Dick Kovacevich On TARP and the Financial Crisis

Dick Kovacevich, the retired Chairman and CEO of Wells Fargo & Company is one of the best chief executives of the hundreds I have met during my career in the capital markets, though I never covered banks.  I heard him tell the story of Norwest Bank for many years, and it was always the same message about the importance of the retail 'stores' and improving the number of relationships per customer. My savvy banking analyst colleague at Roulston and Company held him in the highest regard also, and he didn't hand out plaudits easily. Mr.Kovacevich's  pitch was a model of clarity, simplicity, and focused on a few core metrics. The ROA, with a modest degree of leverage and a portfolio of businesses including asset management, led to a superior ROE: it was beautiful and simple.

When he took on the famous "merger of equals" that was Norwest and Wells Fargo, Kovacevich really stepped on the hornets' nest, but he handled it with brass knuckles in a velvet glove.  Having seen him during a few pickup basketball games, he was unassuming and never drew attention to himself. As a board member at Fingerhut, I know that he was always prepared, engaged and focused on getting the company to do the right thing for all stakeholders; when he couldn't meet his own high standards any more, he left the board. It isn't any coincidence that WFC has been one of Berkshire Hathaway's core equity holdings for many years.  His piece in the current Cato Journal caught my attention, and whenever Dick Kovacevich talks about banking and financial services, it's compulsory listening for me.

In 2009, in the din of drums beating for more special Treasury/Fed/government rescue plans, we stood along side a relatively small minority writing about letting the capitalist mechanism of bank failure under existing mechanisms do its job, as it had done before.  This post, it turns out, is being re-read often today.

CEO Kovacevich was in Washington, D.C. for the 2006 Treasury TARP meeting.  He writes,

"I believed at that time, and I still believe today that forcing all banks to take TARP funds, even if they didn't want of need the funds, was one of the worst economic decisions in the history of the United States."

The Sins of the Few, Not of the Many

At some point, all banking crises have at their root, a crisis of confidence. TARP destroyed confidence in the banking system because the public concluded that all the TARP banks had to be in trouble, otherwise why would they have taken the government's money?   Kovacevich writes that "...isolated liquidity issues turned into a tsunami impacting all banks and industries."

Fewer than twenty financial institutions precipitated the crisis, in his opinion. Dick Kovacevich writes that "The housing crisis got as big as it did...only because of the existence of quasi-public/private entities such as Fannie and Freddie."

Meanwhile, of the twenty institutions he references, half were investment banks and half were commercial banks, roughly. Citi was a commercial bank acting more like an investment bank. Why, he asks, punish 6,000 commercial banks for the sins of a relative few?

Bear, Stearns, Merrill Lynch, Goldman Sachs, Morgan Stanley and others had liquidity crises. Their funding model where trillions in balance sheet assets were funded by short-term liabilities was toxic, just waiting for the music to stop when short-term funds couldn't be rolled over any more.

Abuse of the Term "Systemically Important."

After more than forty years in the banking business, Kovacevich writes,

"In my opinion, there was not any systemic reason to not let banks fail over this time."

Bear, Stearns which was half the size of Lehman Brothers should have been allowed to fail. Had this happened, he writes that Lehman's assets would have been sold as the BS workout would have provided market guideposts for bidders to price Lehman's assets. Under the secrecy of TARP, there was no transparency, and hence no confidence and hence the Treasury could talk about the lack of  bidders for all of Lehman, which is a red herring and disingenuous.

Regulatory Failure and Incompetence

One quarter after being forced to take TARP funds, Wells Fargo reported record earnings, the highest in the firm's 160 year history.  In less than one year, the TARP funds were paid back, along with $2.5 billion in bank interest cost of funds borrowed, and warrants required as part of the shotgun package for the unused and unwanted funds, were exercised in-the-money. 

When WFC stepped in to rescue Wachovia in the fall of 2008, it took about one week for WFC's auditors and examiners to conclude that expected losses and required litigation reserves would exceed existing reserves by more than $60 billion!  

How, the author writes, could have ongoing examinations by the Federal Reserve, Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation have failed to turn up this deficiency earlier?  

SEC oversight over the Financial Accounting Standards Board failed when it allowed FASB to impose mark-to-market requirements when markets had become frozen (i.e. failed) and unable to generate economically rational prices. All the market participants understood the market failure, but their opposition was cast politically as an aversion to regulation and financial discipline.  

The Fed's proprietary risk models overrode those used for the banks' own stress tests, and yet these models weren't shared with the member banks for comparison and testing.  The helter skelter regulatory regime required major banks to put forward profit and capital forecasts for the May-November 2009 in early 2009.  

The Fed's secret, proprietary risk models concluded that WFC's revenues would be 30% lower than WFC's own internal forecasts!  This kind of discrepancy should have set off alarm bells at the Fed, and making the models available for examination would have been the truly 'scientific' thing to do when confronted by an anomalous result like this.  Regulatory chutzpah, arrogance and incompetence fuelled by populist, anti-bank sentiments and by their highly paid outside consultants, ran high. 

Actual results for the forecast period were 2% above WFC's internal forecasts.

The Office of Thrift Supervision failed in its routine examination and regulation of Washington Mutual, Countrywide, IndyMac Bank, New Century, First Franklin, Option One, Fremont Financial and other sub-prime originators.  We have written about WAMU, Countrywide, IndyMac, and New Century in multiple posts.  Various reports by Special Masters/Examiners and others have made the egregious abuses available for anyone to see.

Things were dire at the massively mismanaged OTS, yet nobody was banned from their industry or prosecuted on the regulatory side. OTS was folded into the OCC: the regulatory apparatus wasn't held accountable or downsized, it just got swept under a rug with a new name.

A Simple Idea To Make Banks Stronger

Mr. Kovacevich notes that the total long-term debt of the bank and its bank holding company plus equity and reserves are broadly about 30% of assets, which should be more than sufficient to withstand even a black swan scenario. 

Debt holders, he rightly observes, contribute more capital and can impose more financial discipline than equity holders through either a bridge bank or through the bankruptcy mechanism.  If one felt that this cushion might not be adequate, the author says that an additional 5-10% holdback on uninsured deposits could be imposed; this proposal has been offered by many academic researchers on the banking system, such as Chicago Booth School of Business or the Columbia Business School. 

Dodd Frank Doesn't Make Our Banking System Better or Safer

25,000 pages of new law have not been translated into workable regulation even after more than four years after passage. Regulators have completed only about 52% of the 398 proposed new rules under Dodd Frank, according to the law firm of Davis, Polk. 

More than 100 highly trained and paid regulators office at, or work full time on the specific accounts of the largest banks on a routine basis.  

Fannie and Freddie are still around, not being wound down.  They have once again received the charter, just before the election cycles, to turn on the spigots and make home ownership accessible to all.  Have we learned anything?  No, but that's not the point in politics. 

I'll be posting on a fascinating book by Charles Calomiris (Columbia Business School) and Stephen Haber (Hoover Institution at Stanford University), "Fragile by Design."  It is a must read for any students of money, banking, financial economics and regulation.  

Bank of America, Agency Problems and Selective Blindness in Our Judicial System

We wrote a widely read post about Bank of America's $40 billion mistake in acquiring Countrywide Financial back in 2012, which we link here for context.

The government's 2012 complaint in Federal Court (Southern District) makes interesting reading also for context to the current settlement debates.  According the Feds, Countrywide engaged in a scheme to defraud FNMA and FHLMC, and as a consequence the GSEs suffered more than a billion dollars in unreimbursed losses.

