Thursday, July 19, 2012

Wells Fargo-Goldman Sachs Merger

(Warning: The above title is a title of a blog post, not a news headline!)

OK, so I asked in my last post if GS would be better off as part of a bigger bank and I couldn't put that thought away.  In the past there were rumored merger partners like Wachovia (that was just during the crisis, though), AIG and HSBC (and some others; WFC might have been mentioned during the crisis). 

But WFC kept coming to mind.  Both WFC and GS are owned by Buffett and he loves both of them.

First of all, this is just for fun.  I know this is a long shot and in this political/regulatory/public sentiment environment, this is probably not going to happen (if GS is an octopus, what would you call WFC-GS?!).  But this is a blog so I can write whatever I want, so that's what I'm going to do.

Also, it's a little silly to react too much to short term trends.  I did say the independent investment banks are doing horribly compared to ones that are part of bigger banks.    Morgan Stanley just announced their 2Q and it just confirms this.

So let's add MS to the table from my other post about Merrill:

Independent investment banks
                       2Q ROE                6 month ROE
GS:                 5.4%                      8.8%
MS:                3.5%                      1.4%

IB's as part of bigger banks:
                       2Q ROE                  6 month ROE
JPM (IB):       19%                        18%
JPM (AM):     22%                        22%
BAC/MER:     12%                       13%

The difference is quite clear.  MS's result is horrible.  The market environment is bad, but is it really *that* bad?  I don't know.   The results are horrible, though.

What's stunning about MS is that it's horrible across the board.

From their earnings supplement, here are the returns on average equity for the the various MS segments:

                                                   6 months periods
                                                   2012              2011
Institutional securities                0%                0%
Global wealth management       5%                2%
Asset management                     3%                *
Total                                           1%                1%

I haven't been following MS too closely but I am a bit surprised that shareholders have been so patient there.  Again, look at JPM's returns and that includes the big whale loss!  How can MS not make money?

Investment Banks Better off Inside of Other Banks
OK, so MS may be horribly mismanaged but the fact that the usually very well-managed GS is not doing too well either may imply that investment banks may actually be better off inside other banks.  This is just something that comes to mind just by looking at the facts (even though admittedly, the facts are very short term and may not be indicative of long term 'facts').

Wells Fargo-Goldman Sachs?
So this idea leads me to the Wells Fargo-Goldman Sachs merger idea.  First thing that you are going to think of is what it's going to be called (OK, maybe not the first thing or second thing...).

Wells Goldman
Wells Sachs
Fargo Goldman
Fargo Sachs
Goldman Wells
Goldman Fargo

OK, so none of these really click so let's move on.

As JPM, BAC and WFC grow domestically as the largest banks, increasingly competing in major metropolitan centers like NYC, it's interesting to note that both JPM and BAC have large investment banks.  C, which I haven't included here also has a large investment bank.

WFC stands out as not having a large investment bank even though they do have a wealth management/brokerage segment.

So in that sense, WFC-GS might make sense.  Of course, just because everyone else has something is no reason to get one for yourself.  But still, let's keep looking at this.

First let's take a look at the other large integrated banks:
                    Total assets             Equity                     Equity of IB
JPM             $2,266                     $176                             $47
BAC            $2,296                     $212                             $66
WFC           $1,314                      $140                             (n.a.?)
GS                  $923                       $69                            $69
WFC-GS     $2,237                     $209                            $69

So look at that!  GS fits like a glove into WFC and puts it into the ballpark of JPM and BAC in terms of asset size, equity and equity invested in the investment banking business (The JPM IB equity includes $40 billion for the IB and $7 billion in their asset management business).  

It fits so well it seems almost inevitable!

(WFC does have wealth management and brokerage, so the equity in that business is not zero but it's not disclosed separately (I don't think), and it's not that big)

From this point of view, it looks completely normal and reasonable.

