Thursday, January 15, 2015

Dimon is Right!!

Dimon sounded a bit frustrated on the 4Q 2014 conference call the other day and it is totally understandable.  Yes, JPM and other banks made some mistakes, but it's really strange how regulators are jumping on JPM.  Just like they jumped on Goldman Sachs too, when they were one of the better operators (Fabulous Fab notwithstanding).

Bass Ackwards
The regulators seem to equate size with risk, but I don't think so at all.  The biggest problem that we learned from the financial crisis is not so much the size and complexity of the banks, but the size and complexity of the alphabet soup of regulators!    Simplifying that would go much further in reducing systemic risk.

Size ≠  Risk  (Regulatory Complexity = Risk!)
If we think back to the financial crisis, Citigroup was the only large bank to get into trouble.  The big failures, remember, were Bear Stearns (not even the biggest investment bank and not integrated; it was not too big or too complex at all), Lehman (same, this was not a global bank but an independent investment bank), AIG (this was not even a bank or an investment bank!  And I don't know that complexity had anything to do with it.  Bad trades were put on, basically, in two divisions).   Of course there was Countrywide, IndyMac, Wamu and some others.   (By the way, during the S&L crisis in the late 80's, the absence of size didn't seem to help much.  Sometimes it's more complex to deal with 1,000 small problems than, say, one big one).

I remember when a reporter for the Economist wrote that the beating up of banks and investment banks after the crisis is like when a fight breaks out in a bar.  Some people don't go find the guy that started it and punch him, but just punch the guy sitting next to him because he never liked him (and it was a good time to punch him).  That's sort of what it feels like.

Also, I'm not going to bother to Google it and post it here, but U.S. banks aren't even that concentrated (large relative to economy) compared to most other large banks in the rest of the world.  The deposit share of the large U.S. banks are much smaller than, say, Japanese, German and other banks around the world.  Are those banks riskier?  (well, if the answer is yes, it's for different reasons!).

So I don't agree that size = risk.  JPM, in fact, was (as Dimon keeps saying) the strong haven during the storm of the financial crisis.  They got through the crisis without losing money in a single quarter, and they had to buy some of the failing institutions to help bail the system out.

This is hardly proof that size = risk.

In fact, when the crap hit the fan, Goldman Sachs and others rushed to find a partner that had stable deposits (banks) so as to stabilize themselves.

What does that mean?  Are independent investment banks safer than universal banks? The real life stress test of the financial crisis seems to have proven that the integrated model might be sturdier.

Break Up JPM?
And the idea of breaking up JPM is an interesting one.  Honestly, I looked at that idea too a few times in the past and thought about making it a post here, but didn't because I didn't see it as a good idea.

First of all, JPM has done really well over the years due to the many different revenue/earnings streams it has.  The volatility of the investment bank can be smoothed out by the stable consumer business.

And too, a quick back-of-the-napkin look showed that it's not really all that interesting.

This is very crude and I'm sure Goldman and others have a better analysis, but here's my simple look at the idea of a split:

Value-Enhancement From a Split
I don't know what all the different parts would trade at, but the main things that are viewed as undervalued are the Investment Bank (actually, not the whole investment bank as GS is cheap, but the advisory business which seem to trade at high multiples (Greenhill, Evercore etc...) and Asset Management.

So assuming JPM trades at 10x P/E, this is what the market is implying these divisions are worth:

                                          Net income              Value@ 10x  
Asset Management             $2.2 billion              $22 billion
Advisory                             $320 million            $3.2 billion
Total                                                                    $25.2 billion

For the investment bank, you could use the $6.6 billion investment banking fees, but that includes underwriting and that actually takes capital and size to do.  Evercore and Greenhill are valued highly because they don't need balance sheet and distribution; they just advise on mergers etc.

That's why I used the advisory fees earned by the investment bank of $1.6 billion and used a 20% profit margin to get $320 million net income.  20% happens to be the net margin for the whole investment bank for JPM, but that's a lot higher than the margins at Evercore and Greenhill so I'm being generous.

So how would the market value these independent entities?  Well, asset management used to trade at a 20x P/E; I think it's lower now (Blackrock is at 16-17x) , but let's use 20x to be generous.  Also, boutique advisory firms used to go for 30x.

So using the above net income figures and new valuation, here's what they would be worth on their own:

Asset Management:  $2.2 billion x 20x =     $44.0 billion
Advisory:                  $320 million x 30x =     $9.6 billion 
Total:                                                             $53.6 billion 

So the financial alchemy from this split would increase the value of JPM by $28.4 billion!   Yay!  Right?  But wait a second.  JPM has 3.7 billion shares outstanding and it closed at $55 or so today.   That's a $200 billion market cap.   That's a nice 13% pop!    13%?  Yup.  Just 13%.  All that work, risk, hassle for a one-time 13% pop.