The story picks up, for some reason, in 2007 when Countrywide's originations had fallen from $490 billion in 2005, to $450 billion in 2006 to $408 billion in 2007.  A very superficial discussion of the monthly loan performance monitoring program required of the originators by the GSEs begs a very important question. Surely, delinquent or non-performing loans (here referred to as loans with 'defects') would have been evident from the 2005 vintage long before 2007.  There are mechanisms for dealing with these problems from the GSE perspective, including putting the loans back to the originators.  One would also think that reimbursement or compensation provisions would have been part of normal securitization agreements.  None of this is even mentioned in passing.

As we have said before, agency problems for Countrywide shareholders existed writ large because of the behavior of CEO Angelo Mozillo's outlandish behavior, which has been covered widely in the press. His compensation, bonuses and option grants were conditioned on the volume of originations, even if they were subprime 'stated income,' 'liar loans,' or 'NINJA loans.'

Mozillo, in turn, created compensation opportunities for Franklin Raines, who eventually relinquished $24.7 million of ill-gotten stock options gains from a reported six year earnings manipulation scheme, over which his gains would have surely been greater than $24.7 million. Mr. Raines never felt the heat and wrath of Federal prosecutors, rather his slap on the wrist came from another Federal oversight agency. Why wouldn't the full force of our justice system fall on two kingpins of this mess?  Justice for friends is different from justice for those deep pocketed corporations, who are giving up shareholders' money in the end.

In the government's complaint against Bank of America, there are a few selected quotes from the former CEO and from the current CEO which should arose the ire of BAC shareholders.

"We did extensive due diligence...It was the most extensive due diligence we (Bank of America) have ever done.  So we feel comfortable with the valuation.."  Former CEO Ken Lewis.

"....we will pay for all the things that Countrywide did."  Loose language from current CEO Brian Moynihan.
Fast forward to the recent imposition of fines by U.S. District Judge Jed Rakoff.  As one reads through the 19 page opinion, the judge's conception of gross versus net losses and his infantile examples seem to challenge the usual shibboleth that Federal court judges are more capable of understanding complex financial issues. Recent problems arising in the interpretation of potential sovereign defaults by Argentina raise similar issues.

The total value of 17,611 loans issued by the HSSL loan mechanism of Countrywide amounted to $2, 960,737,608.  But, 57% of these loans were, in the opinion of the government's 'expert' not in fact bad apples.  So the final penalty imposed was 43% of the maximum, or $1,267,491,770.  The wisdom of Solomon!

As Harry Truman said, "The buck stops here."  Well, what about the higher ups who sanctioned all ludicrous, uncontrolled financial malfeasance at their institutions?  According to Judge Rakoff, "....the fact that other, higher-level individuals arguably participated in the fraud but were, for whatever reason, not charged by the government..." doesn't rise to the level of this judge's scrutiny.

Instead, he lays liability at the foot of Rebecca Mairone, a Countrywide executive, who took the actions necessary to perpetuate the fraud described in the complaint.  Was she a lone, rogue agent?  Not hardly. Her crime seems to be having given "implausible testimony."  Judge Rakoff is given to pats on the back and slaps in his opinion. Attorneys on both sides are described as "excellent" (from Wayne's World?) and "superb."  Ms. Mairone apparently wasn't well coached by her excellent attorney to not give implausible testimony.  The jury in fact asked Judge Rakoff why the higher ups weren't being brought up on charges. They got the answer quoted above.

Finally, we are left with Bank of America, which recently reported results. Earnings were a bit better than expected, analysts claim because of expense controls, better than expected trading revenues, and lower provisioning, offset by much higher than expected legal expenses.  Revenues from the core banking businesses were, however, disappointing.  I wonder what will drive 2014 incentive compensation for the executive team?  Based on current expectations, BAC looks fully valued, but longer term its future growth, if it can ever put Countrywide issues behind it, still remains in question.

Our Biggest Banks Are A Mixed Bag

Our March post on the Fed stress tests on our "Four Horsemen" of banking seems like a good background for discussing the first quarter's results for Bank of America, JP Morgan Chase, Wells Fargo and Citigroup.

Bank of America had a lackluster quarter with the biggest surprise being its $6 billion in litigation expense five years into the purported economic recovery.  Analysts concluded that litigation expense was impossible to model, especially given the Catch-22 of the company's not wanting to tip its hand to the plaintiff's bar about how much goodies the legal reserve cookie jar held.  The acquisition of Countrywide Financial continues to plague this company, and no one is in jail.

The return on equity was a paltry 4.6%.  Yet, the P/E is the highest among JPM, BAC, and WFC.  Merrill Lynch may eventually be passed for the most AUM by Morgan Stanley Wealth Management, and it's unclear what synergy the Thundering Herd gets from association with Bank of America.

We've said for a long time that the biggest problem at JP Morgan Chase was not size but complexity.  We characterized this leviathan as "Too Complex To Manage," even for the loquacious, highly numerate, quick witted Jamie Dimon, as the London Whale episode pointed out.  His lieutenants, through all the musical chairs, have not served him well. As time has gone on, our faith in the TCTM thesis is stronger than ever, no matter what any cyclical improvement over trashy quarters might suggest.

The number driven, traditional banker's philosophy that Jamie Dimon brought to Bank One was one of the reasons for its success, plus it was already a well established, high quality name before he became CEO. JP Morgan Chase is a completely different animal, crafted by putting together one of the premier investment banks in the history of American finance with a badly managed Chase Manhattan, a well managed Bank One and many other acquisitions which all together result in the beast that is now a collection of very large fiefdoms.

The management should clean up the portfolio and structure before multiple regulators so something more damaging to shareholders. Average loan balances fell across all market segments, and mortgage originations fell by 68% over the TTM.

Wells Fargo's performance was the best overall in the quarter with its 17th consecutive quarter of earnings growth (+14%) and its dividend increase of 17%, without any surprise in its capital plans with the Fed. It continued with its share repurchases as well.

Deposits grew by 8%, a very healthy number in this environment. Net charge offs were 0.41% of average loans in the quarter and they were down 42% year-over-year.  ROA was a healthy 1.57%, up 76 basis points, and ROE was 14.35%.

The company has quietly moved its institutional and high net worth asset management businesses upstream to customers with significantly higher minimums, and in some areas like stable value the Galliard Capital subsidiary will end the quarter with assets over $100 billion.

The one thing missing from WFC which JPM and C have is significant international exposure.

Which brings us to Citi.  This is still the biggest rabbit warren. It is a structurally messy, grossly under managed managed bank, but the problem didn't originate with Vikram Pandit or even with Charles Prince.  It goes right back to the Sandy Weill-John Reed fractured relationship over decades ago.  Citi, however, has the potentially most valuable future franchises in Asia and Latin America.  It must escape its legacy of Citi Holdings and somehow craft a rational organizational structure and a responsible culture, which it sorely lacks.  It has no Jamie Dimon or John Stumpf.  It could use some activist investors to help whip itself into shape.

The Yellen Fed Doesn't Sound Like A Central Bank

Too much was made over the choice of successor to former Fed Chairman Bernanke.  Making the choice a political or gender equity issue would not have been a good thing, and it seemed logical that someone who had been a longstanding partner to Bernanke would assure continuity, thereby assuaging nervous markets.

Unfortunately, the early "communications" issues have unsettled even the most experienced Fed watchers I know and respect. John Cochrane, AQR Professor of Finance at Chicago Booth School of Business, has identified the underlying problem as being that central banking globally has morphed into something that it is not, claiming powers that it does not have.

That was made manifest recently, in Fed Chair Yellen's public pronouncement about the Fed focusing its policies on labor markets and unemployment.

Given that macroeconomic models don't incorporate any kind of realistic financial sector, and given our very weak recovery, in its fifth year, had its origins in the financial sector and asset markets, no responsible economist could claim that the Fed has the understanding or tools to address failures and frictions in the labor market.

As we've written about many times, unconventional monetary policies such as quantitative easing and unbounded periods of low interest rates have have essentially done nothing for the economy, as evidenced by the unemployment rates.  Again, as we warned from the outset, these novel constructions would have unintended consequences given our lack of experience with their mechanism of action.

