Wednesday, May 1, 2019

Jamie Gets the Last Word for 2018

When Jamie Dimon pens his annual letter to shareholders, the market listens, reads and interprets what's on his mind 
Warren Buffet's annual letter to shareholders is legendary in financial circles.  The messages in the letters extend beyond a review of Bershire Hathaway performance. Over time they became annual seminars in investment analysis.  Reading batches of his letters from over the past two decades could comprise a business school course in evaluating investment performance--not to mention an occasional insightful analysis of accounting rules and financial derivatives.

Over the past 10 years in banking, the annual letter scripted by JPMorgan Chase CEO Jamie Dimon has become the awaited annual address to the financial industry. In years past with customary candor, Dimon has explained the benefits and drawbacks of bank regulation, painstakingly rationalized the bank's dividend-payout and stock-buyback programs, and has dissected the U.S. economy's prospects.

Dimon's 2019 letter was released in April. As he has done in previous years, he took the opportunity to analyze important issues in the financial services industry after he had a chance to applaud JPMorgan Chase's solid results in 2018 across the board.

What's on his mind in 2019? What's the last word for closing out 2018?

Dimon used sidebars to make remarks about inactions and ineffectiveness of government--including excess regulation in financial services, daunting health care costs, and deplorable U.S. public infrastructure (bridges, roads and tunnels that, he says, have become a national embarrassment).

But because he runs a bank, he won't hesitate to evaluate the global financial system, what banks do well, what they need to do going forward, and how regulation too often gets in the way. Much of his 2018 oratory on the banking system is an update on previous years' remarks; he's just now armed with more data to back him, better analysis of costs and benefits, and more heft from running an even larger, better capitalized financial institution. 

Like investment-guru Buffet, Dimon assesses performance (of the bank as a whole and of business units) based on returns on book equity, or return on capital deployed. More specifically, the bank focuses on return on tangible equity (after subtracting out goodwill and intangible assets).  Business units have capital allocated to them from upstair, and senior manager assesses how effectively they use the capital. Otherwise, the bank may choose to redeploy that capital into other businesses or decide whether to "give" that capital back to shareholders, who might invest it better elsewhere. 

Bank management assigns capital to business units based on operating needs, but also based on assessments of worst-case risks. Because shareholders have expectations for returns and performance, bank management holds each business line to similar expectations for returns on this risk-based capial--while managing the same risks banks take on to conduct these banking activities.

Year after year, in his letters to shareholders, Dimon explains and reviews returns on capital and rationalizes when the bank is better off permitting shareholders to get back their capital and do their own thing with it. This year he got to boast the bank's 2018 return on tangible capital leaped to 17% last year.

When it's time to drift into the gory details of accounting guidelines and requirements, Dimon doesn't mind. He embraces the challenge to explain arcane rules to the general public. This year he scolded the profession in inconsistencies of balance-sheet reporting. These are technical nuances that sometimes fascinate (or bewilder) Dimon, but significant enough to gain his attention because the impact in reporting may be, for JPMorgan Chase, in the billions, not in the thousands. 

Why are all the costs (today, tomorrow and long term) shown upfront in some products (like credit cards) but not in others? Why are all the revenues (today and in the futures) shown upfront in some activities (like mortgage servicing) but not in others (like other cash management services)? "Accounting can easily make people do silly things," he wrote, while warning financial analysts to be careful when reviewing bank business activities and product and service costs.

When it's time to assess bank regulation, Dimon explains where it works and describes where it's absurd. And he doesn't buffer his views with diplomatic language. For the past several years, he seems to speak for other bank leaders who (a) might not want to offend Washington bank supervisors or (b) who may not be as intimately familiar with Dodd-Frank rules as he is.

The Federal Reserve annual stress test and regulators designating JPMorgan as a bank "too big to fail" (or a globally significantly important bank) particularly irk him. There is too much "arbitrariness" in the test, he says.  The extra capital requirements that come with being "too big" are based on Federal Reserve Bank criteria and should be "risk-adjusted," he explains, based on factors that contribute to the bank being too big and based on how a bank prudently manages such big risks. 

As he has done in previous years, he questions why banks must maintain capital for operational risks, when those risks are already addressed addressed when a bank quantifies credit and market risks.  JPMorgan has about $40 billion in operational-risk capital requirements, much of which is tied to inherited risks from its acquisitions of Washington Mutual and Bear Stearns and risks that have, in  practice, disappeared as the bank vastly restructured those units. 

Volumes of books and analyses have been written on the financial crisis and the demise of Lehman and Bear Stearns: What caused it? What triggered it? How could it have been averted? The 10-year anniversary of the Lehman and Bear Stearns failures prompted Dimon to review that period in the context of today's bank regulation. 

Dimon explains how Lehman, Bear Stearns and AIG Financial Products might have survived under current Basel III and Dodd-Frank Rules.  (Lehman and Bear Stearns, if they had survived would likely have been consolidated banking organizations, subject to the rules enforced by the Federal Reserve.) The same institutions would have been subject to today's tough minimum liquidity rules and limits on balance-sheet leverage. 

Dimon points out big banks today must also maintain a fourth layer of capital cushion called "T-LAC" (unsecured, long-term debt subordinated to deposits, or "Total Loss-Absorbing Capacity"). 
If Lehman's long-term debt had been treated as a T-LAC capital-like cushion, then the firm would have had a capital base of over $130 billion, not less than $20 billion. T-LAC rules today would have pushed bank supervisors to convert $120 billion of debt into capital, a capital cushion that would have permitted Lehman to get through the crisis.

He has a long list of other laments or "things to discuss:"

The capital requirements for mortgage lending and exposures are too onerous, or they don't grant relief for banks that book well-structured, lower-risk loans. Regulation requires banks to maintain capital for worst-case risks of losses in the mortgage portfolio. Dimon argues that all mortgages aren't the same. 

Along the way, he expressed frustration the bank must comply with over 3,000 federal and state rules just to stay in the mortgage business, enough frustration to cause the bank to question its commitment to the business. 

He acknowledged the criticism levied at many financial institutions and corporates after the reductions in tax rates from last year's new tax legislation. New tax laws had a favorable impact on income, including JPMorgan Chase's 2018 earnings ($33 billion in net income last year). Critics observed many institutions didn't reinvest the extra gains, but used them to reward shareholders with higher dividends and share buy-backs. Dimon counters the gains and possible reinvestments (in loan growth at a bank) should be measured over time. 

A "fortress balance sheet" is a favorite Dimon term for a long time.  He referred to this objective long before the crisis.   A fortress balance for a big bank often means the bank is well-capitalized and isn't vulnerable to unexpected in the loan portfolio and in trading.  A fortress balance sheet means bank has substantial cash and liquid securities to respond to nervous institutional depositors or other short-term lenders. In 2019, the balance sheet has climbed above $2.4 trillion in total assets, but rising levels of capital (over $250 billion in book equity) support a growing loan portfolio that now tops $900 billion. 

He refers to the fortress balance sheet in the latest later, and it may be the title of the inevitable book he writes to reflect on his long career in banking when his days are done. 

Tracy Williams

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