Jamie Dimon on Regulation, Treasuries and the Next Crisis

I'm still penciling through some recent bank financial reports, and I keep coming back to JPMorgan Chase CEO Jamie Dimon's shareholder letter.  Around page thirty on, there are plenty of good nuggets.

He notes that banks today, driven by backward-looking regulation, are part of a banking system "that is stronger than it ever has been."  Yet, the bond market, and particularly the Treasury market, could be the venue for an event-driven crisis in any one of three or four hotspots around the world.

Regulation has made market making in bonds less profitable, and although bond market spreads have come down and stayed low, the market depth has actually declined. The letter says, "..the market depth of 10-year Treasuries (defined as the average size of the best three bids and offers) today is $125 million, down from $500 million in 2007."  This despite the fact that today's Treasury market is $12.5 trillion as opposed to $4.4 trillion in 2007.  Dealer inventories are down 75% from their 2007 levels.  There's no need to run a complex stress test to see that this is not a healthy market for the asset of choice in a global crisis.

For all the talk about a "flash crash" in stocks, the October 15th, 2014 one day move of 40 bp in Treasuries was a much more serious "shot across the bow."  As the CEO's letter points out, this was a move of 7-8 standard deviations!

Bond investors like Blackrock and others have been writing about the need to innovate these markets for some time, but the point is now that the time to formulate a new structure, agree among the market participants, issuers and regulators will be years in this political environment. A crisis could come in the fall, as they often do.

The supply of Treasuries available for sale is relatively small, given the large size of the stock and the burgeoning demand. Total Treasuries outstanding are said to be $13 trillion.  At least $6 trillion are tied up in central bank forex holdings, another $2.5 trillion on the Fed balance sheet, and another $0.5 trillion held by big banks as liquid assets.  Take out this $9 trillion, and about $4 trillion are potentially available to be traded.

The Japanese central bank, for currency and other economic reasons, has published aggressive targets for purchasing Treasuries on top of the $1.238 trillion which they already hold.

In the event of a typical run, driven by the next crisis, global investors will look to U.S. Treasuries as they did in the last crisis, when more than $2 trillion in demand was created by the fire sales of risky assets.

On April 6th, Wall Street Journal correspondent Michael Casey's lead sentence was "The bond market is malfunctioning."  In a full-blown flight from risk, this could be an understatement.

Jamie Dimon's Extraordinary Shareholder Letter

JPMorgan Chase CEO Jamie Dimon has channeled Warren Buffett in his most recent letter to shareholders.  As readers of this blog know, Warren Buffett's letters are on my required reading list, and I have always recommended them to friends, colleagues and students.

Based on his long track record of success in financial services, which I began following during his tenure at Bank One, Jamie Dimon is required listening.  As CEO of one of our nation's Big 4 banks, he was in the eye of the hurricane during the financial crisis, has been pummeled during the political piling on post-crisis, and has now almost completed steering JPMorgan Chase into calmer, post-crisis waters.  There's a lot to learn about his view of finance and the role of JPMorgan Chase in this letter, but there are some real questions that remain for investors, as there should be if there is real content in the piece.

The CEO's Principles for Running A Business

• Especially for a cyclical, highly regulated business which is periodically subject to massive, systemic crises, it's essential to build the company into an "endgame winner." Through the work of his team and those of his predecessors over 30 years, he believes JPMC is in that elite group.
• Compare yourself against your best competitor is each of your businesses, and a convenient chart shows how that comparison looks.  
• A good company doesn't use cycles as an excuse. He is committed to earning competitive margins over the full cycle, whatever its characteristics, while still investing in the businesses and without taking extraordinary risks.  
• A good company, while always investing in its businesses, is always eliminating superfluous waste.  This has been a consistent theme going back to CC and to Bank One. It is also more nuanced and sensible than the somewhat comical and ultimately misguided "reusing paper clips" memos coming out of Bear Stearns.
• Some expenses thought by others to be excessive are in fact essential to achieving the endgame goals: it is something I have lived through myself as a CFO, and I really like seeing this laid out in specifics, i.e. the Retail National Sales Conference for JPM's top 5% producers. CEO Dimon has been to every one going back to Columbus, OH and Bank One.  You can tell I especially like this one, because what matters for a successful company is ultimately what employees think, which informs how they behave. 

As Regulators Sandpaper Away at Big Banks, Who Needs Them?

• Economies of brand name, scale, operation, and technology are important in a global financial services business.  Taking them away, by separating companies, will not be efficient for shareholders and it will leave customers looking for a competitor which can supply exactly what JPMorgan Chase has put together. 
• The CEO uses the example of Commercial Banking which is now 35% of the U.S. Investment Banking business. Out of 20,000 Corporate and Middle Market Banking clients, JPM supplies global banking services--cash management, treasury, currency trading, hedging, and mergers and acquisitions--to some 2,500 of these companies.  With normalized future growth and natural consolidation of customers, these opportunities will grow and become more valuable. 
• The Private Bank, because of the asset base and diverse financial interests will always benefit customers and attract prospects through scale. Right now, through the expanded system there are $190 billion in deposits in the Private Bank system alone. Globally, 2,300 families had assets of $1 billion or more, and as a group they represent over $7 trillion in assets. Having a system that routinely moves $6 trillion in daily funds worldwide gives Morgan bankers credibility with customers.
• In a liquidity or other banking crisis in the future, banks need to keep lending, and especially the Big 4 and beyond. Statistics in the letter talk about how much credit was rolled over to small and medium sized businesses, large customers, state and local governments and to hospitals and nonprofits. As the CEO rightly points out, non-bank entities would not be in this position in the next crisis, the character of which he alludes to in a few, unrelated paragraphs.