Former BIS Economic Adviser William White's paper, which we've cited before, is still worth reading. Focusing on the shadow banking system, he cites research suggesting the shadow banking system was procyclical in the credit upturn, which seems well agreed upon; he also suggests that it may be procyclical in the credit downturn, which is debated.  In a simple model, he shows that the behavior of this sector and our financial sector as a whole, may be a powerful mechanism for increasing inequality of both income and wealth.

Right now, we have a disconnect between expectations for what central banks can achieve (remember Mario Draghi?) and what they really can do.  Dodd-Frank has made the Fed the de facto Regulator-in-Chief of the financial sector, and the guardian of asset prices, housing prices, and architect of financial stability.  To this we are adding labor markets and unemployment.

We've written before that one of the greatest strategic blunders made by the Bernanke Fed was to effectively become an enabler for fiscal profligacy by his employers in the White House and Senate.  The role of the Fed Chair historically was more 'big picture' focusing on rates, inflation, and the currency.  This is a massive agenda in itself, but the Fed was never to be the engineer of policy.  It provided the backdrop for markets to set the term structure of rates and for the economy to move forward with real economic growth.

When warranted, the Fed Chair would call for fiscal responsibility from the executive and legislative branches, and sometimes the Chair would have to 'lean against the wind,' even if only rhetorically.  That's because the Fed was always independent of elections, politics, and of the noisy public square, including Wall Street.

Today, the Fed no longer makes any call for responsible fiscal policy, and now it is firmly in the camp of perpetuating the current status quo of discretion based, as opposed to rules based policies, which is disquieting to experienced Fed watchers who could always infer a path from Taylor Rules and the like. Now, all bets are off. So, financial markets continue to soar, our inflation rate is minimal, corporate profits are up, and the bubbles continue in corporate assets (companies) fueled by large appetites for investment grade corporate debt.

Meanwhile, the traditional financial sector, namely the six mega-banks are effectively becoming ensconced as the heart of our financial system, with no effective competition.  We still don't know what systemically important means, as we randomly suggest that it applies to insurers like Met Life and to asset managers.

Because of the cynical way in which Dodd-Frank was passed, the regulations that will be at the heart of the future evolution of the system and the source of shocks, are being written away from the eyes of the electorate by anonymous lawyers and policy wonks, all aided and abetted by their favored activists and lobbyists.

The final problem facing central bankers is the IMF's incessant clarion call for national central banks to make their decisions in "a global framework."  This sounds like an innocuous platitude, leading to many meetings at tony locations with lots of papers and meaningless declarations. John Cochrane adds that the real motive may be to pool together all the lenders of last resort and to spread the costs of carrying the weaker players among the stronger players. Our Federal Reserve and the taxpayers certainly doesn't need to take on that burden too.

Central bankers need to be independent of politicians and of Wall Street gunslingers, and their measured, predictable tweaks to the economic engine which enhance growth, moderate cycles and preserve the value of the currency are their most valuable contribution to Main Street.

The Fed's Stress Test Gives Citi Heartburn

We were in the minority when Citicorp removed Vikram Pandit from the CEO position and replaced him with Michael Corbat.  There were loud huzzahs from many quarters, from Sheila Bair to the financial press. Things were going to move much faster now, the chorus said, and shareholders would be rewarded handsomely; the stock did extremely well, but today the Fed took the wind out of Citi's sails by both announcing that it had failed its 2014 Comprehensive Capital Analysis.

Analysts' euphoria has reached such ridiculous heights that the WSJ reports analysts expected Citi to raise its dividend from $0.04 per share to $0.53 a share.  Analysts have been known to access controlled substances from time to time, but it would also seem that they were probably pointed to this kind of increase by  naive management guidance.

The bizarre thing about the CCA, is that Citi passed the quantitative portions of the test.  Consider this,

"Therefore, even if the supervisory test for a given BHC results in a post-stress Tier I common ratio exceeding 5 percent and post-stress regulatory capital ratios above the minimum requirements, the Federal Reserve could object to that BHC's capital plan based on qualitative assessment of the practices supporting its capital planning."

Now the problem is that the Federal Reserve has become another reviewer of Sarbanes-Oxley.  Consider this quote from the 2013 auditor opinion letter on Citi's financial statements on Form 10-K.

"We (KPMG) also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Citigroup’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control-Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 3, 2014 expressed an unqualified opinion on the effectiveness of the Company’s internal control over
financial reporting."

But if the Fed, using another set of arbitrary standards, opines that the capital planning process is inadequately supported by reliable practices, then this inadequacy must be reflected in the financial statements.  But, surely the auditors must have gone into more detail than the Federal Reserve?  Something has gone seriously wrong with the CCA process.

Let's be clear that nobody is a hero in this episode.  CEO Corbat deserves a reprimand from the board for allowing his company to be blindsided by its principal regulator. His job was to be far out ahead of this process and to make any changes necessary to achieve the corporate goal of passing both the quantitative and qualitative tests. Former CEO Pandit was said to be "prickly," but CEO Corbat seems inept in dealing with the arbitrary Fed framework. Also, his aggressive plans for capital return to shareholders were premature and unwarranted.

Mr. Corbat, in turn, should probably quite a few changes to his financial organization's senior ranks, and for that matter, to his board.  Why? There is no excuse for not being able to run a stress test, which is not new, to the Fed's specifications.

KPMG should also take some accountability, or they should explain to regulators that they stand behind their assessment of the banks's internal controls, on which they rendered an unqualified opinion.

Remember, finally, in the Fed's recently released FOMC minutes archive the discussion revealing that the Federal Reserve couldn't even figure out that IndyMac was failing even when mortgage brokers and most of the industry knew it months before.

The Federal Reserve didn't adequately audit its member banks in the past, and that is plain even for its staunchest apologists. However, now it seems to have gone too far in setting standards and seemingly not applying them consistently, while also treading upon regulatory oversight of other organizations, like the SEC.

Mamma Mia! UniCredit's Fourth Quarter Loss at €15 billion.

We started watching UniCredit in 2012 when its rights offering was greeted less than enthusiastically by equity investors.  Their slide presentation on Q4 FY13 is fairly confusing, as it tries to weave in extraordinarily bad news with the good news to come from the strategic plan out to 2018. A reeling shareholder probably needs to get his feet on the ground first as to where the bank is today, and that is not clear.

For Q4, UniCredit reported a net loss of €15 billion ($20.8 bn), and a full year FY13 loss of €14 billion, which is the fifth biggest loss reported by a European bank since 2005, according to the Wall Street Journal.

The fourth quarter LLP was €9,337 million compared to a provision of €4,516 million in Q4 FY12, an increase of 107%. For the full year, the LLP was €13,658 million, a 47% increase over the prior year.  €6.8 billion in the fourth quarter provision was attributable to Western Europe, of which €5.4 billion came from Commercial Bank of Italy and €1 billion  from Corporate assets.

The company also wrote off €9,368 million in goodwill, covering €8 billion from acquired assets and €1.3 billion from the impaired value of customer relationships.  Operations in Poland, Austria and Germany seem to be good businesses, and deposit gathering in Poland was strong in the quarter, but there is little goodwill left in these operations.

There was a €1.4 billion pre-tax gain from a revaluation of a 22% stake in the Bank of Italy, among the non-recurring items.

Non-performing loan coverage increased from 54.9% in the third quarter to 63.1% in the fourth quarter. Overall, the gross impaired loan portfolio stands at €2.1 billion, and the charge off rate was steady between the first and second halves of 2013.  It's not easy to glean confidence about the asset quality going forward or about the new management's ability to get out ahead of any problems.

On the cost reduction side, 8,455 full time equivalent employees will leave by 2018, with 5,700 of them in Italy and most of these losses coming from the Commercial Bank of Italy operation.

