Everything you need to know about JPMorgan’s $13 billion settlement

November 19, 2013
They fought the law. Did the law win? (Photo by Spencer Platt/Getty Images)
They fought the law. Did the law win? (Photo by Spencer Platt/Getty Images)

(Note: This post is an updated version of a piece originally published Oct. 21. Apparently the deal then wasn't as close as it had seemed).

JPMorgan Chase has (finally) reached a $13 billion civil settlement with the Justice Department for its mortgage lending practices. So what's going on here? We're here to help. 

What is JPMorgan Chase?

It's the largest bank in the United States, with $2.4 trillion in assets. It is active in a wide variety of financial services businesses, including both what you might think of as ordinary consumer banking--taking deposits and offering car loans, mortgages, and credit cards--and more exotic Wall Street deal-making like helping large companies issue stocks or bonds. It has 255,000 employees, about the population of Orlando.

Its history dates back to 1799, with the Bank of the Manhattan Co., founded by Aaron Burr (the guy who killed America's first treasury secretary in a duel), which helped finance the Erie Canal; that is one of more than 1,000 banks that have merged over the generations to become the colossus that is now JPMorgan Chase.

The most important of those predecessor firms is J.P. Morgan & Co., founded by the great Gilded Age financier in 1871, which played a key role financing the American rail system, the Brooklyn Bridge, and the Panama Canal. Morgan was a titan of American finance, helping guide the young republic through a series of financial crises at a time there was no central bank. Think Tim Geithner circa 2008, but with less hair and a groovy mustache.

J.P. Morgan merged with Chase Manhattan in 2000, leading to the current JPMorgan Chase. It is run by Jamie Dimon, who is arguably the most successful banker of his generation. Dimon also has better hair than J. Pierpont Morgan.


JPMorgan Chase CEO Jamie Dimon at the Justice Department, where he met with Attorney General Eric Holder last week. Excellent hair. (Gary Cameron/Reuters)

So what is this settlement about?

In the years before the 2008 crisis, large banks were in the business of "mortgage securitization." They would take home loans made by retail banks and mortgage brokers all over the country, and sell them to others.

The government-sponsored mortgage finance companies Fannie Mae and Freddie Mac bought some of these mortgages. And the banks also packaged some of them into complex, privately issued  "residential mortgage backed securities" that were bought by investors around the globe.

But a lot of the loans that the banks sold were bad. Many were subprime, meaning to people with weak credit, small down payments, or both. Many more were "Alt-A", a category of loan quality a little better than subprime but worse than prime loans. The companies buying the mortgages knew that they were investing in lower-quality credit risks. What they may not have known is just how bad lending standards had become, that many of the people taking out mortgage loans didn't make as much money as they said they did, for example, or that there were other red flags to suggest that they wouldn't be able to handle their mortgages.

As a result, the people who ended up owning the loans--both Fannie Mae and Freddie Mac, and the private investors who purchased mortgage backed securities--ended losing money as borrowers were unable to make their mortgage payments.

What did this have to do with the financial crisis?

Everything.

It was losses on mortgage securities like those involved in this case that triggered a loss of confidence in the U.S. banking and financial system. Securities that had been rated AAA that were based on faulty underlying mortgages turned out to be junk, and losses on them prompted huge losses for big banks and other investors, causing a crisis of confidence in the global banking and financial system. That in turn necessitated a $700 billion bailout of the U.S. banking system, and a bailout of Fannie Mae and Freddie Mac that has totaled $188 billion.

There were a lot of causes of the 2008 crisis, but the packaging of bad mortgages into mortgage backed securities was the Patient Zero.

So what did JPMorgan Chase do wrong in all of this?

They bought Bear Stearns.

Wait, what?

Okay, that's overstating it a bit. They also got into this mess by buying Washington Mutual. And JPMorgan was responsible for some of the alleged misdeeds on its own. Here's what we're talking about.

One of the firms most heavily involved in this businesses of packaging and reselling subprime mortgage-backed securities was Bear Stearns, then the fifth-largest U.S. investment bank. One of the most active retail mortgage lenders was Washington Mutual.

In March 2008, Bear Stearns was on the verge of failure. In a last-minute deal to prevent the firm from collapsing, facilitated with a $29 billion loan from the Federal Reserve, JPMorgan swooped in and bought the company. Later in 2008, it bought up Washington Mutual out of FDIC receivership.