The Merger
OK, so this is a big deal.  I briefly thought about BRK just buying GS outright, but realized that there would be some regulatory issues (don't ask me what; I don't know exactly, but it would probably be complicated).  Plus, a market cap of $47.6 billion of GS is a bit much for even Buffett to swallow now (but you never know!).  He is looking for a $20 billion whale, and maybe even a $30 billion one if cash keeps accumulating.

Buffett has said that every bone in his body tells him to hold on to his GS warrants, so we know he really likes the business and the management.

Anyway, back to the WFC-GS merger.  Since this is a whopper of a deal, the best way this can be done now would be a stock-for-stock merger.  Why?

Because WFC is trading at 1.3x book and GS is trading under book, it would be deliciously accretive to WFC!  Why not?

Of course, I doubt GS would sell itself at under book value, and certainly not 30% below book value.

But let's take a look at this anyway.  This is a blog, not a deal book (so I can do what I want!).

As of the end of 2Q2012, here are the relevant figures:

                                      WFC                       GS
BPS:                              $26.06                    $137.00
SOS:                               5.3 billion               500 million
Common equity:           $138 billion             $68 billion
Stock Price:                   $34.00                     $96.00
Market Cap:                   $180 billion            $48 billion
P/B ratio:                        1.3x                         0.7x

So at current prices, WFC would need to issue 1.4 billion shares to take out GS.  What would happen if the deal gets done right now at these levels?

After the deal, WFC would look like this:

Common equity:         $206 billion
Shares outstanding:      6.7 billion
BPS:                            $30.74/share

So this deal would be accretive by $4.70/share, or 18%.  That's a nice bump in BPS.  How many years would it take for MS to do that on it's own?   Or even GS?

Of course, with market sentiment the way it is, the market may not increase the valuation of WFC on this merger and in fact may reduce it (the market is already telling us that it doesn't like the investment banking business, as the one bank that doesn't have a major IB attached to it is trading at a higher P/B than the other two (JPM and BAC) and independent investment banks are trading below book).

But a lot of that might be offset if GS can generate higher ROE within WFC than on it's own.   The most important reason why investment banks are trading below book is their single digit ROE.

Benefits of a Merger
There are a bunch of reasons why this merger would be good and of course many that would be bad.  First of all, I would think that the regulatory and political environment would be very bad for this deal.  I'm not sure WFC wants the headache of having to worry about the Volcker rule and other regulatory issues.

On the other hand, the benefits that immediately come to mind are:
  • Cross selling of products throughout merged bank
  • Capital efficiency of having a more diversified business model
I'm sure there are plenty of other pros and cons, but I am just jotting down things that come to mind off the top of my head.

I think both MER and JPM are doing better than GS and MS partly because of the cross-selling advantage.  Dimon has mentioned that in the past.

Also, capital efficiency is another big plus, even though I understand most people would disagree with me and say that hiding a risky investment bank behind an FDIC/taxpayer supported bank is a horrible idea.  I've never subscribed to that view, but of course I understand this deal would be a nightmare for folks who do take that view.

I don't necessarily advocate this merger even though the more I think about it the better it sounds.  As an investor, we can't just react to short term results and events and seek instant gratification.

I still think it's a good idea to look at investments and evaluate them on what you think they can earn in a more normalized environment five years out or so.  So this above analysis clearly is short-term oriented; I am reacting to the poor results at independent investment banks over the past 12-18 months. 

I don't know about MS, but I still like GS and think they will do very well over time.  I do believe that this conservatism is short-term based on the uncertainties and heightened risk of a total financial blowup in Europe (and GS doesn't want to get caught with it's pants down; there would be no political will for any sort of rescue next time around).

But it is something that came to mind as I go over these results, so I just jotted it down (for fun!).

And I know, this post goes against everything everybody seems to be saying. 

Wednesday, July 18, 2012

Merrill Doing Good, What's Wrong with GS?

Bank of America announced their earnings and it looks OK.   Of course, there is still an issue with low interest rates and loan growth like at other banks.

This is not intended to be a full recap of BAC's second quarter.   I don't want to comment on every quarterly announcement of companies I talk about here unless there is something I want to say about it.

