Wednesday, May 22, 2013

Dimon Unchained: Vive Le Roi Soleil!

Since the financial press headlines have trivialized the whole issue of splitting the roles of CEO and board Chair at J.P. Morgan Chase, I felt that I should jump on that bandwagon with a similar headline.  A newspaper with a financial and economic flavor like the Wall Street Journal trumpets, "Dimon Undaunted." 

We learn from the Journal, " shareholders value returns on their investment more than they do making political statements." I'm not sure how what the vote means, but this interpretation of the results, were it valid, casts shareholders as a trend following, lazy lot who can't distinguish among, risk, reward and luck. 

Twelve months-to date, according to Charles Schwab, Financials are up 41.7%.  159 Capital Markets companies are up 59.8%.  Even 59 boring Insurance companies rose 39.5% over the twelve months. 

Schwab classifies JPM in "Diversified Financial Services,"  and this sub-sector of Financials rose 81.7% over the twelve months-to date.  The leaders are, of course, Bank of America (up 93%) and Citigroup (up 92%) with J.P. Morgan Chase rising 56% over the same period.  Bank of America and Citigroup are not without their significant issues, including, for example, the Countrywide overhang, the inevitable cultural clash with the Thundering Herd, and a "bad bank" in Citi Holdings. 

The Standard and Poor's 500 over the same period is up less than 30%.  So, the famous dart throwing monkey, aiming at a Financials board would have most almost certainly outperformed the equity money managers' benchmark. 

Even though the broad sector called "Financials" did exceptionally well, much of the success was owed to something totally outside of management control, namely the unprecedented monetary policy of the Bernanke Fed.  Beyond that, the dynamics within commercial banks were different from those within, say, the reinsurers.  The latter benefited from something of a traditional underwriting cycle, when losses were attenuating, salespeople stopped chasing bad business, and premiums rose. 

The levels of risk among the sub-sectors and companies within the sub-sectors were all distinct, even while the sector's performance was uniformly superior.  Institutional investors and sell-side analysts should be sensitive to the different amounts of risk taken by the various companies to generate the earnings which account for some of the superior stock performance. 

Unfortunately, investors suddenly only seemed to care when things like the London Whale report came to light.  That report showed an organization like most Wall Street houses in every market cycle: traders acting on their own, maximizing the size of their books without worrying about the sign on the balance, and overseen by executives who were clueless and powerless to reign them in.  Everyone managed information upward, to the point where a CEO described legitimate concerns about systemic risk building up in the book as a "tempest in a teapot." 

Politicians are indeed ambulance chasers in our system.  But, there would be no ambulances to chase if boards and CEOs did their respective jobs, which are distinct and different. The board is responsible for the strategy, direction, and long-term risk management to ensure that the business lives forever; it appoints an executive management to create a business model that implements and sustains the growth of profits, which are either reinvested or distributed to shareholders in order to give them their required return.

These are two distinct, but inter-related missions.  The CEO and Chair of the board are intuitively not the same person.  No economic benefit can be attributed to this configuration; no governance benefit derives either. It is an "ego thing," i.e. the CEO expects it.

The Journal closes its article with this quote, "  We also hope he (Mr. Dimon) won't let the recent unpleasantness deter him from calling out Washington's blunders." 

We hope that he stops standing on a soap box, pronouncing on cosmic issues.  Instead, here's hoping that Mr. Dimon improves his board substantially, treats them less like mushrooms and a nuisance, and digs into hiring and overseeing a higher quality cadre of executives who are not afraid to tell him when the risk meter is flashing red. 

A final point we've made many times before.  Rakesh Khurana of the Harvard Business School wrote in 2006,
"Because the CEO market is not, in fact, operating like others, the presumption that it will produce efficient outcomes is unwarranted. The problem is not just one of excess pay. Flaws in the pay-setting arrangements for corporate leaders have produced arrangements that dilute or even distort incentives.."

A forthcoming book by Michael Dorff of Southwestern Law School comes at the same issues with a slightly less economic lens, but he makes similar points to those Professor Khurana and I have raised:
  • “If oil goes to $150 a barrel, is the CEO of Chevron a genius?” he asks. “When oil then falls from $150 to $100, does that make the CEO of Chevron an idiot?”
  • "How about when a CEO borrows billions — because the Federal Reserve is flooding the world with cheap dollars — and uses those funds for stock repurchase plans, or to pay higher dividends? Is that why CEOs are supposedly worth the millions that their shareholders end up paying them?"
  • “There are always outliers,” he concedes. “There are very salient examples, like Steve Jobs or Warren Buffett. You’d say those guys certainly matter, but, on average, CEOs don’t matter.”
Perhaps that's an oversimplification.  Vive Le Roi! 

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