Making sense of the JP Morgan settlement
Are you worried that JP Morgan is being robbed of $13 billion that rightfully belongs to shareholders? Richard Parsons (not the former Citigroup chairman, but rather the former Bank of America executive vice president) is shocked by the size of the JP Morgan settlement, trotting out a line of criticism which is pretty standard in Wall Street circles:
If it is true that J.P. Morgan Chase must pay penalties for mistakes made by Bear Stearns—a firm that Washington encouraged them to take over—then it is likely federal policy makers have actually increased systemic risk to the financial system. In a country that has seen 3,000 banks fail over the past 30 years and more than 12,000 over the past century, it is not difficult to imagine future bank failures…
Little thought seems to have been given to the pursuit of J.P. Morgan Chase over Bear Stearns. Once the government proves itself to be an unreliable “partner” in resolving failed institutions, it will find fewer banks willing to step in next time there is systemic risk to the banking system.
This is doubly false, and no one has done a better job of demonstrating its falseness than Peter Eavis. Back in September, Eavis explained, patiently, that JP Morgan bought Bear Stearns and Washington Mutual with its eyes open. (This isn’t hard to show, when Jamie Dimon was saying, at the time, things like “There are always uncertainties in deals; our eyes are not closed on this one.”) Besides, JP Morgan has made billions of dollars in profit on these deals, even after paying this settlement.
If you have any doubt about this, just look at the accounting. WaMu had shareholders’ equity of some $40 billion, before it was bought, which JP Morgan paid $1.9 billion for. JPM valued that equity at $3.9 billion, so it booked a $2 billion gain the minute that the acquisition closed; it then said that WaMu would contribute about $2.5 billion per year in extra profits going forwards.
The point here is that JPM fully expected that legacy WaMu assets would generate some $36.1 billion in losses. Now that those losses are starting to appear, all that we’re seeing is the arrival of something which was expected and priced in all along.
In reality, Washington Mutual did better than JPM expected: the bank is going to take a $750 million gain this quarter to reflect the outperformance of WaMu mortgages. (I’ll tender a guess, here: underwater mortgages are impossible to refinance, and as a result a huge proportion of JP Morgan’s underwater borrowers are paying well above-market interest rates.)
As a result, there’s no reason whatsoever for JPM to regret playing nice with the government in 2008 by buying Bear Stearns and WaMu. As the WSJ unambiguously reports (emphasis mine):
J.P. Morgan Chase & Co. is willing to pay a steep price to settle with the Justice Department over soured mortgage securities, but it is getting one thing it wanted: It won’t have to pay heavy penalties for the sins of two companies it bought during the financial crisis.
Under the terms of a tentative $13 billion deal that could be finalized in a matter of days, J.P. Morgan will pay roughly $2 billion in penalties that apply to its own conduct during the years before the financial crisis, and not any for problems it inherited from Bear Stearns Cos. or Washington Mutual Inc.
As Eavis explains today, the settlement breaks down into three parts. $6 billion goes to compensate investors for losses on mortgage securities; $4 billion is relief for homeowners; and the remaining $3 billion in fines is specifically targeted only at actions which took place directly under Dimon’s watch.
Despite the concerns that JPMorgan was being unfairly taken to task for the practices of Bear Stearns and Washington Mutual, investigations into the two firms are not expected to lead to any fines. Justice Department lawyers, one person said, decided against allocating fines to those firms because doing so might appear punitive. The government encouraged and helped arrange the two takeovers.
In other words, Parsons’ premise is exactly wrong: JPM is not paying penalties for mistakes made by Bear Stearns. All that it’s doing is making good on obligations of WaMu and Bear related to securities they sold. And it’s inherent in buying a bank that you become responsible for its liabilities as well as its assets.
There is one unexpected wrinkle to this settlement, however. As Matthew Klein point out, some $4 billion of JP Morgan’s non-fine money will go to the taxpayer all the same, in the form of the FHFA, thanks in large part to the dogged efforts of FHFA director Ed DeMarco. DeMarco has been micromanaging Fannie Mae and Freddie Mac for the past four years, which means that he — rather than Fannie and Freddie themselves — has taken the lead in terms of chasing down money the two agencies are owed by the banks from whom they bought mortgage securities.
DeMarco sits in a kind of weird regulatory limbo: technically he only regulates Fannie and Freddie, but because he’s a fully-empowered government regulator, that gives his lawsuits especial force. And so when he sues JP Morgan (and Citi, and Wells Fargo, and other mortgage-bond merchants), the suits fall somewhere in the middle between aggressive regulatory action and a simple civil claim brought by formerly private companies which suffered losses due to miss-sold securities. Most importantly, because DeMarco is a regulator, other regulators, including most importantly the Justice Department, can join in — and, ultimately, settle the whole deal for a huge headline sum.
The best way of looking at this JPM settlement, then, is not as a massive $13 billion fine for wrongdoing. Rather, you should think of it as an upsized out-of-court settlement between JP Morgan and the various private companies which bought mortgage bonds from JPM, WaMu, and Bear. Those companies were mostly Fannie and Freddie, which means that they’re now owned by the government, and so of course lots of other government baggage is being brought in at the same time. But what we’re not seeing is overreach by the SEC, by the Justice Department, by Treasury, or by any other government agency. And we’re certainly not seeing JPM being punished for takeovers which the government asked it to do. We’re just seeing two enormous and bureaucratic systems — the federal government, and JP Morgan Chase — doing their best to disentangle the various obligations that the latter has to the former. It’s opaque, and not particularly edifying. But it’s probably good, on net, for both parties.