In the process, JPMorgan took on all of Bear Stearns' and Washington Mutual's outstanding legal exposures. By some estimates 70 to 80 percent of the dealmaking at the heart of the Justice Department settlement was by the acquired companies rather than the pre-2008 version of JPMorgan. But legally, that doesn't matter; the JPMorgan put itself on the hook for those misdeeds when it acquired the two firms.

OK, but what are they accused of actually doing?

There are two suits that have actually been filed that would be settled as part of the $13 billion Justice Department deal, one by the regulator of Fannie Mae and Freddie Mac, the other by the New York Attorney General.  There are civil charges pending by the Justice Department that have not been filed, but presumably would be if the negotiations over a settlement break down.

Here's the gist of the accusations:

* Bear Stearns said it was doing "due diligence" to make sure the mortgages it was packaging were sound. But the process was shoddy. "Rather than carefully reviewing loans for compliance with underwriting guidelines, Defendants instead implemented and managed a fundamentally flawed due diligence process that often, and improperly, gave way to originator's demands," says the lawsuit by New York attorney general Eric Schneiderman. The workers who were supposed to be vetting the loans were pushed to process as many as possible and not to look at them very carefully. "Have 1594 loans to do in 5 days," wrote one team leader in an e-mail, according to the suit. "Sound like fun? NOT!"

* Washington Mutual, Bear Stearns, and pre-2008 JPMorgan itself "were negligent in allowing into the Securitizations a substantial number of mortgage loans that, as reported to them by third-party due diligence firms, did not conform to the underwriting standards" that had been stated, and that those poorly vetted mortgages were then offloaded to Fannie Mae and Freddie Mac and, by extension, American taxpayers. The Federal Housing Finance Agency suit is full of details of the alleged wrongdoing, but here is the best example of inadequate due diligence. From the suit: "Fay Chapman, WaMu’s Chief Legal Officer from 1997 to 2007, relayed that, on one occasion, '[s]omeone in Florida made a second-mortgage loan to O.J. Simpson, and I just about blew my top, because there was this huge judgment against him from his wife’s parents.' When she asked how they could possibly close it, 'they said there was a letter in the file from O.J. Simpson saying ‘the judgment is no good, because I didn’t do it.'"

In other words, the government has alleged that JPMorgan and the companies it later acquired were offloading bad mortgages on other parties (mortgage backed securities investors, and U.S. taxpayers) through their lax practices. The Justice Department was said to be on the verge of launching a new civil suit along the same lines before negotiations over a settlement heated up.

So was JPMorgan the only firm doing this stuff?

No! There have been similar charges against many other banks; the FHFA filed suit against 17 banks at the same time as the JPMorgan action mentioned above. Indeed, like JPMorgan, Bank of America has been particularly weighed down by legal exposure by firms it acquired during the crisis, in its case Countrywide Financial and Merrill Lynch.

Ironically, the firms that kept their noses (relatively) clean in the pre-crisis years were the ones that were in strong enough financial position to pick off competitors as they failed in 2007 and 2008, and in the process exposed their own shareholders to enormous potential losses.

So did the government force them to buy these companies that are now dragging them down?

Did Treasury Secretary Hank Paulson and New York Fed President Tim Geithner and other federal officials encourage these emergency acquisitions? Absolutely. They even helped broker them in some cases by helping encourage communication among the parties, and in the case of Bear Stearns actively encouraged the deal by putting Fed money up to facilitate the transaction.

But the government didn't have any ability to force anybody to buy these failed banks. That was evident when Lehman Brothers went bankrupt in September 2008, because they couldn't find anyone with the ability and will to buy it.

Jamie Dimon knew when he was buying Bear Stearns and WaMu the risks his bank was taking on. He was advised by some of the most talented, and highly compensated, lawyers on earth. It may have turned out to be a bad bet, with more legal exposure than he and JPMorgan lawyers were expecting, but those are the judgments they are paid to make.

This all happened a really long time ago. Whatever happened to the statute of limitations?

There is only a six-year statue of limitations in federal law for securities and commodities fraud, tax crimes, or violations of securities laws. If those were the charges, then prosecutors would probably be out of luck, given that many of the bad mortgage securities were issued in the 2005 to 2007 time frame.

