More Pain at JPM: Trading Loss Doubles, Implications for Others

The trading loss in JP Morgan Chase's (NYSE: JPM) Chief Investment Office continues to grow, as credit conditions around the world deteriorated further after reporting a massive trading loss on May 10. Chief Executive Jamie Dimon at the time said that the losses were tied to credit derivatives the bank was using to hedge its many businesses.

According to an estimate by International Strategy and Investment Group (ISI Group), the trading loss may be as high as $4.2 billion, more than double the initial estimate of $2 billion. Ed Najarian, an analyst at ISI Group, said that the loss would cut second-quarter earnings to 65 cents per share as compared to a prior estimate of 93 cents, a 30% decline.

Najarian does highlight that some of JP Morgan's core businesses are continuing to deliver. He expects strong mortgage-banking revenue in the quarter and that, combined with realized security gains and a debt valuation gain, will amount to about $2 billion in revenue to offset the trading loss. Najarian cut his price target to $47 from $52, but kept a buy rating on the stock.

JP Morgan was hedging its exposure to corporations by taking positions in credit derivatives tied to corporate debt. The loss has called questions around the Volcker Rule, the rule in which banks cannot trade for proprietary purposes and only for hedges. Questions have also been raised around the true nature of a hedge: what is a hedge and what isn't in the scope of the rule?

Another big concern is the health of other institutions who may have been making bets in other parts of the credit markets. Bill Gross has openly stated that he is consistently increasing his firm's, Pimco's, exposure to mortgage backed securities (MBS) in hopes of further Federal Reserve easing focused on these securities. If investment grade credit markets have been hurt, who knows the extent of losses at Pimco, or any other firm for that matter.

Credit conditions improved after the European Central Bank offered two Long-Term Refinancing Operations (LTRO's) to financial institutions, offering them 3-year, 1% loans in exchange for collateral. However, the effect of these credit injections has weaned over the last few months, and now credit investors are seeing previously successful trades turn against them, with JP Morgan being no exception.

I have a long position in JP Morgan Chase.