What About the Share Price Lagging Peers

• The CEO won't be driven by goosing earnings or short-term performance by pulling easy levers. (see the principles in how to run a business)
• JPM's price-earnings ratio is lower than peers, he says, due to large levels of legal and regulatory settlements, and to uncertainty about future settlements.  This may be true, but it's a bit hard to understand given some of the issues surrounding Bank of America, for example. 
• Stay focused on what you can control.

What Happens in the Next Crisis for Liquidity?

• More high quality capital is on the books than at any time in its history.
• Compensation levels would be adjusted immediately.
• Dividends would be cut or suspended, and share buybacks halted.
• In other words, the customers and businesses come first: a good recipe.

I'm not doing a full summary of the letter, but these are some of my highlights. What about a question or concern?  It goes back to the London Whale report. 

In the letter the CEO talks about learning a lot, and I am sure he is right. He also talks about many of the bad derivative products having gone away.  The culture described in that report seems totally at odds with what would seem to be espoused by this CEO.  How did it get that way?  Are all the bad actors gone?  There is a reference to "fortress controls."  I think that's just a marketing slogan.  They are neither feasible nor necessary: mistakes will happen, bad trades will be made, and earnings will take a hit, but all of these should be ring-fenced, bounded and fixed quickly.  That is not the company described in the London Whale report.

The CEO does make a reference to consistently espousing the principles in the letter during the year and to audiences in different settings. This could be a big deal.  The question is: who's in the audience? The same folks as before, with religion now?  

I go back to Bill Belichick's adage, "Just Do Your Job!"  CEO Dimon needs to be surrounded by leaders who knowledgeably sit over their global operations moving $6 trillion daily and who can truthfully and with confidence say, "No storms on the horizon" if the CEO asks.  A related question is, of course, who can step into Jamie Dimon's shoes if illness or factors require a successor to step in? 

Having a behemoth of a company so dependent on the acumen, drive and leadership of one person isn't the most risk optimal way of looking at the future: just a thought. 

Windows Phone: Still Nobody at Home

I've owned a Windows Phone since they came out, because it was an inexpensive way to own a smart phone without succumbing to the siren song of Apple or to the the peculiarities of Android, where different users got or didn't get OS updates depending on their hardware maker.

I have written about the promise of the phones; because they are Nokia, they work well, and the Windows Phone OS isn't bad at all, and it works well with Outlook, which I have used for a long time.

I was impressed by CEO Nadella's comments when he first came on board about how he understood the needs of the developer community, and Microsoft would meet them where they live (their income statements) and increase the app store and therefore the user base.

Well, it looks like absolutely nothing has happened.  Windows Phone isn't an option for someone who wants to download popular consumer apps in many, many different areas.

I would guess that they are going to have to write-off some of the goodwill attached to the $7 billion plus Nokia acquisition, because surely the cash flows won't be there in the future.

At lease my phone still works, and Microsoft hasn't orphaned me as a user,....yet.

What Are We Doing in Yemen?

After six odd years of unprecedented ineptitude and colossal arrogance informing our foreign policy, the U.S. is now "backing" a Saudi-led coalition against the Houthi in Yemen!  If a poll were taken in Congress asking "Where is Yemen," and "Who are the Houthi?" a handful at best would be able to answer.

Al-Jazeera describes the Houthi as a theologically-based peace movement. However, once their assigned role in a national government of unity was found inadequate, they have suddenly become a well-armed militia, causing the Yemeni President Hadi to seek refuge in Saudi Arabia.

Now, there is a full-fledged proxy war underway, and we are aiding air strikes that are killing civilians and fighters who seem to be dressed just the same as the civilians.  At the same time we signing "unprecedented" accords with Iran, they are running arms to Yemen in opposition to the Saudi coalition, that includes the U.S.  Got that?

No nation can rationally claim to be able to be able to stop a flow of arms by ship or tanker. Who is going to interdict vessels under different flags in territorial or international waters?  Under what authority? Now that Russia has offered high-powered weapons, President Putin would only be too eager to show his dictatorate that he will stand up to the West whose sanctions are keeping bread off their tables. China's opposition to military action has been clear, but their activities are off the radar screen.

So, Saudi Arabia has continued to export revolution to its Western customers for several decades, and now we are helping them in a battle that ultimately, among other things, will redraw the map of the Middle East in ways in which our moronic foreign policy can't fathom.

Greece Finds Some Cash

Even though we've been out of the blogosphere for a while, nothing has really changed in the drama between Greece and its creditors. Despite some last second posturing through Finance Minister Varoufakis being photographed with Russian President Putin, Greece really had no cards to play and miraculously found $450 million euro for a scheduled debt repayment to the IMF today. Answers: Greece blinked.