And since I recently posted about the value of Merrill Lynch, as a sort of follow-up to that, I decided to take a look at the old Merrill and see if they're still doing good and it turns out they are still doing pretty well; better than Goldman, in fact.  So what's wrong with Goldman?  That's another question for later.

Anyway, here are the results of the three segments that are sort of the old Merrill Lynch even though Global Banking includes the investment bank (underwriting, advisory etc.) and what used to be the Global Commercial Bank.

So I just grabbed these figures from the supplement so I can add it all up to see what the aggregate result of the old Merrill is (EC = economic capital, which is basically tangible equity. GWIM = Global Wealth and Investment Management, units = $mn):

So in the second quarter, the old Merrill earned an ROE of 11.9%, not bad at all.  In case some people object to the mixing of the commercial bank with the investment bank, I also put a row at the bottom which only includes Global Markets and Global Wealth and Investment Management.  The ROE figure is close, so I think it's OK to look at the whole "combined" figure; the commercial bank doesn't distort that too much.

In the first six months of 2012, the old Merrill earned an ROE of 13.17%.   This is a pretty solid result, and the results seem solid across the segments.

So how does this compare to Goldman Sachs (GS) and JPM's investment banking operation?
Here are the ROE figures for GS and JPM (investment banking operation and asset management operation):

                        2Q ROE                  6 month ROE
GS:                      5.4%                      8.8%
JPM (IB):          19%                        18%
JPM (AM):        22%                        22%

So Merrill compares very favorably against GS, but not so great against JPM.

Of course, since these equity figures are internally allocated equity figures, it's hard to say if they are 'realistic'.  I think management tries to allocate enough equity so that on a stand-alone basis they would be able to conduct business at the same level. But that's still quite a bit different than actually being stand-alone like GS.

So what's wrong with GS?
It seems like GS is being very conservative and cautious; they do have excess capital and liquidity and their VAR is, I think they said, the lowest it's been since 2006.  They are clearly being very cautious.  On the conference call they do sound confident that opportunities will arise but they just don't know when. They do talk about having a lot of capital ready to deploy, and that they have a lot of operating leverage so that when things stabilize and pick up, they can really make some good money.

But still, why is GS earning single digit ROE's while JPM is earning 20% ROE and even the old Merrill is earning double digit ROE's?

Yes, one point is management; GS is being very conservative for whatever reason.    Does this have to do with GS being independent?  Do they have to be more conservative than JPM and MER because they are not part of a bigger bank and therefore there is nowhere to turn if conditions worsen (in terms of reallocating capital/liquidity to it)?

I still like GS, and I do believe that GS knows what it is doing and is waiting for the right opportunities to deploy capital profitably and I don't think this single digit ROE is going to continue forever (I know many will disagree with that; many will say, ha, told ya so.  Investment banking is dead!).

Diversified Business Model actually GOOD?
So I was wondering if the superiority of JPM and MER versus GS is the diversified nature of JPM and BAC.  One of the benefits of Berkshire Hathaway is that cash all goes to Omaha and then it gets redeployed by Buffett according to where the best opportunities are.  So if you are a furniture store not doing so well but generating cash, you don't have to reinvest the cash in the business; you send cash to Omaha and Buffett will deploy it where he sees good returns.

This is one of the benefits of the diversified financial institutions too which was popular back in the 1990s and 2000s; this idea is not so popular these days, though, obviously.  But these things seem to move in cycles.  Sometimes a diversified model is good, at other times it's bad. 

I actually think there is a benefit to the diversified model.  Of course, any good idea can be taken to extremes.  When a diversified model reduces risk (or perceived risk), that encourages more risk-taking until you take it too far and blow up.  But that doesn't mean a diversified model is necessarily a bad idea.  (If you lever up thinking you have a diversified portfolio, you might lever up too much and blow up like LTCM.  But that doesn't mean running a diversified book is a bad idea).

