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More JPMorgan Legal Woes

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This year is turning out be a worse-than-expected period for JPMorgan Chase & Co. (JPM - Analyst Report) as it has landed in troubled waters yet again. After stabilizing to some extent following the huge trading debacle, the company is now accused of a civil fraud by the New York Attorney General (AG), Eric Schneiderman. The AG alleged that Bear Stearns – acquired by JPMorgan in 2008 – defrauded a large number of mortgage bond investors.

The lawsuit, filed under the New York’s Martin Act (that does not require proof of intent to mislead) has named J.P. Morgan Securities, JPMorgan Chase Bank and JPMorgan’s EMC Mortgage unit as defendants. Though the litigation does seek any damages, it demands proper compensation for the investors who were defrauded by deceptive practices.

As per the complaint, the investors suffered losses aggregating to about $23 billion – nearly 26% of the original value – as a result of flawed documents used by Bears Stearns while selling more than 100 Residential Mortgage-Backed Securities (RMBS). These RMBS were sold in the 2006-2007 period.

The lawsuit alleges that Bear Stearns, while selling the RMBS, convinced the investors that the underlying loans had been evaluated properly and were being monitored continuously. However, Bear Stearns failed to do either.

Further, the executives ignored various negative signals that showed that the underlying loans were most likely to fail and continued to bundle them as RMBS and sold them to investors. Bear Stearns also failed to take corrective measures once flaws were detected. Also, the firm misled the investors about the quality of the underlying loans.

Further, when these loans started defaulting in large numbers, Bears Stearns demanded nominal cash payments from the originators instead of asking them to buyback the loans. Also, the firm failed to pass on this cash amount to the aggrieved investors.

The litigation has been filed with the backing of the RMBS Working Group, which was formed by President Barack Obama in January to investigate and impeach the alleged misconducts that led to the financial crisis. The group consists of officials from the U.S. Justice Department, the Securities and Exchange Commission, the FBI and other federal and state officials.

JPMorgan’s spokesperson, while commenting on the litigation, stated that though the charges pertain to the period prior to its acquisition of Bears Stearns, the company will challenge the allegations.

Many of the major banks continue to face problems related to the acquisitions they made during the height of the financial crisis. Last week, Bank of America Corporation (BAC - Analyst Report) announced a payment of $2.43 billion and said that they would undertake various corporate governance changes to settle a class-action lawsuit that was filed by its shareholders related to the acquisition of Merrill Lynch & Co.

Apart from Merrill, BofA had acquired Countrywide Financial Inc. in 2008. Both these acquisitions have been draining the company’s funds through various litigations and losses.

JPMorgan is passing through a rough patch with all the litigation overhangs. Apart from the aforesaid litigation, the company is also facing the money laundering probe and many other lawsuits related to the sale of MBS. However, on the brighter side, the ill effects of these are likely to be eliminated by the strong fundamentals of the company.

JPMorgan currently retains a Zacks #3 Rank, which translates into a short-term Hold rating. Considering the fundamentals, we also maintain a long-term Neutral recommendation on the stock.

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