But there's a different set of financial violations that carry a 10-year statute of limitations. Under legislation enacted in 1989 to help deal with the savings & loan crisis, prosecutors have a 10-year statute of limitations on crimes that involve defrauding banks. They are using that time now. (They would have a lot more time if the charge was major art theft, with a nice 20-year window for prosecutors to do their work).

So is anyone going to jail?

Maybe! In negotiations with the Justice Department over the settlement, Dimon has reportedly pushed for the terms to include absolving bank employees of criminal charges related to mortgage securitization being weighed by a U.S. attorney in Sacramento, California.

The Justice Department, led by Attorney General Eric Holder, has reportedly rejected that possibility, and this will be solely a civil settlement. Any criminal charges that materialize from that investigation or others could still go forward. And under terms of the settlement, JPMorgan reportedly will agree to cooperate with the investigation.

But why now, more than five years after the financial crisis and six or more years after the bad lending practices took place?

The version of this that is generous to the Justice Department goes like this: It took a while after the crisis to figure out where legal culpability might lie. Once they zeroed in on mortgage securitization as a key area of potential fraud, it was a massive job to ascertain who might have broken which laws. They had to examine thousands of transactions worth trillions of dollars, by dozens of banks and other financial intermediaries. As much as we might want to believe this is a "Law and Order" world where the most complex of cases can be promptly tied up within an hour (less when time is allowed for commercials, introductory theme song, and final-scene-wistful-scotch-drinking), that's not how the law really works. Especially with complex securities litigation, it takes time to build these cases and ensure they are nailed down.

The version that is less generous to the Justice Department is this: In the aftermath of the financial crisis, they were too timid and chicken to go after the big banks. But now some time has passed, the financial system is less on the brink, and new leadership is in charge at the criminal division. Eric Holder wants some legacy cases to show he has gone aggressively after those culpable for the financial crisis, and this will be one of those cases.

This is going to be a $13 billion settlement. But how much is that for JPMorgan?

It's a lot of money even for a bank the size of JPMorgan, though certainly nothing approaching a death blow. The bank earned $32 billion in operating income in 2012, so the settlement would be equivalent to about five months worth of income for the company. It is clear that JPMorgan lawyers had hoped for a much cheaper price for settling the cases; earlier settlement offers were as low a $1 billion and $3 billion.

Put another way, the reserve that JPMorgan set aside for the settlement last quarter caused the company to record its first quarterly loss since 2004. It managed to remain profitable throughout the financial crisis, but not through the legal losses that followed.

So who gets the money?

Of the $13 billion, $9 billion is to go to fines that would ultimately end up in government coffers, essentially helping repay taxpayers in part for their $188 billion bailout of Fannie Mae and Freddie Mac that was necessitated in part because of bad mortgages the companies bought from JPMorgan.

The other $4 billion is to go to help homeowners struggling with their mortgages. The exact contours of how that money will be used will be a matter of some focus once more details of the settlement materialize.

You may notice who is not included in this list: The private investors who bought residential mortgage backed securities stuffed with bad loans.

So are they going to admit wrongdoing?

It looks that way! In recent civil settlements with financial firms, prosecutors have insisted that the firms cop to whatever bad behavior they stood accused of. A past practice was to not require any admission of guilt, which often eased the pathway to a settlement. Now, JPMorgan lawyers and federal prosecutors are reportedly hammering out a "statement of facts" in which the company will concede some misdeeds.

So what does this mean for Jamie Dimon and JPMorgan?

First things first: it doesn't resolve a number of unrelated legal matters the firm is facing, ranging from a probe of energy trading practices to investigations into its "London Whale" trading scandal to an investigation into whether the firm bribed Chinese officials by hiring their children. The company has said it will ramp up its hiring of compliance staff and spending on technology to try to prevent its sprawling, multi-trillion dollar business from having so many legal issues in the future.

Still, JPMorgan shareholders appear to be relatively happy to have the legal exposure potentially behind them despite the record-high settlement. Its shares have bounced around between roughly $50 and $54 since word of a potential settlement. And when they last had the opportunity to voice their view of Dimon's performance, in a shareholder referendum this past spring, some 98 percent endorsed his continued leadership of JPMorgan.

Is JPMorgan too big to manage? Its shareholders, from all appearances, don't think so, even with the $13 billion soon to be heading out the door to settle these old legal problems.

Is there a song, preferably by The Clash, that characterizes JPMorgan's recent entanglements with the Justice Department?

There is.

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Ezra Klein · November 19, 2013