Oh, and don't forget, synergies from this integrated model is $6-7 billion according to JPM's 2014 Investor Day presentation.  This synergy can come from all over the place, not just between these two entities and the bank.  But since Asset Management probably gets a lot of assets from JPM the bank, a lot of it might be from there.

If a split makes these companies independent, then that $6-7 billion might go away. Yes, maybe not.  We don't know where those synergies are.  But let's say it goes away.  What is that $6-7 billion in net profit worth to shareholders?  Let's just use the lower 10x that JPM trades at.

That's a possible $60-70 billion decrease in value due to un-synergies!  

So yeah, you might be giving up $60-70 billion value (at a cheap 10x) for an instantly gratifying one-time gain of $28.4 billion today.   Is this really a good idea?  Hmm...

Splitting the Whole Investment Bank Itself
OK, so you may be wondering, wouldn't the bank itself be worth more without the investment bank?  Maybe.  But here, in the above scenario we are just ripping out the good businesses; Asset management and Advisory.

But yes, if the whole investment bank is holding down the valuation of JPM, we can look at it the other way.  Take away the whole investment bank and put a 12x multiple on the bank (and leave the investment bank at 10x,  12x is where Wells Fargo is trading).

Well, the banking businesses had net earnings of $11.8 billion.  I'm looking at Consumer and Community Banking and Commercial Banking.  If the multiple on that goes from 10x to 12x, that's an enhancement of $23.6 billion in total value, similar to the above splitting off of the high value pieces.

And the same argument about synergies may apply.


Capital
Oh yeah, it's not that simple.  There is a cost to being big and integrated (and diversified, stabler and more Gibraltar-like).  There is that extra capital for the bigger, more complex banks (how about lower taxes for entities that have to deal with unnecessarily complicated multiple regulators?!  Banks seem to have to play a game of Twister to keep everyone happy.  It's a miracle they are still in business!).

So here's a snip from the 2014 Investor Day:


The net income contribution assumes 50% overhead ratio and 38% tax rate.  Cost of equity is 12% based on some CAPM model they used (5-year average).

But check it out.  They only need $3 - 6 billion in gross synergies to be SVA positive (Shareholder value added) on incremental capital requirement.   By the way, that equates to $1-2 billion in additional net income.

So looking at the G-SIB requirement of 2.5% (JPM falls under the 2.5% bucket), let's see how much additional capital they need to hold.  Risk-weighted assets at year-end was $1.6 trillion.   2.5% of that is $40 billion.    So JPM needs to hold $40 billion more in equity capital than others, just because they are big, sturdy, safe, diversified and rock-solid.

Assuming a 12% cost of equity capital, JPM needs to earn at least $4.8 billion in incremental net profits to justify being a Systemically Stable Important bank (remember, they were a stabilizing force during the crisis; how about negative capital requirement for that?!).  As shown above, the synergistic effects of the current integrated model is $6-7 billion.   So already, they are earning enough to more than offset that added capital requirements for their current model.

And from there, if further capital is required, as it says in the above slide, they only need another $3-6 billion (in gross synergies), or $1-2 billion on a net income equivalent basis.

But you will notice that they already earn $6 - 7 billion extra from the current model versus the $4.8 billion needed to make up for the 2.5% G-SIB, so they are already earning enough to make up for another 50-100 bps in capital.

I'm sure, though, that JPM will keep refining pricing and products so that they will more than make up for further capital requirements.

Conclusion
OK, so this was quick and crude so you can nitpick this and that.  I know there are other businesses within JPM that earn high ROE's, but I don't know about tearing them apart and then slapping high multiples on them.  If you do that, then you have this huge corporate piece left over.

For me, the idea of a spin-off or split to enhance value was mostly about splitting off the asset management business.  That's where the multiples differential seems to be the highest.  And the advisory business too.

But ripping the whole investment bank away probably wouldn't change the value much as Goldman Sachs, Morgan Stanley and others are not valued any higher than JPM.  It might make the lone bank trade higher (12x vs. 10x), though.  Plus, the fact that the two independent pieces would not be able to smooth each other out would suggest higher earnings volatility, lower balance sheet stability and lower credit rating, so it might be value destructive.

But I don't know.

