JPMorgan Legal Bills Soar in 2010, Menacing Profits

JPMorgan Chase & Co. and the biggest U.S. banks face billions of dollars in legal costs related to their role in the financial crisis, threatening their profits and the stock price gains they made in 2010, analysts said.

JPMorgan, the second biggest bank by assets, reported $5.2 billion of legal costs in the first nine months of last year, compared with a gain of $10 million in the same period a year earlier. The costs would rise if the bank reserves for multibillion-dollar lawsuits by Lehman Brothers Holdings Inc. and the trustee liquidating Bernard L. Madoff’s firm.

Bank of America Corp., the largest U.S. bank, and Citigroup Inc., ranked third, are also besieged by lawsuits stemming from the credit crisis, brought by plaintiffs ranging from foreclosed-upon homeowners to institutional investors whose mortgage-backed bonds turned out to be money-losers.

“They’re under legal attack,” said Richard Bove, an analyst at Rochdale Securities in Lutz, Florida, who rates JPMorgan’s stock a “buy.” “They’re similar to the asbestos or the tobacco industry, and they’re going to be repeatedly sued in the next few years.”

JPMorgan rose about 1.8 percent in 2010, while the Standard & Poor’s 500 Bank Index climbed 18.7 percent and Citigroup gained 43 percent. Both banks are based in New York. Bank of America, based in Charlotte, North Carolina, fell 11.4 percent, while San Francisco-based Wells Fargo & Co. rose 14.8 percent, according to Bloomberg data.

Photographer: Jin Lee/Bloomberg

JPMorgan, the second biggest bank by assets, reported $5.2 billion of legal costs in the first nine months of 2009, compared with a gain of $10 million in the same period a year earlier. Close

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Photographer: Jin Lee/Bloomberg

JPMorgan, the second biggest bank by assets, reported $5.2 billion of legal costs in the first nine months of 2009, compared with a gain of $10 million in the same period a year earlier.

Cost of Business

JPMorgan’s third-quarter net profit of $4.4 billion, up 23 percent from the year earlier, would have been larger if it hadn’t set aside $1.3 billion of pretax income for lawsuits and $1 billion for mortgage repurchases. Banks haven’t yet reported their results for the fourth quarter.

Litigation “ain’t going away,” Chief Executive Officer Jamie Dimon told analysts on an Oct. 13 conference call. “It’s becoming a cost of doing business.”

At least JPMorgan’s shareholders are more likely to be informed about legal expenses than some other bank investors. The bank, which used the word “litigation” about 50 times in its latest 10-Q filing with the Securities and Exchange Commission, discloses more about lawsuits’ effect on results than Citigroup or Wells Fargo, and has been taking larger reserves than some rivals, according to company filings.

Array of Suits

Stephen Cutler, JPMorgan’s in-house lawyer and a former SEC enforcement chief, declined to comment through bank spokesman Joseph Evangelisti.

Bankrupt Lehman is claiming $8.6 billion in collateral from JPMorgan plus tens of billions of dollars in damages, while Madoff trustee Irving Picard is demanding $6.4 billion on the grounds that JPMorgan aided and abetted the biggest Ponzi scheme in history.

Almost nine pages of JPMorgan’s third-quarter 10-Q deal with legal issues. They range from home foreclosure investigations by state officials, to shareholder lawsuits against Bear Stearns Cos., which JPMorgan bought in 2008, to suits from nine different Federal Home Loan Banks demanding compensation for mortgage-backed securities bought from JPMorgan, Bear Stearns or Washington Mutual Bank, also purchased in 2008.

Investors concerned that they aren’t getting enough information to assess litigation risks spurred the Financial Accounting Standards Board to issue proposals last year that would make banks estimate legal losses and say how much they’re putting aside. The FASB, based in Norwalk, Connecticut, sets accounting rules for public companies under authority delegated by the SEC.

Expensive Season

The coming year may be the most expensive litigation season since 2005, when JPMorgan and Citigroup each spent about $2 billion to resolve a lawsuit accusing them of helping energy trader Enron Corp. hide billions of dollars in debt from investors. JPMorgan said in its 2009 annual report it got some money back from insurers for the two settlements.

This year, though, the usual fraud and mismanagement suits are dwarfed by the potential liabilities stemming from the collapse of the housing market. Litigation may force banks to pay back about $134 billion for so-called private-label mortgage loans, said Chris Gamaitoni, a bank analyst at Compass Point Research & Trading LLC in Washington. Such loans are considered riskier than mortgage loans issued by Fannie Mae or Freddie Mac.

Book Value

For JPMorgan, its $24 billion share of the potential losses would equal 13 percent of its book value, Gamaitoni said. Bank of America’s $35 billion of possible losses would be 17 percent of book value, he estimated.

While bank stocks rose about 3 percent this week after Bank of America paid $2.8 billion to settle loan disputes with Fannie Mae and Freddie Mac, the banking industry’s liability could be almost five times greater on private-label mortgage loans, Gamaitoni estimated.

“Private-label losses on loans are much higher and therefore the liability from lawsuits is a much larger percent than in the agency market,” he said. “On a book value basis it would be more negatively impactful. If there is a large private- label settlement or court case, the stocks will react negatively. There will be an earnings headwind.”

