Breaking Down JPMorgan's $13 Billion Settlement for Investors

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

The government shutdown and the threat of default are behind us (for the moment), and the stock market is on new highs to start out a clear week during which investors will be free to focus on fundamentals. The S&P 500 and the narrower, price-weighted Dow Jones Industrial Average are flat as of 10:15 a.m. EDT.

The most important news of the day concerns embattled Dow component JPMorgan Chase , which on Friday struck a tentative $13 billion settlement that would end several civil investigations into the sale of mortgage securities in the run-up to the financial crisis. The bank has been negotiating this settlement -- which would be the largest penalty exacted by authorities on a U.S. company -- with the Department of Justice and the Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac, the mortgage finance agencies that came close to failure in 2008.

JPMorgan Chase, which initially sailed through the financial crisis relatively unscathed, has become a lightning rod for litigation and regulator scrutiny in the wake of last year's "London Whale" trading debacle, which ultimately produced a loss of more than $6 billion. The $13 billion settlement, if finalized, would be an important milestone in the battle against the phantoms of credit-bubble practices and losses that have come back to haunt the bank.

Other banks, including competitor Bank of America , will be watching the developments very closely; attorney general Eric Holder says he expects the agreement with JPMorgan to be a template for deals with other institutions. Yesterday, the Financial Times reported that the Federal Housing Finance Agency is seeking $6 billion from Bank of America, compared to the $4 billion it is expected to receive out of the $13 billion JPMorgan settlement.

What's at stake for JPMorgan Chase? Allow me to answer that question with another one: How do shares that pay a 2.8% dividend yield, belonging to a bluer-than-blue-chip institution that earned $18 billion in profits over the last 12 months, trade at barely more than their book value, or 9.2 times estimated earnings over the next 12 months?

Will this settlement lift the pall that has been cast over the stock? The market's reaction this morning is muted: JPMorgan's shares are up 0.17% so far. Despite the fact that this would represent significant progress in the bank's goal to move forward and put these issues behind it, multiple thorny issues are not covered in the deal:

  1. The issue of whether or not the bank will have to admit wrongdoing remains outstanding. That has a bearing on the size of its potential liability with regard to private litigants; such an admission would place JPMorgan in a much weaker position.
  2. The government has not ruled out pursuing criminal charges against the bank.
  3. The agreement is not all-encompassing. JPMorgan continues to face multiple investigations on a range of issues, including the London Whale episode and nepotistic hiring practices in China.

Finally, while most of these problems represent one-time costs, JPMorgan's operating costs have increased as a result of heightened scrutiny. Last month, it announced that it is spending an additional $4 billion on risk management and compliance, with 5,000 additional employees coming on board.

JPMorgan faces significant near-term headwinds with regard to direct and reputational costs. The bank earned an 8.8% return on equity over the past 12 months. If it can raise that level to low single digits or low teens, the shares ought to provide a decent long-term return to shareholders. But investors may need to be patient in order to reap that return -- JPMorgan isn't out of regulators' crosshairs just yet.

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Fool contributor Alex Dumortier, CFA has no position in any stocks mentioned; you can follow him on Twitter @longrunreturns. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America and JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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