What I do know, though, is that it seems like:
  1. Splitting up JPM might enhance value on a one-time basis, but the loss in synergies might lose more value in the end. 
  2. Splitting up JPM to escape G-SIB and other capital measures is interesting, but the above analysis shows that maybe the synergies more than offset the onerous, additional capital requirements necessary to maintain their model. 
So I think the "break up JPM!" crowd is wrong.  It may not enhance value.  I think much of JPM asset management AUM comes from the bank and investment bank.  On it's own, they don't have any of the distribution infrastructure like Fidelity and other independent fund companies.  To build this out would probably take a lot of time and money.  

Too, the advisory business on it's own would have to work harder to get business.  Oh yeah, and think about how JPM got the Shake Shack IPO partly because JPM was their banker!  That's synergy right there, right?  (OK, SHAK is not an advisory client, but an underwriting client)

And for regulators, I think they're wrong! It's not the banks and financial institutions that are too complicated.  It's the regulations and regulators!!  Simplify that alphabet soup of regulatory entities and stop making the banks play a game of Twister trying to satisfy this and that rule from all different directions!  

As usual, things are just bass ackwards, and I can see why Dimon is so frustrated these days.












23 comments:

  1. Hi! Love you blog, glad you are writing regularly again!

    Since you seem to be on a more high-level/macro kick, I was wondering if you had seen this, and what you think of the "correlation bubble" caused by widespread indexation and ETFs?

    http://www.horizonkinetics.com/docs/Q4%202014%20Commentary_FINAL.pdf

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    1. Interesting article. Those guys are great! But I wouldn't care too much about daily correlation at all. Who cares? If there really is less valuation dispersion, that can be a pain. I think some metrics show less p/e dispersion in the stock market too. But as long as CMG is trading at 50x p/e and YUM is trading at less than 20x, there is still some valuation diffentiation going on even though their stock prices might be 100% correlated on a day-to-day basis.

      On the other hand, if there are companies that differ in quality and both trade at the same p/e, that's a nice opportunity too.

      We don't care what causes it, but I think it's key for value investors for the market to have these inefficiencies and the less sense it makes, the better.

      Also, I do take issue with some of the examples. DIS, for example, has a higher p/e due to it's broad portfolio of quality franchises (Pixar, Lucasfilms, ESPN, ABC, Parks etc...). So it's not hard to see why the street would put a higher multiple on it, than, say, Starz or Discovery, which have just a few franchise/brands in a single area (cable TV channels). The breakup of the current cable TV industry structure is certainly a big risk for these guys that depend on it with a few big channels.

      Anyway, we've seen this before; it's nothing new. Yes, the extent of the ETF boom is new. But every time we have a crash, every time active managers underperform, we have these same cycles. There was an indexing boom in the 1980's too, that partly contributed to black monday (portfolio insurance, which was part of an indexing (with hedge) strategy).

      Like all of the other fads and trends, this will come and go too.

      At the end of the day, if you are right, the market will come around and value things correctly. But eventually. Not right away.

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    2. So do you think active management in general is actually going to come back into repute?

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    3. Yes, I think it will. And then something will happen and it will go away again. These things cycle back and forth...

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  2. I wonder if they did split the bank, if they would be small enough able to guesstimate derivatives losses, such as those generated by the London Whale within say $2-3 billion in a reasonable period of time (preferably before offering definitive sounding public testimony with respect to the amount of said losses), or if they would be able to detect and maybe even prevent widespread currency manipulation. hah. I'm kidding...sort of. I never like it when execs blame disappointing reports on external factors that they presumably could have built into their projections and which there is no upside to mentioning in an earnings call other than preserving the ego of the reporting executive. It seems to me to be a poor a forum for policy discussions.

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    1. Nah, Lehman, Bear and Morgan Stanley were small enough and they blew giant holes in their balance sheets too. The Whale was not about size/complexity at all. I read the internal report and congressional investigation and it wasn't about that. I think I made a post about it back then.

      Dimon made these comments only in response to questions from analysts; all of this stuff came up in the Q&A. People kept asking, shouldn't they break up? Aren't the higher capital requirements too burdensome, wouldn't it be better to just break up and get smaller etc...

      So he didn't bring it up. And yes, it may not be the right forum for policy discussions, but it's good that a CEO of a firm clarifies his thoughts to his investors. I think Dimon did a great job of that.

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    2. Oh yeah, and I forgot to mention that the London Whale was a tiny percentage of JPM's net worth. I mean, that was a total, total disaster that lead to congressional hearings and whatnot, and it was a low single digit percentage of their equity capital that they blew!

      Contrast that with Bear Stearns, Lehman, AIG, Morgan Stanley, oops, forgot to mention Merrill Lynch that *really* blew up their firms. We have to put this stuff in the right context.