So in the case of JPM, they can deploy capital where it sees opportunity.  What's interesting is that JPM's allocated equity to the investment bank is constant at $40 billion, which means that all returns generated are paid up to 'corporate' or wherever it goes.  It doesn't build up equity and then create the need to invest more.  

Dimon will up the allocated equity on an as-needed basis.

On the other hand, GS has a very focused business model so when capital builds up, it just stays there at corporate (or wherever) with nowhere to deploy the capital.  Of course they can pay it out as dividends or repurchase stocks, but then that would be a permanent return of capital to shareholders and if opportunities suddenly arise, they won't be able to get that capital back.

At JPM, if something happens and opportunities arise, they can shuffle capital back and forth between business lines.

So that does increase capital efficiency.  I understand that there is an argument that this sort of thing may actually encourage too much risk-taking and an eventual blowup.   But as I said above, you can take any good thing and take it too far.

(Also, I will leave out the benefits of cross-selling that JPM and MER might be enjoying at this point).

I know this argues against the BAC-MER spinoff, but it is something that came to mind when going through the second quarter numbers for these institutions.

The Opposite Question
All of this ironically raises a question that goes the other way (that actually used to be asked all the time); should GS be a part of a larger financial institution?!  That would be the corollary to all of the above observations.
I have no strong views on that at this point, but it is an interesting, contrarian thought (contrary to people calling for MER to get spun off, for big banks to split up etc).

Tuesday, July 17, 2012

Wall Street Firms Only for Employees?

So I keep hearing people say that Wall Street firms exist only for their employees.  One guy on Bloomberg TV said that GS only exists for it's employees; why not get that compensation down and return some of it to shareholders? 

As proof that GS exists only for the employees, he states that compensation is 40-50% of net revenues.

OK, so let's think about this for a second.  Is it really true that GS only exists for employees?  If someone started a business only for the benefit of the employees, can it really exist for a long time?  I tend to doubt that.  We have heard so much how awful GS is despite the "muppet" story and Fabulous Fab etc.  Are people really that stupid and irrational to keep doing business with these awful people?  Or does GS actually provide a service that people want to pay for?

Compensation Ratio
Anyway, first of all let's think about this 40-50% compensation expense ratio.  Banking is a service business and it makes sense that much of the expense in a service business is labor cost.  Unfortunately, there isn't much detail in financial disclosures to calculate labor costs in various industries.

One industry where labor cost is disclosed is the restaurant business, which is a service business.  McDonald's has a breakdown of costs for their owned restaurants.    From that we see that owned restaurant labor costs as a percentage of restaurant sales is 25%.  But wait a minute; banks and investment banks report revenues as "net" revenues, net of interest expense which is basically their cost of goods sold.

So let's look at labor costs at McDonalds as a percentage of "net" revenues (revenues less cost of food and paper).  That comes to 38%.

So 38% of McDonalds restaurant sales (net of cost of goods sold) go to payroll and benefits.  McDonalds, too, then exist only for their employees?  By this definition, yes.  McDonalds restaurants only exist for the employees.

How about another restaurant?  Darden Restaurants is a large chain restaurant.  I am not cherry-picking any names here; that's the first one that came to mind that seems like a 'typical' chain restaurant (that runs "owned" restaurants versus franchises them which have different economics).

Labor costs at Darden is 32% of sales.  If you exclude cost of goods sold, then labor costs is 45% of "net" sales.  So I suppose Darden restaurants too only exist for their employees according to this person that is complaining that GS only exists for their employees.

How about another one?  I remember Dimon mentioning newspapers when he commented on this issue. 

Again, I am not picking names that make my point.  The first pure play newspaper that comes to mind is the New York Times.  Wages and benefits at NYT in 2011 were 37% of total revenues.  That's 37%.  Yup.  New York Times too exist only for their employees.

How does this 37% compare to the evil banks?

Compensation and benefits expense as a percentage of net revenues for the three financial firms I mention often here are:

GS:        42%
JPM:      30%
WFC:    34%

These are all figures for the full year 2011.