Group revenue increased 6%, as UniCredit's trading operations and presence in syndicated loan markets is still strong. Most of the one-time items were non-cash impacts, and the company's massive additions to provisions were neutral for Basel III capital tests.  The stock price went up after the announcement.

Some U.S. value fund managers who got into UniCredit early have been burned and left.  Some others, like Oakmark, have continued to hold positions in Intesa Sanpaolo, an Italian retail and commercial bank, which had strong fourth quarter 2013 share price performance.

With UniCredit, the value of the equity is a bit opaque. In some ways, it is analagous to Bank of America's position a few years ago.  On the credit side, however, KKR has become engaged with the new management, and this may be the better play in the short-term.

Banks and Regulators Break Faith With Consumers

Bank managements have put their institutions down a path away from their traditional mission, namely to take in deposits and, acting as intermediaries, to transform this base into consumer and commercial loans, using a modest amount of leverage. Financial intermediation and maturity transformation were the bread and butter of the banking model.

Having sat at the side of a respected banking analyst for many years, I was troubled by the increasing number of bank CEOs who trumpeted the growing importance of fee income, as opposed to net interest income, in their revenue lines.  Next, came the move to get into all sorts of other businesses, like asset management, mortgage lending, investment banking, trading, and unsecured lending, or credit cards. Consolidation, driven by changes in banking laws, was the next step.

Soon, consumers were faced with fewer choices for their banking needs.  Finally, the current financial crisis made the U.S. consumer banking  highly concentrated.  The top ten banks hold about a 50% share of deposits, according to the FDIC. The extensive network of community banks, your friendly neighborhood banker like Jimmy Stewart, can't really compete with their 20-30 bp cost of funding disadvantage compared to the larger banks.

After the latest financial crisis, with the advent of regulatory schemes advocating for bigger layers of equity and higher capital reserves, regulators are making the traditional bank model even more unattractive than ever.

The upshot of all this?  According to the WSJ, 80% of  U.S. financial institutions offered free checking accounts as recently as 2008, but the number is down to 59% now.  What this number doesn't highlight is that the biggest banks have abandoned this model almost completely, even for their better customers as everyone migrates into an asset gathering model, as opposed to a banking services model.

Credit unions and community banks which should really be havens for new immigrants to begin building their financial relationships are increasingly marginalized, and so piranhas like the pay day lenders and all other forms of predatory financing are flourishing among a vulnerable population.

All these regulators looking backward at yesterday's problems have created incentives for rational bank CEOs to walk away from their primary mission as bank charter holders, viz. to serve consumers and small business customers with affordable, high quality financial services while earning attractive, but not outlandish, returns on equity.

Jamie Dimon Comment on Share Buybacks

Looking back at my notes on JP Morgan's earnings call, I forgot to recount a somewhat offhanded comment the CEOmad  to a multi-part question from an analyst.  The analyst recounted  how much stock the company had bought back year-to-date, and  he asked whether or not the company would complete the current authorization in a big chunk.  It was an incredibly stupid question, but it elicited an interesting response.

CEO Dimon said something like this paraphrase, "When the stock was in the thirties, it was a once in a lifetime value.  We don't buy back shares just for the sake of doing it.....with the stock where it is now....(trails off)"

This is spoken like a CEO who understands the difference between price and value.  The big technology companies historically like buying shares like automatons.  I give the CEO kudos for saying something his mega-cap CEO peers should understand better.

JP Morgan Looks Like It's Positioned Well

Let's think back to the beginning of Bob Paulson's plan to save the global banking sector from itself, when the nine CEOs were invited to sign the famous one page deal injecting $250 billion of taxpayer money into their banks. On top of that, Wells absorbed Wachovia, JP Morgan absorbed WAMU, and Bank of America absorbed Merrill Lynch.  WWE-style chest thumping and outrage was shown by most of the participants, except by JP Morgan CEO Jamie Dimon, according to the newspaper. He apparently did the cost of capital calculation in his head and saw the Feds as a cheap source of funds.

Fast forward and we've concluded with the Feds now raiding the JP Morgan treasury for some $30 billion in fines for originating and selling bad mortgages to the GSEs and for not blowing the whistle on the Madoff Ponzi scheme.

So the fourth quarter of 2013 capped a pretty miserable year compared to 2012, but the fourth quarter showed all the signs of the bank being well positioned for an improving U.S. and global economy and for the concomitant steepening of the yield curve.

On a managed basis, 2013 corporate revenue of $99.8 billion was flat with 2012 revenue.  Reported, diluted EPS of $1.30 was down compared to $1.39 in the prior year, on the same basis.  However, excluding extraordinary items, 2013 diluted EPS was $1.40.  During this long waiting period for the economy to show a lasting rebound, banks like Morgan and Wells have been pulling out all the stops to generate some semblance of earnings stability.  JP Morgan has taken allowances into income in prior quarters, to the consternation of some analysts, but based on some of the underlying trends in credit cards, business loans, mortgages and deposits, the turn may be coming.

JP Morgan's efforts to position the bank for an economic rebound look like they've put the bank in a strong position,

JP Morgan's Consumer and Community Banking business now serves 43% of U.S. households, and its increased penetration has most certainly been helped by the acquisition and build-out of the old Washington Mutual branches.  What seemed like poison at the time may turn out to be honey for the shareholders. The base of 5,600 or so branches will not be expanded in the near-term as much as it will be reshaped and optimized for better productivity.

The CaCB business grew deposits in the fourth quarter of 2013 to $461 billion compared to $426 billion in the prior-year period, a solid 8% increase.  Allowances for loan losses, non-performing assets, and the net charge-off rates are all down year-over-year in the quarter, and its looks like the charge-off rates are near historic lows.

Fourth quarter 2013 provision for credit losses was $72 million, compared to $1.1 billion in the fourth quarter of 2012, a decline of 93%; the full year provision for Consumer and Community Banking declined similarly to $335 million compared to $3.8 billion in 2012.

The Mortgage Banking business, to no one's surprise, fell out of bed.  Full year 2013 net revenue of $10 billion was down 28% from 2012 revenue of $14 billion.  Provisions for credit losses benefited 2013 pre-tax income by $2.7 billion compared to a benefit of $0.5 billion in 2012. Non-interest expense declined 17% for the full year, driven by the large headcount reductions. Net income of $3.1 billion declined only 8% in 2013, year-over-year.

Mortgage production revenue was down 78% in the fourth quarter, and 54% for 2013, yielding $2.7 billion in production revenue.  According to a slide in a recent analyst presentation deck, the current mortgage underwriting standards look pretty strict, with average FICO scores of around 750+.

The credit card, merchant services and auto businesses had good solid quarters, and delinquencies on the card portfolio have been on a ski slope downward and the portfolio has been cleaned up.

A slide talking about earnings sensitivity to a rising rate environment back in June 2013 modeled earnings gains of $2.1 billion and $3.8 billion, respectively, from a 100 basis point and 200 basis point parallel shift in the yield curve.

The investment bank made gains in various underwriting segments, and the compensation levels ended the year so as to give opportunity should the global IPO and acquisitions cycles continue to heat up.

The one truly eye-watering item was the prevalence and magnitude of the legal expenses all over the financial statements.  The "Other Expense" category for 2013 showed expense of $19,761 million compared to $14,032 million in 2012.  Of these amounts, legal expenses comprised $11 billion (56%) in 2013 and $5 billion (36%) in 2012.

Legal expenses are also buried in some of the mortgage production operation results.  I couldn't follow the CFO's rapid fire presentation about reserves for litigation, but it sounded like large amounts. Because she is a British physics major by training, she has real command of numbers and of the Basel and mark-to-market modelling issues.  The speed of her delivery made me think of the classic Fed Ex commercials.

