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Will JPMorgan take a "big bath" on the London Whale?

June 19, 2012: 10:52 AM ET

JPMorgan has a lot of leeway when reporting its recent trading losses.

JPMorgan CEO Jamie Dimon

JPMorgan CEO Jamie Dimon

Fortune -- JPMorgan Chase (JPM) could be headed for the tub. Some are wondering if the bank could take a so-called big bath - an accounting term for exaggerating losses in order to benefit later - on the London Whale's trading red ink.

Jamie Dimon is testifying in front of Congress again on Tuesday, this time for the House Financial Services Committee, about how a unit of his bank that is charged with risk management was able to lose $2 billion in a little over a month.

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As with last week's hearing, JPMorgan's CEO is not likely to say more about how big the loss could get - though many think it has mushroomed. The question is whether JPMorgan will choose to be conservative when it reports its second quarter earnings about a month from now and say the trading loss could end up being large or instead try to make the red ink in the chief investment office, which is where the London Whale works, look as small as possible.

Banks have a certain amount of leeway when reporting trading results. They are supposed to use so-called mark-to-market accounting, under which they would value all stocks, bonds and derivatives at current market prices. The problem is that some investments don't trade regularly. In those instances, banks can use their own judgment. JPMorgan's losing trades were reportedly in complex, illiquid derivatives, so Dimon could easily defend a more flexible approach to assigning value.

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There might be an advantage for JPMorgan to make the trading losses look as big as possible, taking a so-called big bath. JPMorgan has a history of being conservative about losses. For instance, JPMorgan has recorded losses on its books on some delinquent mortgage loans that are backed by government guarantees, even though it's almost certain to get its money back on those loans from Uncle Sam. Other banks have not taken a loss on similar loans.

If JPMorgan were to take a conservative estimate on the London Whale's trades, recording the high-end of the range of what the misstep could cost the bank, JPMorgan could get an earnings boost later if the trades don't turn out to be as disastrous as the bank predicts. Indeed, Dimon has surprised some people about how vocal he has been about the trading losses. Some have questioned why he didn't try to bury the losses from the start.

Nonetheless, JPMorgan has a number of different levers it could pull if it wants to make the loss as small as possible. Last week, Dimon said that the bank's chief investment office has $7 billion in unrealized gains in its portfolio. The bank could sell off some of those profitable positions to limit the losses in its CIO unit. A smaller than expected overall loss in that unit could quell some fears about the CIO office, which is likely to be under intense focus from analysts, investors and regulators for some time.

MORE: How JPMorgan made its multi-billion dollar blunder

"JPMorgan always finds a way to manage their earnings to get a relatively positive result," says Richard Bove, an analyst at Rochdale Securities. "There are multiple sources of income they could use to blunt the losses."

A number of analysts have taken the stance that JPMorgan's trading loss could be larger than expected. Morgan Stanley bank analyst Betsy Graseck recently estimated the hit from the London Whale to be as large as $7 billion. The bank will report quarterly results next month, and analysts are predicting JPMorgan will earn $0.86 a share in the second quarter, or roughly $3.3 billion. That's down from an estimate of $1.24 a share, or $4.7 billion before the London Whale's losses were announced.

But during that time the outlook for Europe and the U.S. economy has worsened as well, potentially contributing to the lower expectations for JPMorgan's earnings. Bank analyst Andrew Marquardt of Evercore says JPMorgan has yet to release enough information about the exact London Whale trades to make an estimate of how large the losses are. "It's complete speculation," he says.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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