OK, so maybe I am reaching here a little bit.  Fine.  

Let's look at this another way then.

People keep saying that GS (and other investment banks and banks) exist only for their employees but let's look at shareholders.

I already mentioned how great JPM has done for shareholders throughout the crisis.  You can see growth in tangible book and book value per share over time, plus JPM pays a nice dividend even now.

Here's the post on the JPM 2Q.

It looks to me like JPM is doing fine for shareholders. 

GS No Good For Shareholders?
OK, fine you say.  JPM has a lower compensation ratio than even the New York Times.  And they have done well for shareholders over time (management can't control stock price so you have to look at ROE, growth in BPS etc...).

Let's see how the poor GS shareholder has done (I'm just cutting and pasting here from an old post):

  • The average ROE from 2001-2011 is 17.2%, and for the last five years it's been 15.1%.

That looks good to me.  How many companies have achieved that?  I'm sure New York Times shareholders would love performance like that!

BPS for some key years were:
                   2006       2007      2011
BPS           $72.62     $90.43   $130.31
TBPS         $61.47     $78.88   $119.72
  • Since the peak in 2007, GS grew BPS by +9.6%/year and tangible BPS by +11%/year.
  • For five years, the respective growth rates were +12.4%/year and +14.3%/year.
  • For the past decade, 2001-2011, BPS grew +13.6%/year.

That looks pretty impressive to me.  How many companies have achieved something like this, especially after all that has happened in the past decade?

Anyway, it doesn't really matter what people say but when people keep saying something over and over without looking at the facts, it gets a little annoying and I can't NOT point it out.  It's a little disappointing that so many reporters and commentators have been in the business for many, many years and still don't seem to check the simple facts before commenting.   There are a lot of people saying a lot of things all the time and a lot of it has no basis in fact!    Beware of these people.

Friday, July 13, 2012

Howard Marks on Macro etc.

Howard Marks was on Bloomberg TV yesterday and it was a great interview.  I think Bloomberg TV is way better than CNBC these days as they seem to ask better questions and give the guests more time to answer questions (rather than trying to make them say things that the interviewer wants to hear, or force / trick them into supporting a political view).

Anyway, any time you can hear someone like Marks speak, it's worth your time.  Here's the link:

Howard Marks on Bloomberg TV

This blog is not about posting links so you know more is coming. 

I don't intend to summarize the interview or anything like that.  There were a couple of points in the interview that really struck me and I wanted to point that out.   If you have followed and read Marks over the years, you know he is a really solid guy and very credible.  So I found it interesting that he said:

Central Bank Actions Reasonable
He was asked if recent central bank actions were a mistake and he said no.  He said the Fed is stimulative and it's appropriate that they are stimulative.  He said that "their course is reasonable".  I think Buffett is on that side too, defending the Treasury and the Fed in their actions in preventing an economic collapse.

Anyway, I tend to be on that side too so it's refreshing to hear people on this side (instead of the Fed bashers which seem to be the majority these days).

Macro-forecasting Bubble
Ever since the financial crisis (and actually from before then, but a lot more since then), a major pet peeve of mine has been what I think is a big macro-forecasting bubble.  Reading letters from value investors, I got so tired of reading about the macro.  Many equity fund letters spend so much time talking about the debt, the crisis, the coming depression if politicians don't get their act together etc.

Others blamed their poor performance on the macro environment, saying that their mistake was ignoring the macro environment.

I have always thought that the equity funds that lost a lot of money lost money on poor securities analysis; Buffett's portfolio didn't blow up despite being heavy into financials and Buffett didn't sell down his stocks, buy puts, hedge or anything like that at all.  He just stuck to strong balance sheets and he did just fine, thank you. 

Others jumped into AIG, MER, BSC, LEH, FNM, FRE and suffered permanent loss of capital. 
I would call that a securities analysis error, not a macro forecasting error.

But I still keep hearing stock experts spending so much time on the macro.