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  3. By the way, the Asset Management division at JPM includes wealth management. It seems wealth management doesn't get a high multiple judging from Morgan Stanley. If we did the above analysis with just investment management, the value bump would be even lower. Investment management had net income (assuming 38% tax rate) of $1.2 billion, so the value enhancement from p/e going from 10 to 20 would have been $12 billion.

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  4. Hi kk,

    Isn't the breakup talk a result of different opinions on how JPM has performed - mgmt thinks they have done a great job and the company is doing well, while some analysts and investors may disagree. What's the objective assessment?

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    1. Well, that might be part of it, but the two main themes from an investors viewpoint is that JPM might be worth more broken up than together and that breaking it up might lighten up the capital burden for the bigger, integrated banks.

      Regulators and bank critics think JPM is too big to manage, and I don't believe that at all.

      My opinion of JPM is that it has been very, very well managed. Look at the performance in the last five years; forget about quarter-to-quarter or even year-to-year. If you looked at the growth of tangible book value per share over the past ten years, you wouldn't even know when the London Whale happened.

      To see if JPM is too big to manage and if it would be better managed separately, you can look at some independent comps and compare it to JPM. For example, is JPM's investment bank doing better or worse than GS? JPM is earning a higher ROE. What about the bank. Is it doing better or worse than, say, WFC?

      I think JPM is doing fine. Some of the headwinds they are facing are things like slow economy and the interest rate environment which is getting worse (rates are going lower). If anything, that's what I worry about most, and that's not something that's going to be fixed or changed by breaking up.

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  5. Wow -- just wow!

    As recently as 5-6 years ago, we had an object lesson in how big banks nearly blew up the world economy and now as sharp an investor as you is saying that size does not equal risk and even worse that regulatory agencies are the real danger. (?!?)

    In addition, Dimon could legitimately be prosecuted for violations of Sarbanes-Oxley if anyone actually cared. The idea that JPM is safer than any other big bank is simply a fiction. They blew a $6 bn hole in their balance sheet and had no idea what had happened. Financial controls? Really? Read Naked Capitalism to find out what is actually going on here.

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    1. Thanks for commenting. Yes, your view is basically the consensus so I am very aware of that view. Just google Dimon, or search "Dimon" on twitter; I know most people don't agree with me (which is one of the reasons why I made the post).

      I have followed the crisis from before, during and after and have a pretty good idea what happened. I've written a lot about JPM and the crisis here so I won't repeat everything.

      A "$6 billion hole" in the balance sheet amounts to 3% of equity, which at other companies would be a non-event.

      And yes, maybe I overstate my case blaming regulatory agencies, but there is a lot of blame to go around and for whatever reason the banks pretty much get all the blame.

      There is a new book coming out that looks at bad government policy as the cause of the crisis.

      Anyway, thanks for dropping by!

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    2. By the way, the bad banks could have went under and it would have been OK. What really threw the world into turmoil was actually the bankruptcy of Lehman Brothers. If you look at the indicators until then, things were fine. Bear Stearns broke? Fine. AIG bust? Fine. The market can deal with it.

      But when Lehman went under, the credit markets literally froze and that's when the economy and everything went into a tailspin.

      But why would an investment bank failure cause such turmoil? Its just an investment bank and not even a major money center bank.

      What almost caused the complete collapse in the economy was money market funds. When Lehman went under, some money market funds broke the buck. And then $700 billion or so cash ran out of them. Then even the good companies couldn't roll their commercial paper. That's where the weak link was. A $700 billion run on money market funds is like have a real run on a major bank like JPM or C (which can be averted due to the FDIC etc.).

      The money market funds were allowed to guarantee the $1.00 to investors, but the funny thing was that they had neither FDIC backing (like banks), SPIC backing (like investment banks) nor were they required to hold any capital against their guarantee. So when money funds broke the buck, of course people ran! When Citi got into trouble, I don't know anyone that took cash out. They were happy that FDIC was there, or that the 'deposits' would just be transferred to another bank if Citi really went under.

      There was never a 'run', really. (maybe there was some, but not like the run out of MMF).

      Banks have to hold capital against their deposits. Broker-dealers have to hold capital.

      Why are MMF allowed to guarantee principle with no such capital requirement? It still boggles my mind.

      Regulation, when you look at it, is full of holes and weaknesses like this that cause "real" trouble, but nobody pays attention because the narrative that Dimon is a jerk and is the cause of all problems is the easy way to go; the press loves the story, politicians and regulators love it as it takes the heat off of them. And the public loves it because the public needs a "face", or someone to blame. You can't really discuss regulatory issues and weak links with non-financial people (believe me, I've tried in various social occasions. It's much easier to hate Blankfein and Dimon than to actually sit down and think).

