Despite Cries of Unfair Treatment, JPMorgan Is No Victim

The government’s legal pursuit of JPMorgan Chase strikes many people on Wall Street as unfair.

The Justice Department, other regulators and the bank are trying to negotiate a settlement over allegations of mortgage abuses. To put the cases behind it, JPMorgan might end up paying more than $11 billion in fines and relief to homeowners, according to people briefed on the negotiations.

“There’s a lot of value to regulators and officials to show they’re really punishing people,” Alan D. Schwartz, who was chief executive of Bear Stearns when JPMorgan took the firm over in 2008, said in an interview on CNBC on Friday. “And I think it’s overdone,” he added.

The portrayal of JPMorgan as the victim goes back to the days of the financial crisis, when the bank bought Bear Stearns and the remains of Washington Mutual, a large savings and loan that was crippled with mortgage problems.

Those two former institutions appear to have committed most of the missteps that are at the heart of the settlement talks. Yet JPMorgan, which largely sidestepped the subprime debacle, is being held to account for troubles not of its own doing.

The government’s actions today also seem opportunistic and ungrateful to some banking experts. In 2008, JPMorgan’s decision to assume two problematic institutions helped the authorities manage the financial crisis. Now, they say they believe that the government is picking on JPMorgan, perhaps because its strong profits make it a tempting target.

Commenting last year on lawsuits relating to Bear Stearns, Jamie Dimon, JPMorgan’s chief executive, said, “Yes, I’d put it in the unfair category.” He added, “I think the government should think twice before they punish businesses every single time something goes wrong.”

But JPMorgan may not be the martyr some think it is.

One version of events says that the government pressed a reluctant JPMorgan into buying Bear Stearns and Washington Mutual. But at the time, JPMorgan was keen to use its relative strength to pick up financial firms at steep discounts.

The bank was interested in acquiring Washington Mutual months before it collapsed, but was rebuffed. JPMorgan had also considered Bear Stearns before it bought it. What stood out was Bear Stearns’s prime brokerage unit, a business that provides services and loans to hedge funds.

“If a special opportunity came up to acquire a prime broker at a decent return, we wouldn’t hesitate,” William T. Winters, a senior JPMorgan executive, told investors, some days before it swallowed the firm.

Another feature of the JPMorgan-as-victim narrative is that the bank simply didn’t have time to properly size up the true risks of buying Bear Stearns and Washington Mutual. The argument goes like this: To help save the financial system, JPMorgan rapidly took on hard-to-spot risks, for which it is getting unfairly punished after the fact.

But JPMorgan executives made comments at the time that cast doubt on that interpretation. “We’ve known Bear Stearns for a long time,” Michael J. Cavanagh, then JPMorgan’s chief financial officer, said when justifying what looked like a short due diligence period. “There are always uncertainties in deals,” Mr. Dimon said after the Washington Mutual deal. “Our eyes are not closed on this one.”

JPMorgan’s defenders say that the bank could not have foreseen the specific type of mortgage losses that are at the heart of the settlement talks. Bear Stearns and Washington Mutual packaged mortgages into bonds and sold them to investors. As part of that process, they vouched that the loans met certain, agreed-upon standards. It appears that many mortgages fell short of such warranties, contributing to huge losses for those bonds, and making them particularly vulnerable to lawsuits today.

Though legal actions relating to bond warranties hadn’t emerged in large number in 2008, it is not clear why JPMorgan’s lawyers didn’t anticipate them. By early 2009, purchasers were gaining immunity from these sorts of potential liabilities.

And it is not as if JPMorgan didn’t notice some serious mortgage-related problems at both firms. When buying Bear Stearns and Washington Mutual, it marked down their assets by a large amount, in part to reflect the mortgage risks. In its haste to make the acquisitions, JPMorgan may simply have miscalculated and underestimated the problems.

The notion that JPMorgan should be legally liable for the sins of other entities also stokes outrage on Wall Street.

But the practice of holding acquirers accountable for the missteps of purchased companies is quite common. For instance, Fiat now owns Chrysler, and it is in theory liable for warranties that Chrysler provided to consumers before Fiat bought its operations. Like an automaker, JPMorgan could have voluntarily paid up to honor the warranties. But in many cases, it has yet to do so.

Law enforcement agencies cannot simply ignore evidence of mortgage missteps as a favor to JPMorgan for its crisis-era actions. It is their job to ferret out wrongdoing and press forward with legal actions, if there are reasonable grounds for doing so.

Then there is the financial burden of the two acquisitions. While Bear Stearns and Washington Mutual have no doubt cost JPMorgan more than it expected, the bank derived many monetary advantages from the deals.

Using special deal accounting, JPMorgan substantially lessened the financial risks of the acquisitions. Before Washington Mutual was bought, its shareholders’ equity was nearly $40 billion. To reflect the perceived losses and expenses embedded in Washington Mutual’s balance sheet, JPMorgan adjusted its equity down to just $3.9 billion.

JPMorgan then paid $1.9 billion for that equity, which allowed it to immediately turn around and book a $2 billion gain. In other words, JPMorgan effectively got Washington Mutual free, wiped clean of more than $30 billion in potential losses.

This sort of accounting maneuver is one reason JPMorgan’s managers were so optimistic about the financial outlook of both acquisitions.

Soon after the deals, JPMorgan executives estimated that Bear Stearns would contribute $1 billion a year in net income. Washington Mutual would add $2.5 billion annually, they said. Using those figures, the two entities would have contributed nearly $16 billion in net income since the end of 2008.

There are good reasons both institutions might have fallen short of those figures, like lower-than-expected lending income at Washington Mutual. But other factors might have propelled them to do better than expected. For instance, the Bear Stearns operations most likely benefited from being subsumed into a strong bank like JPMorgan just as other firms were pulling back from Wall Street activities.

Washington Mutual and Bear Stearns have given JPMorgan sizable one-time gifts. It got a Madison Avenue skyscraper that Bear Stearns had just completed at an attractive price.

From Washington Mutual, JPMorgan inherited tax breaks worth more than $2 billion. The bank recently indicated it had been too pessimistic about some of its Washington Mutual costs. This quarter, JPMorgan expects to take a $750 million gain to reflect that mortgages made by Washington Mutual, often called WaMu, are performing better than expected.

“JPMorgan has pretty well subsumed WaMu and done a decent job paving over any benefit has received from that acquisition,” said Kevin Starke, an analyst at CRT Capital Group, a brokerage firm. “It probably is pretty significantly net positive.”

Still, the settlement could end up driving legal costs higher than analysts expected. Before reports of the talks, John E. McDonald, a bank analyst at Bernstein Research, thought JPMorgan’s maximum hit from mortgage litigation would be $21 billion, but he’s now thinking of increasing that to $25 billion. He calculates that JPMorgan has already taken $21 billion of reserves to absorb litigation costs since 2009. Some $6 billion of that appears to have already been used up on identifiable payouts, according to Mr. McDonald, leaving $15 billion for future legal costs.

With JPMorgan’s shares up nearly 30 percent over the last 12 months, investors don’t seem too concerned about the long-term legal costs. The $21 billion litigation expense is reduced to $15.5 billion when applying JPMorgan’s corporate tax rate. The overall bank, enjoying whatever profits Bear Stearns and Washington Mutual are churning out, is performing strongly.

In JPMorgan’s 2008 annual report, Mr. Dimon predicted that Washington Mutual “will add enormous value to JPMorgan Chase in the future.” Bear Stearns, he added, “has added significantly to our franchise.”

Even if it settles for billions of dollars, such words may still be true.