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JPMorgan investors choke on much higher litigation reserves

Dick Bove: Broke government is going after the banks

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The unseen litigation and regulatory risk that banking analysts have been warning investors about for years, finally surfaced at JPMorgan Chase (JPM) on Friday.

By afternoon trading, the firm's stock was still down a slight 0.13%, falling alongside the HW 30 -- a composite of stocks linked to the mortgage finance and real estate industries.

Shortly after JPM's third-quarter earnings release – which showed JPM facing a $380 million third-quarter net loss on higher litigation and regulatory-related expenses – CFO Marianne Lake elaborated on the losses that apparently took the bank by storm.

"I’ll start by saying that we appreciate that the litigation expense of $9.2 billion is much more significant than you’ve been expecting," Lake said during a third-quarter earnings call. "It’s much more significant than what we expected until very recently."

Lake took investors through the firm’s reserve holdings, which essentially are used to buffer against potential legal and regulatory expenses. The company started out with $3 billion in reserves back in 2010.

However, by the third-quarter of this year, JPM had added $28 billion to its entire reserve balance, Lake said. So far, JPM has settled just under $8 billion in outstanding litigation and regulatory issues, leaving the bank with roughly $23 billion in reserves, Lake noted.

This does not include a separate $2 billion reserve account held separately to deal with repurchase risks stemming from the GSEs, according to Lake's update.

Banking analysts and investors reacting to the report maintained mixed feelings, with some suggesting it shows the banks are unable to handle today’s litigious environment in a precise manner. Others blame prudential regulators and the government for creating an environment that’s hostile to financial institutions.

"Basically, the government is out of control,” said Dick Bove, an analyst with Rafferty Capital Markets. "And because the government is out of control, the banks don’t know what they are going to do next."

Whether the higher loss on litigation expenses was expected is unknown, Bove suggested.

Banks in general are not going to say a deep loss was expected, he pointed out. In that case, "you are going to get sued because you have not properly told investors what your risks are in this area," he added. "What you have to do is say that it was a total surprise … it came out of left field. Any other statements would have opened them up to more lawsuits."

Yet, Bove has a more sympathetic view of the banks – painting the government’s recent pressure on the firms as one reason banks cannot get the crisis behind them.

"They are going to keep pushing and pushing, because there is no push from the other side," Bove said. "The government has simply lost its mind in terms of fairness, justice and honorability. It’s completely gone to a position of blackmail and extortion, and it’s doing it because the government is broke."

Manal Mehta with Sunesis Capital continues to follow the banks, as well as the legal storm brewing silently around them.

"JPMorgan’s quarter highlighted the difficulty of trying to analyze the opaque balance sheets of too big to fail institutions,” Mehta noted. "There’s no clarity on how JPMorgan determined its litigation reserves, whether they are adequate, or what to expect going forward."

This issue is particularly notable considering JPMorgan is reportedly in discussions with the Department of Justice to resolve lingering mortgage-securities issues.  

Mehta added, “There is also significant uncertainty on whether JPMorgan’s increase in litigation reserves reflect a potential admission of wrongdoing in settlement discussions with the Department of Justice and what impact such an admission may have on other private litigation. It’s a huge giant black box and gives further credence to the argument that big banks are simply unmanageable and need to be broken up to protect the taxpayer from their largesse."

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