There's a difference between buying into risky, leveraged institutions and hoping that a recession won't get too bad, or just buying the strongest companies and not worrying about how bad a recession can get secure in the knowledge that the company you own can cope with everything but maybe the moon crashing into the earth (this is a Jamie Dimon scenario when asked if JPM can lose $50 billion or whatever it was during the congressional hearings).

Buffett has said over and over that he doesn't pay attention to the macro when evaluating investments.  If he likes the business and the price, he doesn't check to see if the economic forecast is going to be OK.  He doesn't worry about what will happen in Europe.  He said he has never *not* done a deal or bought a stock due to macro concerns.

Marks on Macro
So anyway, it was very refreshing to hear Marks talk about the macro.   He was asked about how macro is getting to be more important in investing in these volatile times.  He said that most people think macro will determine investment results (so they pay a lot of attention to it).  But he points out that in investing, there is always another side to it.

Of course, it's desirable to be able to forecast the macro to improve your investment results, but the big question is can you do it?  Can it be done?  Marks said that he personally doesn't believe that you can be consistently superior in macro judgements.  The two key words are consistently superior.

He also noted that the smartest investors from Buffett on down don't make macro judgements; they find great values to invest in.

He was asked what he thought will happen in Europe (just after telling them that forecasting macro can't be done consistently).  He said that it is a complex situation but he is sure of three things:

1.  He doesn't know what will happen in Europe
2.  Nobody knows what will happen in Europe
3.  If you ask an expert what they think and take their advice, you're making a mistake.

He quoted Mark Twain: "It's not what you don't know that gets you into trouble, it's what you know for certain that just ain't true".

Can you know more than others?  That's the real question.

Julian Robertson on Macro
Interestingly, Julian Robertson too was on Bloomberg TV in June and it was really interesting to hear him say something similar to Marks.  Someone asked him about the Europe situation and the macro environment and Robertson said that the macro situation is always tough to call.  And he said that the problem with hedge fund performance has been stock selection and not macro.

If you look at the performance of hedge funds and stock funds over the past few years, I would bet that the performance has been much more influenced by stock selection than market-timing.  Guys like Bill Ackman and Buffett's recent hires have done very well in the recent past while other value funds have done horribly and it's not due to one of them getting out of stocks before the crisis and getting back in right at the low.  They didn't do better because of their macro insight.

Of course, there are guys out there that specialize in macro. One big fund these days is Bridgewater Associates that pretty much make all of their money on macro. I suppose Bill Gross at Pimco is like that too. George Soros is another that has made a lot of money over the years doing macro trading/investing.

But these people do macro full time and it's their specialty. This is a lot different than a value investor who raises cash due to economic uncertainty and trying to enhance their returns through this macro 'insight'.

Marks on Best Opportunities Now
Marks was asked where he sees the best opportunities now and he said real estate and real estate debt.  He said that people are staying away from the area and in terms of deal flow he sees a lot of opportunity there.

Like other value managers, he also likes residential real estate.  He said it's a good idea to buy housing and housing related investments when the market is assuming that housing will never recover.

Most Important Point of Marks' Book
At the end of the interview, he was asked what is the most important point that he wants his readers to understand about investing.  He said that he wants people to understand that it's not easy.  He said that when he talked to Munger, Munger told him that none of this stuff is meant to be easy and anyone who thinks it is is stupid.

JPM: 2Q Conference Call

This must have been one of the most anticipated corporate conference calls ever.  I have to admit to looking forward to it too.  Anyway, we finally see the big number.  This is not a summary of the conference call which lasted two hours, but just some thoughts.

Whale Loss
Rumors of losses were as high as $9 billion at one point but settled around $5 billion for the quarter.  The announced "whale" loss was $4.4 billion; the actual loss was $5.1 billion but they shifted $460 million (after-tax) of the losses to the first quarter as they found the marks were bad in the first quarter (I think they said that the 'wrong' marks were still inside the bid-ask range, but not credible).