The Chrysler UAW Bailout

The auto industry bailouts during the financial crisis completely overturned our traditional legal statutes governing how creditors are treated during bankruptcies. With today's announcement that Fiat is buying out the 41.5% of Chrysler which it does not already own, these issues are as evident as ever.

A 2012 Backgrounder from the Heritage Foundation gives good information and references which are very consistent with the most recent October 2013 report from the SIGTARP Inspector General.

Chrysler has been mismanaged for many decades, and it has had several turnarounds.  None of them ever really addressed their operational and product development mismanagement, or their labor costs which were among the highest in the American automobile market.  Pre-bankruptcy labor costs at Chrysler were $76 per hour in May 2012, higher than both GM and Ford at the time and significantly higher than costs at Honda, Toyota and Nissan.

Pre-bankruptcy, Chrysler has $6.9 billion of senior secured liabilities and $2.9 billion of junior secured liabilities, according to the figures in the report.  $5 billion was owed to unsecured trade creditors.  Chrysler owed $8 billion to the VEBA (Voluntary Employee Beneficiary Association) formed in 2007 to assume the liabilities of the employee retirement plans.

Bankruptcy allows the corporation to restructure its contracts, subject to two heretofore inviolable principles. Secured creditors stand first in line for recoveries, including the ability to seize encumbered assets if necessary.  Unsecured creditors are considered the great unwashed, and they are traditionally wiped out or in unusual circumstances get pennies on the dollar as recoveries.

Because of Chrysler's long, troubled financial history its bonds were secured debt, which wasn't typically the case.  Senior secured creditors of Chrysler who were owed $6.9 billion recovered $2 billion, or $0.29 on the dollar.  The junior secured creditors somehow recovered $0.0 on $2 billion owed.

In this kind of structure,  which is very unusual, the unsecured creditors, including the UAW/VEBA, should have expected nothing except to be wiped out. Instead, the Obama administration converted the $8 billion into a 41.5% stake in the reorganized Chrysler, along with a 9% note.  The total 2012 PV of the Chrysler bailout, which only benefited the UAW and its membership, was estimated at $9.2 billion in the report cited.

Labor agreements and labor costs are traditionally renounced and reset in bankruptcy agreements.  While labor costs were adjusted to close the nominal gap to Honda/Toyota/Nissan to around $56 per hour, Chrysler workers will still earn substantially more than the average U.S. manufacturing sector worker, with no ties to productivity or work rule flexibility.

The exercise of Federal control and intervention in financial markets and in matters like executive compensation of corporations in which it has bought a stake at gunpoint will surely be regarded as a weakening of our economic system whose virtues we trumpet so loudly.  The government's facilitating of rent seeking by its favored political constituencies, like auto unions, is also an unprecedented manipulation of the bankruptcy process in which the role of the judges and administrative apparatus have also been marginalized. "If there's money up for grabs, I might as well be the one grabbing," a client once told me. He was a greenmailer, but his motto is still relevant today.

Feds Continue To Pick the Pockets of JPM Shareholders

Going back to JP Morgan's own internal report on the "London Whale," everything is there for an interested party to see. The need to fix the way JPM goes about its businesses was lost in a referendum on CEO Jamie Dimon keeping his Chairman of the Board position. Now as the Feds grab another $11 billion from the shareholders, it is once again open season on a celebrity bank CEO.  This is ridiculous and more befitting a reality television show than talking about the management of one of our largest banks.

Let's try to put some things in context.

Over the past five years, eyeballing raw charts from Schwab, JP Morgan's stock is up about 30%, which looks slightly better than Wells Fargo's rise of about 23%.  The big losers are Bank of America (-40%) and Citigroup (-70%).  Here's what Andew Ross Sorkin wrote in the print edition of the New York Times,

"When I called Dennis Kelleher, president of Better Markets, a nonprofit Wall Street watchdog (he was playing golf when I reached him), he put it this way: "By any objective measure, Jamie Dimon should be fired. The compliance failures are egregious and systemic."   

What objective measures are those?  Everyone of the big four banks are digging out from under the mortgage mess, and if WFC is now considered a darling of the sector, JPM's performance has been on a par or better.  This is a ridiculous suggestion, and shareholders see it differently.

However, the age old question about having a global investment bank together with a global commercial bank and a global asset manager is an appropriate question to ask.  Not necessarily because of "systemic risk," since nobody can really define what this means, but because the cultures of these businesses are distinctly different and they are operationally impossible to manage effectively together.  [on the issue of not being able to define systemic risk, see NBER  working paper 185 (2012) from Nobel Laureate economist Lars Peter Hansen].   The London Whale report makes it clear that layers of executives and multiple complex regulatory schemes cannot inoculate shareholders from outsize trading losses.  It's happened in the past, from the beginning of mortgage backed asset trading, and it will happen again in some market.

What's to be done?  Split up commercial banking and investment banking, at a minimum.  However, the Volcker Rule is eons from implementation, so this is tilting at windmills.  It is interesting to note that Warren Buffett likes commercial banking and asset management, and he owns both these businesses through his investment in Wells Fargo.  He also likes global investment banking because of his investment in Goldman Sachs.  He could have bought a financial supermarket through Citigroup, Bank of America, or JP Morgan Chase, but he didn't.  Instead, he bought what he regarded as best in breed for each business in the public market.  JP Morgan's board should think about this, after all there's always something to be learned from Mr. Buffett's investment behavior.



For JP Morgan shareholders, they should think about a few things:

• Strengthening the board and making it more than a rubber stamp.  Bring some people in to help in the real areas of weakness, like risk management. Comments about the board's failure to monitor their own systems of internal control and to align compensations structures with governance are right on the money.  What's in place for a company of this size and complexity has been shown to be woefully inadequate. 
• Think about the continuing legal settlements and the implications for future liability.  $11 billion for acquired mortgages in a shotgun acquisition at the behest of the Feds themselves?  How could the board have signed off on this?   Bank of America CEO Brian Moynihan seems to have a better handle on managing this issue than does JP Morgan; have a board member give him a call and compare notes. 
• Look at the whole mortgage business itself.  The originate-to-distribute model and the structure of MBS deals needs to be reset.  Wells Fargo seems to be tuning down its mortgage engine.  The servicers effectively hung their clients out to dry and have escaped unfazed.  Does the board understand how this business operates?  
• Assign a team from the CFO's office to help the board manage the legal bills.  An $8 billion quarterly bill?  I used a blended bill rate of $1,000 an hour, assumed minimal sleep for all, and the number of people involved in a quarter is nonsensical.  Next time, admit nothing, put up no resistance, and offer to pay $8 billion on the spot; you're $3 billion to the better and the Feds are better off, since their costs are largely fixed. 
• Pick a lead director to interact with the CEO on a weekly basis.  This is to make sure that he has someone to talk to besides his self-interested lieutenants, who clearly let him down during the trading crisis.
• Think about a different corporate structure, portfolio and business model for JPM.  Value is being destroyed on a large scale with the current model. 

JP Morgan New Narrative: Shareholders Are Victims!

We are a nation of self-anointed victims. Victimhood extends both across our population demographic and up and down our economic demographic to include institutional shareholders of JP Morgan Chase, according to the New York Times and to Professor John Coffee of the Columbia Law School.  He should know better, but here's a quote:

“It is perversely inappropriate. You are adding injury to injury. All we’re doing is punishing the shareholders more,” said John C. Coffee Jr., a professor of securities law at Columbia Law School. “This is a case where the victims are the shareholders.”

These remarks were made as JPM paid $920 million to "settle" civil cases related to the London Whale fiasco.  This is just the beginning, as politically ambitious politicians, Federal prosecutors, and corporate governance activists jump on the bandwagon to feed at the trough filled with the shareholders' assets.