Bank of America reported $1.2 billion in litigation costs for the nine months through Sept. 30, excluding fees to outside law firms. It is suing or being sued in 5,696 legal proceedings in federal court, compared with JPMorgan’s 3,757 lawsuits, according to data compiled by Bloomberg.

Litigation Expenses

Cases for which Bank of America has already reserved some money may wind up costing the bank $400 million to $1.9 billion more than it has set aside, according to its 10-Q. The bank’s nine-month litigation cost of $1.2 billion compared with $477 million a year earlier.

“Our litigation-related expenses are cyclical and are not attributable to a single factor,” said Bank of America spokesman Lawrence Grayson.

Citigroup, now dealing with 1,713 federal court proceedings according to Bloomberg data, tries to settle lawsuits, the bank said in a filing. Shannon Bell, a spokeswoman for Citigroup, declined to comment.

Wells Fargo, the fourth biggest bank, is involved in 2,758 lawsuits, according to Bloomberg data. Mary Eshet, a Wells Fargo spokeswoman, declined to comment.

JPMorgan’s litigation reserves are an “estimate” that, “if wrong, could cause unexpected losses in the future” from lawsuits, fines or penalties not covered by insurance, according to its latest 10-K.

Fight for Right

Dimon articulated the bank’s approach to lawsuits in the October analyst call.

“When we’re wrong, we’re going to settle, and when we’re right, we’re going to fight,” he said.

JPMorgan was the last major underwriter of WorldCom Inc. securities to settle suits started in 2002 after an $11 billion fraud sank the long-distance telephone company and sent Chairman Bernard Ebbers to prison.

Banks have leeway under current accounting rules to report litigation costs, or not. Citibank and Wells Fargo don’t give a dollar amount for legal costs; JPMorgan and Bank of America do.

Among other things, the FASB proposal would force banks to report the basis for the legal claim, the amount being claimed and how the company will defend itself. Banks will have to regularly update their estimated loss, and when it might occur; and in cases where they are “reasonably” likely to lose, they have to estimate their possible range of loss and say how much they’ve put aside to pay for it.

Mission of FASB

“The mission of the FASB is to establish financial accounting and reporting standards that provide useful information to investors,” said Bill Hildebrand, a FASB staff member, in a telephone interview. Hildebrand couldn’t say when the proposal might become a rule.

JPMorgan currently is fighting Lehman’s lawsuit, which alleges the bank and Dimon helped cause its failure by siphoning off badly needed funds.

JPMorgan twice asked a judge to dismiss the suit, saying it took the $8.6 billion in collateral from Lehman under a contract to clear trades for Lehman’s brokerage. So-called safe harbor laws protect a clearing bank from being sued if a brokerage client fails, the bank said in court papers.

U.S. Bankruptcy Judge James Peck in Manhattan, who hasn’t yet ruled on JPMorgan’s request for dismissal, has at least three times rejected the safe harbor defense in other cases. Bank of America was ordered to return $500 million of deposits to Lehman, and pay $90 million in interest.

Madoff Trustee

Madoff trustee Irving Picard sued JPMorgan on Dec. 2, saying the bank aided the now-imprisoned con man’s fraud from its position “at the very center of that fraud” when it acted as the Madoff firm’s banker.

The trustee unraveling the remains of a $3.5 billion Ponzi scheme run by Thomas J. Petters has also accused JPMorgan of gaining about $280 million from that scam.

Bank of America’s legal proceedings cover five pages of its latest 10-Q -- and 11 pages of small print in a footnote to its latest annual 10-K filing, under Note 14. Like the other banks, it says it may be exposed to losses “in excess of any amounts accrued” for legal liabilities.

Like JPMorgan, Bank of America inherited lawsuits from companies it bought: Countrywide Financial Corp. and Merrill Lynch & Co. Together, they’re facing lawsuits alleging they misled investors in offering documents for more than $375 billion in mortgage-backed securities, the bank said.

Allstate Corp. sued Bank of America and Countrywide on Dec. 28 over $700 million in mortgage-backed securities the insurer bought.

Current Accounting Rules

Like other banks, Citigroup said it follows current accounting rules in setting up litigation reserves “when those matters present loss contingencies that both are probable and can be reasonably estimated,” adjusting the reserves as new information comes in.

Citigroup still faces 14 billion euros ($18.4 billion) of claims for damages resulting from the 2003 bankruptcy of Italy’s biggest dairy company, now called Parmalat SpA, according to the bank’s 10-K annual regulatory filing.

Citigroup in another Parmalat case won $431 million by countersuing, it said in the filing.

JPMorgan fell 42 cents to $44.28 at 2:51 p.m. in New York Stock Exchange composite trading.

Lehman’s case against JPMorgan is Lehman Brothers Holdings Inc. v. JPMorgan Chase Bank NA, 10-03266, U.S. Bankruptcy Court, Southern District of New York (Manhattan). The Madoff case is Picard v. JPMorgan Chase & Co., 10-ap-4932, U.S. Bankruptcy Court, Southern District of New York (Manhattan).

To contact the reporter on this story: Linda Sandler in New York at lsandler@bloomberg.net.

To contact the editor responsible for this story: David E. Rovella at drovella@bloomberg.net.

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