No good can come from extending this drama further.The longer the charade goes on, the more the politicians and their weary voters will come to feel that there is either (1) no real crisis and the drama has all been brought on by outsiders, so no need to change anything; or, (2) there is no hope for Greece except to be Europe's indebted beggar, and therefore no need to strive for growth or improvement. Neither reaction helps the nation in the long-term.

 Despite the dire consequences of a Greek exit from the euro currency, it can be handled and indeed we believe that were once contingency plans for doing just this.  27% plus unemployment rates for two years running, the uncertainty of meeting April government payrolls, the capital flight and the growing lame-duck feel to the current government all point to the benefits of Greece taking the bitter medicine and going it alone.

The euro itself will be less damaged that if the system were to countenance a "slow bailout" of Greece.

The Bank of England's recent Fiance Committee minutes show that UK banks' net exposure to Greece comprised less than 1% of the Common Equity Tier I (CET1) Capital, and bank counterparties as a whole had about a 2% exposure.  Were an exit to hit other heavily indebted countries in the eurozone, the exposure are significantly greater, but Greece itself can be ring-fenced by current capital cushions. JPMorgan Chase CEO Jamie Dimon has said that his bank has been working on a Greek exit for some time, through its risk management simulation exercises.

European stocks smugly reach new highs, while the ongoing complexion of the European experiment continues to look wan.

Who Blinks First: Greece or Germany?

Some of my most widely read posts, both by numbers and by geographical dispersion, relate to the Euro and the Grexit, dating back to 2012.  This particular one, "Revisiting the Euro and the Grexit," hit it all right on the head.

Today, even the Guardian seems to waking up out of a fog when it writes,

"A month ago, such an outcome(economic collapse or exit) to the Greek crisis looked highly improbable. It now appears far less unlikely, which is one reason why the euro has been under such pressure on the foreign exchanges. At some point, the 35% depreciation of the single currency against the dollar is going to lead to strong exports and a much-needed growth boost."

Bailing out Greece, or Germany blinking, puts another nail in the European experiment.  The EU violated its own rules when it admitted Greece (and others) into the currency union, and a bailout (or other euphemism) is the ultimate practical repudiation of both economic principles and rules.

The multi-year charade that has brought us to this point can't continue by just accepting more austerity: for the economic well being of the people and for the political self interest of its politicians, Greece needs to undertake fundamental structural reforms in taxation, labor market and public pension reforms.  Without some outside representation by the EU machinery in providing technical assistance or monitoring, it's hard to see how blank checks can be written.

If the bitter pill were accepted, how could the current Greek government, elected on a sham platform, continue to hold the confidence of the electorate?

Taking the euro down to stimulate exports helps Germany much more than it will help Greece in the short-term, without labor market and regulatory reform in, for example, Greek ports and shipping.

All eyes may turn to Mario Draghi, but his tune is already tired and won't be enough.

HP Buys Aruba: What Does It Mean?

Here we go again: HP makes another significant acquisition.  The timing, before effecting the separation of HPQ into HP Enterprise and HP, Inc. seems a bit awkward, but there were probably market reasons.

From what I can gather, Cisco having the dominant share in wireless networking (over 50% according to some industry research) couldn't have made a move on Aruba (around 13% according to industry trades) without some concerns about its prior Meraki Networks acquisition and without risks of being perceived by the Feds as anti-competitive.

Dell is probably preoccupied with its recent privatization and with internal redeployment of executives and resources to have done the deal now, but later...that could explain why HP moved now.  Many non-Cisco players have private-labeled or bundled Aruba's technology into their offerings already, including HP.  So now HP leaves Dell, Juniper Networks and Brocade out in the cold to forage over a smaller universe of targets to exploit new wireless standards with enhanced security.

According to Credit Suisse, the $2.7 billion price is 2.6x revenues, and CS projects that the acquisition will contribute about $0.07 per share to HP's FY 2015/16 earnings. According to Argus Research, HP's networking revenues in their prior fiscal year were $2.25 billion, and the annualized run rate of FY15 revenues for Aruba (based on their fiscal second quarter) is $852 million.  So, without any sales force synergies and without significant losses from Dell and other customers, Aruba's revenue contribution should be 25-35% of HP's 2015/16 networking revenues.

One thing this acquisition does point out: the acquisitions of Colubris Networks (2008) and 3Com (2010) weren't the best-timed, and the combination, along with deficient R+D spending dating back to CEO Mark Hurd's time, has failed to add value to make HP's offering credible in the future, without Aruba.

If HP Enterprise is indeed a "nimbler" company going forward and a more astute company, then the sales force, product development team and executives at Aruba will not only stay with HP Enterprise, but they will be enthused and energized by the possibilities for vastly increasing their distribution and market uptake.  If they get frustrated with a big bureaucracy of HP insiders who things the "HP Way," then this acquisition too could fall apart.

Creating an Enterprise-centric company via the split was probably a strong selling point to Aruba's management.  Let's hope that this acquisition is different.