It's the fault of the shareholders, and they deserve nothing but what they get, which may not be too much of a penalty on the stock prices, since QE infinitum continues to expand forward multiples.  These same shareholders bought into the findings of the London Whale report without demanding any changes in the way this sprawling financial supermarket is managed.  They also chose not to split the Chairman and CEO roles, in a referendum on Jamie Dimon's popularity.  They also backed not penalizing or changing the structure of management compensation.  These folks are not victims but lazy and uninvolved in delving into their own investments beyond the newspaper and analyst reports, which might as well be newspaper reports.

Shareholders should not be rescued from their own lassitude.  They always had the opportunity to sell, and they must be copacetic with the management of their company.    Shareholders, in turn, don't refund any of their investment management fees for separate accounts or overpriced mutual funds due to their lack of diligence, so let's leave this narrative where it belongs, in the circular file.

Do Regulators Want To Run Their Supervised Banks?

A big story this week has been the Fed's current hobby horse, "Comprehensive Capital Analysis and Review ("CCAR") for the 18 largest Bank Holding Companies ("BHC") with assets of over $50 billion.  The Fed's March 2013 publication set the stage by redoing the stress tests done by each of the BHCs with an "interdisciplinary team" of Fed staffers who sound just like most corporate staffs, with the exception of not having bank auditors on the corporate teams.

In August, the Fed published "Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practice."  The large bank holding companies, as we've said before, have become too complex to manage, especially if we are looking to eliminate any possibility of a failure like the system wide crises of confidence and then liquidity which brought the global system into paralysis.

This document reads like a rehash of many reports on risk management, internal control, and corporate governance.  Have a look at the Report of the Committee of Sponsoring Organizations of the Treadway Commission from 2009, and the reader will see language, themes and recommendations which are reprised in the Fed's August volume.

Basically, the agenda seems to come down to this: the Fed doesn't want banks to consider returning capital to shareholders through dividends and buybacks without redoing their stress tests and then changing their return of capital plans to add a second significant digit (after the decimal) improvement to some capital ratios.

Here's a stirring sentence from the report's conclusion,

"The fundamental insight governing the Federal Reserve’s
expectations about capital planning is the importance
of having a forward-looking perspective on the risks
to a BHC’s capital resources under severely stressful
conditions."

We also learn, "These elements represent substantial conceptual and operational improvements in capital planning that go well beyond simple consideration of current and expected future capital ratios."  It's never clear at all what lies at the end of having gone "beyond."  A new set of indicators?  A digital dashboard of minute-by-minute risk indicators for every business, financial product, trading desk, currency, and country?  What would it all mean anyway?

We've often made reference to Andy Haldane's speech at the Kansas City Fed's Jackson Hole Meeting, "The Dog and The Frisbee."  In it he notes,

"It is close to impossible to determine with complete precision the size of the parameter space for a large  international bank’s banking book. That, by itself, is revealing. But a rough guess would put it at thousands, perhaps tens of thousands, of estimated and calibrated parameters. That is three, perhaps four, orders of magnitude greater than Basel I.   

If that sounds large, the parameter set for the trading book is almost certainly larger still. To give some  sense of scale, consider model-based estimates of portfolio Value at Risk (VaR), a commonly-used  technique for measuring risk and regulatory capital in the trading book. A large firm would typically have  several thousand risk factors in its VaR model. Estimating the covariance matrix for all of the risk factors means estimating several million individual risk parameters. Multiple pricing models are then typically used to map from these risk factors to the valuation of individual instruments, each with several estimated pricing parameters."

We haven't yet implemented Basel III, and now we are layering Dodd-Frank's evolving regulatory creosote on top of other complex, costly and ineffective frameworks.

The stories about traders dealing with marks on their trading books should tell a dispassionate observer the reality about how global international banks work, as opposed to the bureaucratic schema envisioned in the schemes of European, American, and other regulators. There is no single, infallible, scientifically correct number for the marked to market value of a trading book full of instruments with few buyers and sellers that trade by appointment.

So, some traders walked away from the midpoint of a spread convention.  A regulator would have acted differently.  So what?

Let's also not forget about the boards of directors of the largest bank holding companies. With all due respect, the membership of these corporate boards would never be willing or able to, for example, challenge management on the specifics of their scenario designs or on their methodologies for estimating credit loan losses.  Yet, the Fed report talks about these issues in bureaucratic abstraction as if their schemes can be actually implemented. They can't and they won't.  And, even if it were possible, there would probably be no net marginal benefit to shareholders.

By quoting Haldane's example, I am certainly not advocating the continuing or exclusive use of VaR models, but at least everyone has had some experience with these, for good and ill.

People who are really fluent with complex financial modelling, like Emanuel Derman know their limitations too. He writes,

"Derman, a professor at Columbia University and former head quant for Goldman Sachs, is outspoken on the limitations of modeling and the need for risk managers, along with CEOs, CFOs, financial engineers and traders, to keep their enthusiasm for modeling in check. “There isn’t a short cut or mechanical formula that will help you figure out the right price for a financial product,” said Derman in an interview, adding that, “these financial models are only trying to capture human emotions and instinctual feelings that we use to help us determine prices in financial markets. They are not absolute things like the distance from here to there or here to the sun, where everyone agrees on the distance.”

The managements of many of the largest bank holding companies have failed to exercise a degree of care, diligence and commitment over their sprawling organizations, and JP Morgan has been one recent example, among many.  Their businesses, which each have distinct portfolios with different risk profiles, have been stitched together by acquisition and by evolution.  Trading desks have cowboy cultures that are polar opposite to consistently profitable, high net worth wealth management businesses. Their compensation metrics, conventions and attitudes towards regulation and oversight are polar opposites: yet, they exist under one corporate roof, as in JP Morgan, Bank of America and Wells Fargo, for example.

When things have gone wrong, they have gone wrong in trading businesses, often by the action of rogue individuals who are allowed to buck the oversight.  These are not complex, multidisciplinary, quant issues.  The heads of profit centers, their supervisors, everybody in the C-suites, the board, internal and external auditors, analysts, shareholders, creditors, rating agencies, bank regulators, securities regulators and the courts all have responsibility for making sure that the inevitable issues that arise in complex businesses don't become systemic issues.  We already have plenty of infrastructure aimed at the problems, and we don't need more regulatory complexity.

Bank of America: Good Fundamentals But Not Yet Ready for Prime Time?

Bill Murray in "What About Bob?" plays a hyper-neurotic, emotionally stuck man who can't get out of bed in the morning.  In this clip, he achieves a breakthrough and goes "sailing." But, his version of sailing is not ours: he is lashed to the mast high above the water.  I hope this lightens up the end of a heavy earnings week.  There is a loose analogy to Bank of America's position after the second quarter. (An aside: Richard Dreyfuss as Bob's hyper-anal shrink resembles which current Fed Chairman?)

It was an eye opening quarter in a lot of ways:

• $1.1 trillion in deposits, up 4%;
• Net income of $4 billion;
• Non-interest expense down $1 billion from the prior quarter;
• Net credit loss rates at 0.94%, the lowest since the second quarter of 2006.

The problem?  BAC is hamstrung by two distinct legacies.  The first is of its own corporate actions: the acquisition of Countrywide Financial and its consequences which resonate throughout the consumer business.  The second is the overhang related to the Federal bailout, impending regulations and restrictions on dividend policy.  

The company increased its consumer and commercial banking sales force (financial solutions advisers, mortgage loan officers and small business bankers) by 21% year-over-year in order to extract more relationships, products and revenue from the huge deposit base.  However, the company has to judiciously balance this against the ongoing costs of dealing with the thousands of mortgages which had to be restructured due to errors in applying fees and foreclosures by the mortgage servicers. The former Countrywide mortgages and loans (PCI--"purchased credit impaired") are reported separately and are still a drag.  