The total loss year-to-date is therefore $5.8 billion compared to what we thought was initially a $2 billion loss (that Dimon said could easily get worse over time).

So that is a pretty stunning loss.  But what is even more stunning to me is that JPM was able to earn an ROE of 11% and ROTCE (return on tangible common equity) of 15% despite booking this loss.  Sure, it includes a bunch of one time offsets to the loss.  So let's take a look at that:   

They earned $5 billion net in the second quarter, but let's take away those one time gains.  They realized some gains in their CIO securities portfolio, had reserve releases, DVA gains in the investment bank and a markup in their Bear Stearns note. 

So we can subtract all of that from the $5 billion net income in the quarter:

There was a total of $2.7 billion in one-time gains according to the above table (CIO securities gain of $628 mn, reserve release of $1.3 bn, DVA gains of $468 mn and Bear Stearns note gain of $338 mn).

That's still an annualized 5% ROE and 7% ROTCE; pretty impressive given the big one time loss.

Here is the book value and tangible book value of JPM over the years and through the second quarter of 2012:

Despite the "huge" loss, JPM grew tangible book value per share an annualized 12% since the year-end 2011.   BPS grew an annualized 7.8% year-to-date. 
It looks like all the business lines did pretty well in the second quarter.  Revenues and earnings will fluctuate so let's just look at the ROE by lines of business:

JPM overall had an ROE of 11% and ROTCE of 15% in the second quarter.

Investment bank:                         19%   (15% excluding DVA)
Retail financial services:              34%
Card services and auto:                25%
Commercial banking:                   28%
Treasury and security services:    25%
Asset management:                      22%

Capital, Dividends and Share Repurchases

Dimon did say that capital and earnings-wise they can start repurchasing shares any time but after discussions with regulators and the Fed, they will only do that after submitting a capital plan to the Fed; they hope they can restart share repurchases early in the fourth quarter of 2012.

In the above table that shows capital projections, JPM used analyst estimates to project future excess capital.  Dimon said that these are analyst estimates of future earnings but noted that JPM hopes to do better than the estimates.  He said that he can't promise it, but he hopes to outdo the estimates.  That's encouraging.

Anyway, according to the above table, if they wanted to get their capital to 9.0% Basel III by the end of 2013, they will have excess capital of $22 billion.  This is the amount that they would be able to repurchase shares.  At 9.5% by the end of 2013, they would have excess capital of $15 billion (this is cumulative through the end of 2013).  The figures for the period through the end of 2014 are $42 billion and $34 billion respectively.

Dimon also said that they do plan on paying out 30% of normalized earnings over time, but that they can do better than that and hope to do so.

$24 billion in Earnings Still Doable?
JPM continues to believe that on an absolute and static basis, earnings should be $24 billion on a normalized basis.  This has been a figure they have been using in presentations for a while in demostrating the core earnings power of JPM.

Someone asked during the conference call whether this is still the case after the CIO incident since the CIO did contribute to earnings in the recent past (the question was asked despite the fact that it was stated clearly in the presentation that JPM still believes the $24 billion normalized earnings figure to be good).

Dimon said right away that the $24 billion earnings figure didn't include assumptions of profits in the synthetic credit portfolio  (They disclosed that the synthetic credit portfolio in the earnings presentation (the problem part of the CIO) earned a total of $2 billion during the years 2007 - 2011).

Wouldn't the winding down of the synthetic credit portfolio reduce the risk in the CIO and therefore future returns?  The answer was a simple no.  The CIO is a conservatively managed, low return portfolio and that won't change going forward.

Too Big and Too Complex to Manage?
Someone asked if this incident proves now that JPM is just too big and complex to manage and Dimon simply responded that he doesn't think so.  He mentioned that hundreds of small banks have failed, monolines have failed etc.  I don't know why people keep saying this when the big failures during the crisis were for the most part, non-complex institutions (FNM, FRE, monolines, MER, BSC, LEH, WM, etc...).

He also mentioned the benefits of the diversified business model and the cross-selling advantage.

