This Big Bank's Brush With the Law Should Make Everyone Nervous

The next time you hear the financial crisis being referred to in the past tense, think about this next bit of news. JPMorgan Chase (NYS: JPM) has recently agreed to pay a fine stemming from its mishandling of Lehman Brothers' funds leading up to the storied investment bank's bankruptcy filing.

Three and a half years after it began, the financial crisis continues to haunt companies, consumers, and the markets. JPMorgan's current brush with the law isn't its first, and it probably won't be the last we see from it or other too-big-too-fail financial institutions stemming from the crisis. Here's why you should be nervous.

The gory details
The fine is $20 million, and it was levied by the Commodity Futures Trading Commission, one of the many federal regulatory bodies that oversee the banks. The charge is that JPMorgan "mishandled" Lehman Brothers' funds -- specifically, that the bank included Lehman "customer funds" when considering how much credit Lehman would be granted. JPMorgan apparently did this for two years, right up to the time Lehman filed for bankruptcy protection in September 2008.

This broke a cardinal rule of finance, i.e., that customer funds belong to the customer alone and must be kept strictly segregated from other money the bank holds. As part of this CFTC action, JPMorgan was also charged with holding on to this customer money for two weeks past Lehman's filing and returning it only after being ordered to.

I'm just the middleman
The reason JPMorgan was involved in Lehman's financial dealings at all is that it's what's known as a "clearing bank," i.e., a bank that, because of its size, processes transactions for other banks. JPMorgan is one of only two major Wall Street clearing banks. The other is Bank of New York Mellon (NYS: BK) . The smaller banks rely heavily on big banks like JPMorgan and New York Mellon to keep their trades in motion and, hence, keep them solvent.

So when things go wrong on Wall Street, you'll often find the clearing banks at the center. JPMorgan was Lehman's clearing bank. In the weeks leading up to September 2008, as JPMorgan became more and more concerned about Lehman's exposure to the collapsing real estate market, the bank began asking Lehman to post more and more collateral to cover its trades.

As a result, Lehman told JPMorgan to count the funds in these separate accounts as collateral. A major no-no. In agreeing to pay the fine, JPMorgan admitted to nothing and said it didn't know the separate accounts were customer funds.

Brother can you spare a bailout
$20 million is chump change for JPMorgan -- the biggest bank in America -- hence the fast settlement (the suit was filed March 28 and the fine agreed to one week later). But it's the third time in four years the Wall Street powerhouse has had to pay a fine to regulators for mishandling customer accounts. In this particular case, JPMorgan wasn't charged with intentionally mishandling the funds.

In the fall of 2008, especially after Lehman went down, all the big banks felt they were on the firing line -- including Goldman Sachs (NYS: GS) and Morgan Stanley (NYS: MS) . These two in particular were so worried that, within weeks of Lehman's filing for bankruptcy, both announced they would become "bank holding companies." This would give them increased access to Federal Reserve funds, thus helping them remain solvent in a desperate hour but at the cost of increased regulation.

Seeing the glass as half broken
A cynic might venture that a bank as big and influential as JPMorgan factors fines like these into the cost of doing business. A cynic might also then add that if this sort of thing is going on at JPMorgan, it's also going on elsewhere in the banking system. We know for a fact that mishandling customer funds wouldn't be the sole province of JPMorgan, as such behavior is precisely at the heart of the ongoing MF Global scandal.

The bank's investors clearly aren't too nervous about any effect this case may have on their portfolios. But investors as a whole ought to be nervous. Regulators ought to be nervous, too. Nervous about how systemic this kind of behavior might be. Nervous about what banks do when they're desperate or more concerned with making money or surviving than doing the right thing -- therefore contributing to the instability of a financial system we all depend on to operate smoothly.

This JPMorgan/Lehman case is the first federal enforcement case to stem from Lehman's downfall, but it's unlikely to be the last. On more cheery note -- a note you can more safely and confidently profit from -- learn about some delightfully straightforward bank stocks, including one Warren Buffett could have loved in his earlier years, in our free report, "The Stocks Only the Smartest Investors Are Buying."

At the time thisarticle was published Fool contributor John Grgurichis mad as hell and isn't going to take it anymore, or he's going to finish rereading The Da Vinci Code tonight: one or the other for sure. John currently owns no shares of any of the companies mentioned in this column. Follow John's dispatches from the front lines of capitalism on Twitter,@TMFGrgurich. The Motley Fool owns shares of JPMorgan Chase. Motley Fool newsletter services have recommended buying shares of Goldman Sachs. The Motley Fool has a positively gripping disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.