The net charge off rate for consumer and business loans was 0.94%, but if the PCI loan portfolio were included the reported rate increases very modestly to 0.97%, because of the fact that most of the principal is insured, even though interest in not accruing on the loans.  If the PCI write-offs are included then the NCO rate goes to 1.07%.  

Overall fee income was down in the quarter compared to the prior-year period.  Having to deal with the Countrywide legacy has resulted in BAC ceding mortgage market leadership to Wells Fargo, in terms of originating new home mortgages and refinancings.  

Overall, for Consumer and Business Banking, the return on average allocated capital (a non-GAAP measure) was 18.6% in the second quarter, down from 19.5% in the first quarter.  Average loans in the second quarter were flat to the first quarter and down $10 billion from the prior-year period. 

So, things are improving in terms of banking relationships and credit quality, but the company can't go full speed ahead to capitalize on its opportunities because of the legacy of bad loans, especially those associated with the Countrywide acquisition.  

Global Wealth and Investment Management (GWIM) comprises Merrill Lynch, U.S. Trust and other operations.  In the second quarter of 2013, this business recorded $4.5 billion in net revenue with non-interest expense a surprisingly high 72% of net revenue. The pre-tax margin for this business was a record high of 28 %.  GWIM's return on average allocated capital was 30.6% , ahead of the prior quarter's 29.4% and compared to a return of 18.6% for the capital-intensive core banking business.

The problem with GWIM and core banking, as we have written about before, is one of cultures.  They are totally different, and I don't believe that any company has been able to make them work together to effectively cross-sell and work together on accounts.  GWIM responds instantaneously to rising equity and bond markets, as they did in the second quarter.  Right now, GWIM fits into BAC, but let's see if the marriage has legs, or if, at some point, Merrill Lynch's leaders cry to be on their own.  

Global banking and investment banking had nice quarters, and Bank of America's global banking franchise, like that of Citi, is something of real value.  

Capital ratios for all the current and soon-to-be standards are improving and close to where they need to be.

Tangible book value at the end of the quarter was $13.32, and most analysts argue for an appropriate P/TBV multiple of less than one, around 0.95 in the case of Credit Suisse.  On their projected 2014 TBV of $15.12, the stock appears fully valued after the strong second quarter.  It has had a glorious run from the low, though.  One day it may really be sailing!  

A French Banker's Refreshing Report

Recent days have seen a variety of reports come across my screen; Governor Christian Noyer's letter presenting the 2012 Annual Report of the Banque de France was refreshing because it deviated in part from the droning, repetitive structure of reports from the IMF and even from our own beloved Federal Reserve System.

Some of the issues he discusses relate well to a popular post, "Plus ça change, plus c'est la même chose," from February.  Governor Noyer notes that by the end of 2013, the French economy is likely to have had two consecutive years of zero GDP growth, which is quite extraordinary.  Public debt is likely to end the year at levels not seen since WWII. 

Paul Krugman and his political followers have cobbled together a counter-intuitive narrative of low growth being about inadequate fiscal stimulus.  To this, Noyer says simply, "...this vision is incorrect."  He notes, as we did in our earlier post, that French competitiveness has been waning for some time.  For this and other reasons, France and much of Europe haven't benefited from economic globalization, despite having significant economic, human capital, and technological assets. Again, in our earlier post, the Alliance Bernstein analysts showed how much France lost ground to Germany because of its lack of competitiveness.

For the past ten years, he notes, France has had the highest levels of public spending in the world.  As the public debt soared, he contends that French households saw through this process to higher future taxation and cut their spending accordingly and quickly. 

France will have committed about 4% of GDP per year from 2010-2013 in order to stabilize the ration of debt to GDP at 90%.  Governor Noyer realizes that there has to be another set of policies which help release the growth genie from the lamp.  He focuses on the broad issues of regulation and unproductive social programs. 

He notes that France is the biggest spender on employment programs, but it has one of the Eurozone's highest unemployment rates, particularly among younger workers.  Money spent on expensive programs for professional retraining have had no results.  Welfare spending in total, he writes, accounts for 30% of GDP! 

In the administration of President Hollande, this is not something discussed over champagne in the Palace; the points Governor Noyer makes have to be said, and he says them in a style acceptable to the French elite.  To some extent, though, he dances around the problem, rhetorically. 

Nobody has put the problem in such stark and easily understandable terms as did CEO Maurice Taylor of Titan International when he responds to an inquiry about taking over a French tire plant in danger of closing.  "The French workforce gets paid high wages but only works three hours. They get one hour for breaks and lunch, talk for three and work for three. I told this to the French union workers to their faces.  They told me that's the French way."

I don't want to make it seem as if the U.S. unionized work force is superior.  When Hostess Brands slid into bankruptcy, one of the work rules on which the unions would not bend was this: bread trucks and cake trucks could not be consolidated.  Never mind that the customers didn't want two separate trucks tying up their parking lot and receiving for adjacent categories on the shelves.  Never mind that it was inefficient and duplicative.  Well, we know where that vision of a business took the company. 

The basic problem for Governor Noyer, as everywhere, is that he is a central banker: an intelligent and articulate one at that.  Politicians have to see some payback for themselves in challenging an ossified welfare state.  Don't hold your breath.

Jamie Dimon: Votes Have Consequences

The Wall Street Journal piece on the aftermath of J.P. Morgan's proxy victory makes the central point that we've made from the beginning, namely that the whole issue of better risk management, governance and allocation of time for CEO Dimon shouldn't turn into a personal referendum on Mr. Dimon. Of course, it did just that.

Now, come apocalyptic predictions from moguls who had Dimon's back.  This, for example from Marc Andreessen,

Mr. Andreessen, who runs venture-capital firm Andreessen-Horowitz, worries, perhaps overly so, that episodes like these give public capital markets a bad name. "My big concern is whether the public markets continue to function and whether it is still practicable to take companies public," he said.

Really?  The era of public equity ends with a disagreement over splitting the Chairman and CEO role?  I hardly think so.  Fraud, accounting misstatements, and secular mismanagement of shareholder assets over decades haven't killed the markets--yet, so this will be forgotten soon.

Except, Mr. Dimon is reported to have called institutional shareholders moaning how much the proxy fight took out of him.  If this is true, it is symptomatic of the corporate royalty mentality and the sense of entitlement.  JPM is a global powerhouse and an effective company, but that doesn't mean that it does everything right or that it doesn't make egregious mistakes.  Mr. Dimon should have said something like this to his opposing shareholders, "Look we're on the same side; we both want results, success and superior returns.  Somehow, this all got off track.  If you'd be amenable, let's talk privately about your concerns when you feel they're not being addressed.  I've got lots of active shareholders, and they're all important.  The lines of communication, directly to me if you need, are always open. Anything else you need to tell me and my team?"


The Journal writes, "To paraphrase what the economist Paul Romer once said about crises: "A catharsis is a terrible thing to waste."  I think that a pithier version of this notion comes from Bill George, who writes in his book on leadership, "Never Waste a Good Crisis."

JPM Morgan's CEO and board should pay attention.

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! 

It's Not All About Prince Jamie Dimon.

Americans reflexively poke fun at royalty, especially their finery, rituals and pretensions. They raise our democratic hackles, and folks like Britain's Prince Charles are easy targets on both sides of the Atlantic. Divine right and hereditary succession are anathema.

But, Americans too have our own royalty and their supporting elites.  Our royalty includes corporate CEOs, hedge fund managers, private equity moguls, political dynasties like the Clintons, and media icons like Barbara Walters, whose "retirement" is front page news in the New York Times.

So, the issue of separating the Chairman of the Board position from that of CEO at JP Morgan Chase has become a referendum on the Princely rule of CEO Jamie Dimon. Riding the wave up to the mortgage bubble of 2006-8, getting princely bailouts from the general taxpaying rabble, and now riding the next wave of rising stock prices due to unprecedented monetary easing, Mr. Dimon is wealthier than ever and politicians hang on his every word.

