No tears and sweetheart deals for JP Morgan

Joseph R. Mason Senior Fellow, Wharton School
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The potential settlement announced between the Department of Justice and J.P. Morgan Chase over the weekend was received initially with great fanfare and relief. This wasn’t surprising considering that the settlement was the largest of its kind ever orchestrated – $13 billion – combined with the prospect that it would resolve a number of pending legal claims that have weighed down financial institutions and slowed economic growth. However, once the details of the settlement began to emerge, both the news-reading public and market participants turned sour on the deal.

Initially, most people assumed the settlement was structured to address mortgage-backed securities and loan sale lawsuits initiated by the government against banks. For example, in 2011, the Federal Housing Finance Administration (FHFA), which regulates government-sponsored enterprises like Fannie Mae and Freddie Mac, filed suit against JP Morgan claiming two of its subsidiaries – Washington Mutual (WaMu) and Bear Stearns – misled Fannie and Freddie about the quality of some $33 billion in investments it sold them. These investments, which were comprised of thousands of mortgages pooled together, contained hidden delinquencies, defaults, and foreclosures. They were assets that were sold to Fannie and Freddie as AAA-rated, but were ultimately downgraded to CCC or worse.

Had the settlement been directed to Fannie, Freddie and other government institutions, there wouldn’t have been much concern outside a relatively small cadre of current investors. But there was more.

In the midst of the financial meltdown in 2008, as the value of WaMu and Bear Stearns was imploding, the FDIC orchestrated JP Morgan’s acquisition of both banks for pennies on the dollar. This was universally acknowledged as a “fire sale,” in recognition of the liabilities (legal and otherwise) that would be assumed by JPM in order to continue the banks’ business.

After the sale, WaMu’s holding company, which was never purchased by JP Morgan, filed for bankruptcy and was liquidated. Immediately JP Morgan tried to lay claim to the holding company’s assets, which were valued at $20 billion; FDIC disagreed and lawsuits ensued.

Most of the dispute was resolved in a February 2012 settlement that produced a head-turning, one-time gain of $1 billion for JP Morgan. Roughly $2.7 billion still remains to be distributed by the FDIC from the bank receivership. Now JP Morgan is arguing that its liabilities stemming from its purchase of Washington Mutual should be paid from the receivership as well. If it succeeds, it would effectively be giving JP Morgan Washington Mutual for free!

Worse, the $2.7 billion is specifically for private claims of bank creditors who lent money to Washington Mutual before it failed. So JP Morgan is essentially attempting to use the DOJ settlement to grab the value of assets it did not purchase from Washington Mutual after the FDIC has worked to liquidate them, and it is doing so at great cost to taxpayers and other bank creditors who invested in good faith.

But it doesn’t end there. JP Morgan is also negotiating for relief from criminal prosecution for a variety of claims unrelated to the DOJ settlement such as LIBOR, the energy market, and potentially Foreign Exchange market rigging. These aspects reflect ongoing difficulties at the financial institution as it continues to struggle to digest its acquisitions and tighten operational controls in a post-bubble world.

Despite popular thinking, JP Morgan’s acquisition of Washington Mutual was a “favor” to no one. It was a shrewd opportune business decision resulting in hundreds of billions of dollars in assets and potential earnings that enriched shareholders, provided extended retail reach, built a nationwide portfolio, and fueled profit margins that now run into multiple billions of dollars. On this, JP Morgan CEO Jamie Dimon has served his constituents well. However, the DOJ also has an obligation to consider the impact any settlement would have on its constituents, namely the FDIC and taxpayers.

The government must ensure that any final settlement with JP Morgan does not create the liquidation environment that led directly to the sweetheart deals JP Morgan took advantage of in the first place. Another sweetheart deal would establish a dangerous precedent that would undermine the FDIC’s reliability as a receiver. It would spook not only bank investors, who would envision value drained away from them during future bailouts, but also bank purchasers, who would fear exposure to whimsical interpretation of their purchase agreements after the fact.

Crisis-era litigation is a drag on economic growth, so it’s important that the government and JP Morgan reach a speedy and equitable settlement that more accurately compensates investors and taxpayers for the damage done by reckless lending. But JP Morgan cannot be allowed to raid the FDIC through Washington Mutual’s receivership, while receiving a full pardon for all of their potential criminal misdeeds, just for the sake of a speedy resolution.

Dr. Mason is Endowed Chair of Banking at Louisiana State University. He has served as an expert witness for the government in the Department of Justice’s suit against Bank of America.

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Joseph R. Mason