People keep talking about this as a big failure in risk management and a reason JPM is too big to manage.  It was a loss big enough for Dimon to be called to congress.

Yes, it was a big loss and yes, it was a massive failure in risk management.  It was a big mistake.

But let's put this in perspective for a second.   In the first six months of 2012, JPM earned an ROE of 11% and ROTCE of 15%.  The whale loss was $5.8 billion in total.  Let's call that $3.8 billion after tax.

So if this mega-loss didn't happen, the six month ROE and ROTCE would have been 13% and 18% respectively.

Think about that.  So Dimon was called down to congress to face grilling in both the house and senate, people are calling JPM too big and complex to manage and some other person said JPM has "serious managerial issues" (a former prosecutor, governor and 'trick').

Let's get this straight.  So a bank manages to earn only an 11% ROE instead of 13%, and this is a major problem?

I can point to a lot of financials that earn nowhere near 11% ROE and their ROE fluctuates much more wildly and nobody utters a single word (what happened to Goldman Sachs' ROE in recent years and especially last year?!). 

JPM made a mistake that caused their ROE for the first six months of the year to go from 13% to 11% and ROTCE from 18% to 15%.  Many people would be completely happy with a 15% ROTCE!

Hardly tragic.

Of course, there were questions regarding LIBOR, but Dimon won't comment on the issue.  He did say that not all banks are in the same position.

There were questions regarding the yield curve and net interest margin.  Dimon said that even with the current yield curve, they are making good returns.  He also said that the yield curve flattening is entering it's final stages; that it is coming to the end or final stage.  I don't know what he meant by that; if he thinks that the flattening will reverse and steepen in the future, or if he means that the curve can't get that much flatter and JPM will keep doing well regardless.

He did say that if the curve keeps flattening, they will adjust and still will make money; they will only do things for good returns.  There may be some repricing, adding fees for some services if they can't make money otherwise etc...

Either way, Dimon didn't seem all that concerned about it.

Isolated Incident?
Many people are skeptical that this is a one-off event.  People see the huge derivatives book and are afraid there might be a big "oops" there too some day.  What do I think?

I really do think this is one-off.  This is not to say that JPM won't make other mistakes.  I'm sure there will be other problems in the future.  It's a risky business. But what happened at CIO is not really indicative to me how good or bad risk management at JPM is.  I think in other business lines, the risk management is very tight.

There have been reports recently about the resentment from the investment bank how lax the risk management was over at CIO compared to what the IB traders had to go through.

This is because I think Dimon had a lot of faith in Ina Drew and cut her a lot of slack.  In hindsight that was a mistake because she obviously screwed up.  But I do understand that dynamic.  There are certain areas where a CEO might cut someone some slack for a certain project and keeping them outside of the general corporate infrastructure.

This is what I thought happened when I first heard the news and everything I've heard and read since then confirms this view.

So in that sense, I really do think this is a one-off event. 

Going Forward
Dimon said that under stressed conditions, the structured credit portfolio can lose another $1.7 billion.  But that's under a stress test-like scenario, not an expected loss.   I think it's safe to say that the worst of this trade is over.

Stock Still Cheap
The tangible book value per share of JPM was $35.71 at the end of June and the stock even after rallying 6% today is trading at $36/share so I think it's pretty darn cheap.

JPM has grown tangible book value per share throughout the crisis at 12%/year and in the first six months of the year it grew an annualized 12% including this huge loss that shook the financial world.  That's insane.  Imagine what JPM can do in more normal times!

So yes, I do still believe that JPM is a great value at tangible book per share.

I don't think Buffett has changed his views about JPM despite this incident (he announced earlier this year that he owned shares of JPM in his personal account).  Kenneth Langone was interviewed briefly outside of JPM HQ today and he said that if he can only own five stocks, JPM would be one of them.  He said this incident shows why Dimon is such a great CEO (how he is handling it), and I do agree with him on that.  I do wonder what the other five stocks are, though (other than HD).