rating leaned on J.P. Morgan's skillful use of repurchases, but the London Whale incident forced a halt to repurchases at a time when the firm was trading at a sizable discount to our fair value estimate. More importantly, the SEC found that the incident was due in part to several failings on the part of senior management.
Returns at the firm have also been less than impressive, not only since the financial crisis but during Jamie Dimon's tenure as CEO. Return on assets has rarely exceeded 1.1%, while less risky competitors like Wells Fargo (WFC) have regularly posted figures over 1.5%. J.P. Morgan was forced to add $28 billion to litigation reserves since the beginning of 2010, well over a year's worth of earnings at the current rate and roughly 14% of the company's current market capitalization. Furthermore, regulators have reportedly lost confidence in management, and penalties for a variety of issues are escalating. Finally, a large number of changes in the management team in recent years has reduced our ability to point to J.P. Morgan's track record as evidence of superior management. We acknowledge that even the best management teams make mistakes, but we no longer feel comfortable writing off all of J.P. Morgan's mistakes as aberrations. That said, the company posted an otherwise respectable third quarter.
Not surprisingly, mortgage revenue fell by 54% during the third quarter, as interest-rate volatility caused a precipitous decline in refinancing volume. We have long anticipated a drop in total volumes, even as purchases rebound. While other sources of revenue performed well, they were unable to pick up the slack. Investment banking performance suffered from the environment--although J.P. Morgan maintained a number one rank in several categories, advisory and underwriting fees across all categories have not varied much over the course of the last 12 months. The same can be said for the company's trading operations, and even asset management income rose only 7% during the course of the year as the markets reached an all-time high and J.P. Morgan Chase's funds performed well. In our view, it will be these noninterest lines of business that must fuel most of the growth at J.P. Morgan in years to come as credit growth remains elusive in developed markets, especially if the yield curve stays low and flat for years to come.
Our expectations for capital return have also been dashed in recent quarters. J.P. Morgan's plans to achieve a Basel III Tier 1 common ratio of more than 10% (currently 9.3%), the uncertainty around the supplementary leverage ratio (now 4.7% on a firmwide basis) and management's continuing issues with regulators do not inspire confidence that the company will be able or willing to aggressively return capital in 2014. In fact, J.P. Morgan just resubmitted this year's CCAR in September and will not receive feedback until close to year-end.
Overall, we view the quarter's performance (excluding unusual charges) as representative of the company's medium-term earnings potential and continue to believe J.P. Morgan's stock is fairly valued in that light.
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