      Also, people blame banks and are trying now to even more restrict them. But why is the FHA still guaranteeing mortgages with 2% or 5% down payment? That's like, total nonsense. No wonder we have blowups. The GOVERNMENT is guaranteeing bad loans!

      We never had a real big problem in the stock market (we have crashes and bear markets, but they usually don't lead to depressions) thanks to Reg T. People are generally required to put up 50% of the cash if they want to buy stocks on margin. This is why we don't have those 1929 like crashes anymore. Yes, hedge funds and instututions can get around Reg T, but it helps that the general public can't do it.

      This is also one of the big problems that lead to the financial crisis. If it 20% or 30% down payment was required for all mortgages, the crisis wouldn't have happened.

      So yes, I do believe that regulations is such as much if not more a problem than the banks themselves.

      Also, when we discuss banks, we have to distinguish the good banks from the bad banks. The general (and even business press) press generally do not; they see all banks and brokers as the same, and I disagree with that.

      But again, that's hard to discuss too as the publc has been trained to view them all as the same: evil, greedy people who caused the crisis!

      Anyway, this is interesting stuff and I don't mind discussing more, but I will be going away for the weekend so if I don't respond, it will be because I don't have internet access (which I don't plan on trying to get).

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    3. "There is a new book coming out that looks at bad government policy as the cause of the crisis. "

      About time. What's the name?

      The Big Short is going to be a movie, no doubt it will be used to bash Big Banks and bankers in every way possible.

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    4. I have no idea if the book is any good, but it's refreshing that someone is looking at a different cause of the crisis than the one we always keep hearing about. It's so strange that one of the big things that came out of the crisis is banning banks from proprietary trading etc...

      http://www.dispatch.com/content/stories/editorials/2015/01/21/1-government-caused-financial-crisis-may-do-it-again.html

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  6. Hi kk, hello again. I did a post with similar themes back when Warren was pushing Glass-Stegall a year or so ago. So much of what the focus on is just wrong. http://dumbmoney.tumblr.com/post/55284210574/the-21st-century-glass-steagall-act-misses-the

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    1. Hi,
      Nice post. But I don't know that national banks are necessarily bad either. It does allow for scale and efficiencies. Just imagine if Costco / Walmart was not allowed to open stores across state lines; retail would be horribly inefficient.

      Plus, we do not live in an isolated bubble. If other banks around the world have scale, American banks would be at a disadvantage. Banks in Japan are largely national; there really aren't arbitrary state lines (although there are regional banks).

      This too is the argument about investment bank + city banks; if other global banks operate as universal banks and U.S. banks are not allowed to, that makes no sense (as you agree).

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  7. Yeah, it seems plain silly to talk about breaking up JPM, so we clearly agree on that account.

    But I do understand the impulse to regulate and watch the industry carefully --- after all, things just about blew up a few years ago.
    To my mind, the real underlying cause (not the proximate cause, that was a lot of things and a lot of ink has been spilled on 'what caused it', but the actual systemic flaw) --- was simply too much leverage in the system.

    If you list the firms that failed, or that almost failed, or that were about to fail and were eaten by someone else, then they all had tremendous leverage. In many cases it was 30x Assets to Equity. So any misstep was catastrophic. For instance, Wikipedia lists Bear Stearns as having $11 billion of equity supporting $385 billion of assets at the end of 2007. This is terrifying for a major institution and is essentially like juggling dynamite.

    There is no really good reason I can think of to allow that kind of leverage. It doesn't serve any purpose useful to society, and ultimately it doesn't even serve the shareholders (as we can see). So if I were writing the laws, I would definitely regulate leverage (which is certainly more complicated than it sounds).

    But if you're a well-run financial institution, then this kind of meddling is just the price you pay for your peers blowing up and causing a crisis every 20 or 30 years, and for things like the FDIC, and for the support and liquidity of the government when its really needed (like TARP, and so on).

    By the way, JPM's current leverage is 11x assets to equity, which is pretty reasonable given their structure, and I see no reason to put restrictions on that.

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    1. Yeah, leverage is what causes the problems in finance. Gross leverage, though, tells very little about what's going on. I guess in the last financial crisis, it correlated with disaster. I would look at net leverage. Gross leverage includes treasury repos and other very, very low risk assets. Net leverage cancels those out so is more accurate a picture.



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  9. Looking forward to your take on the investor day presentation today. The theme seemed to be based entirely on your post!

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