Except for one thing.  With a dismissive wave of his royal hand and using a British metaphor of "a tempest in a teapot,"  Mr. Dimon irritatingly put up with questions from the stock-owning rabble about there being too much risk in JPM's proprietary trading operations.  All of his own, hand selected, massively compensated traders, executive vice presidents and risk managers told him, "It's okay, we're good."

Well, it wasn't. We've looked at the London Whale report in great detail and said before that it was a colossal failure at the top, where the Prince makes his royal abode. Splitting the positions of board chair and CEO is not a guarantee of better risk management or lower volatility of the share price.  However, nobody can make a rational argument for why combining the roles is better for shareholders and for corporate governance.

The only argument for combining the positions: the Prince might abdicate and go off to do something else. Seriously, what would that be? The "picking up your jacks and going home" card has already been played, which is amazing for its chutzpah and pettiness.

Mr. Dimon's friends in Greenwich, perhaps akin to Henry Vth's "band of brothers," have announced to the world that "they got his back." So, a real issue of governance has descended, in the finest American tradition, into adolescent posturing for the media.

Jamie Dimon should be able to do a better job of running JP Morgan Chase, of selecting a better inner cabinet, and of holding them accountable and monitoring their results, if he were freed from the drudgery of running and managing a board and its committees.  Running the business is where he has a comparative advantage and a track record.  Put all his time there: it is the best thing for shareholders.

Meanwhile the board probably should change over time and change its committee charters.  Risk management, such as it is which isn't great, should report in some fashion to a board committee.  This committee should be free to go where it will, looking under the covers for Warren Buffet's "ticking time bombs."  Opinions vary on how this kind of change can be structured, but it's not rocket science.

The goal is to get better first, lowering risk incrementally and increasing oversight and transparency for the entire board.  Splitting the roles is just a first step, but hopefully the board is strong enough to stand up to the Prince and his court.

Split the Chairman and CEO Roles at JP Morgan Chase: No Excuses

The discussion about splitting the Board Chair and CEO positions has become a referendum on the popularity of Jamie Dimon, or a stroking of his ego by another less-than-stellar board.  More and more companies are splitting the roles: it is clearly not a one-off measure aimed at Dimon.

Our post after reading the London Whale report shows the reasons, based on the board's own discussions,

"The J.P. Morgan Chase board of directors rightly concluded that the CEO should be able to rely on the competence and ethics of his direct reports.  However, it also said that "...he (Dimon) could have better tested his reliance on what he was told."  The board had no choice but to take the approach of "the buck stops here" with CEO compensation, and it did." 

The CEO would be in a much better position to test the veracity of what he is being told by self-interested lieutenants, and to enlist the help of internal audit or whomever he wants if he were not required to be busy planning and running board meetings.

After re-reading the Whale report, it is even more laughable than the first read.  Really, a systemically important institution that can't even measure its own risk profile, turns to some unknown British "mathematician" called "the modeler?"  Getting a handle on these issues requires the CEO's attention to focus his own management team, and this is not the work of the board, except insofar as it forms its own independent view through the audit committee.

Separate the roles and don't make a big deal out of it.  The SEC and the New York Fed should also weigh in through their back channels and insist on the change.

Megabanks and Our Failing Banking System

Readers of this blog have seen many references to the work of President Richard Fisher and his research staff at the Dallas Fed.  The New York Times columnist Gretchen Morgenson cited a recent speech by Fisher, which reiterates themes expressed in the Dallas Fed's 2011 Annual Report.

Our last post on J.P. Morgan Chase concluded, based on the contents of JPM's own internal report, that the organization had become too risky to the financial system, and too complex to manage.

The work of the Dallas Fed comes at the megabank issue from the truly fundamental level: what are they doing with their privileged position in our financial system, to really help the economy?  The megabanks, according to the Dallas Fed research, are impeding both the transmission of monetary policy and the traditional path to additional lending and recovery.

Our banking industry post-crisis is more concentrated than ever, as shown by this chart from the Dallas Fed.


So, 0.2% of U.S. banks hold 69% of the industry assets.  This isn't good for systemic risk management, enterprise risk management, or for job creation and economic recovery.

The next point about this kind of system is that the resolution process for the 5,500 community banks can be completed in a weekend, and we've seen that happen in my home state, Minnesota.  The resolution process for banks with moderate asset size may take weeks or months, but we have a lot of experience with these too.  There is no workable resolution process for megabanks, and so they are guaranteed perpetual life support by the U.S. Federal Reserve Bank and the U.S. Treasury.  Their shareholders and creditors know this too.  There can be no "creative destruction" for JPM.

This "implicit subsidy" is extremely valuable to the managements, shareholders and creditors of the megabanks.  As a result,

"unsecured depositors and creditors offer their funds at a lower cost to TBTF banks than to mid-sized and regional banks that face the risk of failure. This TBTF subsidy is quite large and has risen following the financial crisis. Recent estimates by the Bank for International Settlements, for example, suggest that the implicit government guarantee provides the largest U.S. BHCs with an average credit rating uplift of more than two notches, thereby lowering average funding costs a full percentage point relative to their smaller competitors.[8] Our aforementioned friend from the Bank of England, Andrew Haldane, estimates the current implicit TBTF global subsidy to be roughly $300 billion per year for the 29 global institutions identified by the Financial Stability Board (2011) as “systemically important.”[9] To put that $300 billion estimated annual subsidy in perspective, all the U.S. BHCs summed together reported 2011 earnings of $108 billion.

The rating uplift, the significantly lower cost of funding, and the ability to leverage back office expenses on a huge asset base puts the other 99.2% of U.S. banks at a huge disadvantage in offering competitive products and services to their customers.   Paradoxically, the megabanks get this free ride despite the fact that they are inherently more complex to manage and to regulate.  They also pose the systemic risk.

Dodd-Frank, as we have said until we're blue in the face, adds nothing but complexity to what the British call "macroprudential regulation."  Here are some interesting charts, again from the fuller Dallas Fed study.

These are the deadweight economic losses from regulations like Dodd Frank, which are blunt instruments that weigh most heavily on those organizations for which existing regulatory and resolution mechanisms are both adequate and proven.

Finally, businesses need loans most urgently when times are tough.


This chart shows that the community banks, and the moderately sized banks are the ones which have maintained or expanded their business lending through and after the financial crisis.  Ultimately, this is why our nation needs a banking system, for maturity transformation and intermediation.  We don't need banks for proprietary trading.

Also, anyone who deals with one of the big twelve banks knows a few things about their business models:

• Over a long period of time, most of their income has become fee income as opposed to net interest income from traditional lending.
• Fees on traditional small checking and deposits have climbed into the stratosphere when measured against the risks and cost of funds.  
• Seniors, students, new entrants to the work force, and new immigrants can't get a low cost, plain vanilla banking product without arbitrary limits and high fees.  Credit unions can't compete with limited locations and few ATM's.  
• Megabanks are inexorably milking their former best customers with higher fees in the hope that they leave. The megabanks want to get into upmarket services like asset management accounts combining brokerage and banking with significant minimums.
• The investment banks in these holding companies can take as much risk as they like to show attractive returns on equity.  
• Traditional commercial and industrial loans are not attractive products for megabanks to offer, and their best customers, awash in liquidity themselves, have already floated large issues of fixed-rate term paper at historically low spreads for investment grade. 

Fisher's paper ends with the following quote,

"To us, the remedy is obvious: end TBTF now. End TBTF by reintroducing market forces instead of complex rules, and in so doing, level the playing field for all banking institutions."

Have a read through these materials linked above which are clear, well researched, and fundamentally sound.

Note: all charts and graphs above are from the hyperlinked Dallas Fed publications.