Thursday, April 11, 2013

JPM 2012 Annual Report

So the JPM annual report was put up yesterday.  There is not much new here but as usual I'll just make some simple comments and highlight things that struck me.

One thing, though, is that at the front of the annual report (and at the end of Dimon's letter to shareholders), they mentioned that they put up a video about JPM.  You can see it here.

So, Loews puts up a comic book and here JPM puts up a promotional video.  What's going on? 

Actually, I do think it's a good thing that JPM (and others) get their stories out there.  The general press and even the financial press is so biased and tends only to talk about the bad stuff (if it bleeds, it leads works in financial journalism too, I guess).  And there's nothing wrong with having a video like that out there.  I'm kind of surprised that there are 200+ likes and only 6 dislikes.  Maybe JPM has control of this 'channel' (YouTube).  On a typical YouTube post, you would have all sorts of nasty comments, even for good videos.

But anyway, it's a sign of the times.

As usual, I won't summarize the whole report, but just point out some things.

The Usual Figures
Here's the usual stuff that JPM shows.  Tangible book value has grown from $16.45 to $38.75 from 2005-2012.   That's +13%/year.  As I always say, this is great given what happened between 2005 and 2012.

Long Term Performance
And here's some long term stuff that they showed on investor day.  Dimon shows that shareholders would have done well investing with him since his Bank One days.  Since the Bank One days, Bank One/JPM since March 2000 has gained 8.6%/year versus +1.4%/year for the S&P 500 index and -1.0%/year for the S&P Financials index.

Since the merger with JPM, JPM has underperformed the S&P 500 index a little, but outperformed the S&P Financials index.

Long Term Tangible Book Value per Share Growth
And this table was in the annual report and I don't think it was in the investor day presentation.   It is basically the same as the above but compares growth in tangible book value per share over time with the S&P 500 index.  Share price performance is important, as that's what determines total return to shareholders, but CEOs can't control valuations.  If valuations are high at the starting point and very cheap at the end point, it may not show how well the CEO has actually done.

From this table we see that since 2000, Dimon has compounded tangible book value per share at a 13.4%/year pace compared to 2.6%/year return in the stock market; that's a 10.8%/year outperformance.

Since the merger in 2004, tangible BPS has grown +15.4%/year versus +4.8%/year for the S&P 500 index.  Pretty impressive.

And this was all done while improving capital ratios.  Not only has JPM grown tangible BPS at a respectable clip over the years despite the financial crisis and even the whale loss, it has done it while increasing capital ratios.

Dimon says, JPM has "been able to grow its business, increase dividends, buy back stock AND materially increase capital ratios".

Dimon said that dividends will go back up to $0.38 per quarter (pre-crisis level) in the second quarter of 2013, but share buybacks would be half the level of last year because they want to get to the Basel III target capital ratio by the end of 2013 (they will buy back an additional $6 billion this year).

Whale Loss
Obviously, the first issue covered is the whale loss.   He takes full responsibility for it and apologizes to everybody and then covers some key points to prevent something like this from happening again.   You can imagine what he means for each point:
  • Fight complacency
  • Overcome conflict avoidance 
  • Risk management 101:  Controls must match risk
  • Trust and verify
  • Problems don't age well
  • Continue to share what you know when you know it
  • Mistakes have consequences
  • Never lose sight of the main mission: serving clients

Senate Report
I'm reading the Senate report on the whale loss (and embarassed to say not quite done with it), but I have something to say about that.  This wasn't mentioned in the annual report but I am just tossing my thoughts in here.  

Does it make me uncomfortable?   Yes, of course.  There are a lot of disturbing things in there, particularly the mismarking of the position and some of the discussions between the trader and his supervisor (level below Ina Drew). 

But on the other hand, the way the report is written, it seems to show this incident in the worst possible light and forces the facts into a story that the committee wants to tell.

For example, the report says that the CIO was supposed to use the SCP (synthetic credit portfolio) to hedge the overall risk that JPM is exposed to.  But contrary to JPM's claims, the SCP was in fact not a risk hedge but actually added risk and was in fact just a huge speculative, proprietary trade.  Or something like that.

The reality the way I understand it is that the SCP morphed into something completely different due to their attempts to wind down the position.  Someone had the horrible idea to put on offsetting positions to reduce the book instead of just unwinding it.  And this turned out to be a big mistake.  But it's hardly a situation where someone was secretly making huge directional bets on market direction and things like that.

Also, the report says that the SCP was never really a hedging transaction as nobody within JPM can tell the committee exactly which positions / loans the SCP was supposed to hedge.   In GAAP accounting, you have to have an exact match to use hedge accounting.  But in these so-called 'macro-hedges', that is often not the case.  For example, in the old days, some equity trading desks would routinely buy put options or short index futures as a 'hedge'.  This may have been partly to hedge the inventory of stock that they held for market-making purposes, but it was also a business hedge; if the markets tanked and business dried up, they can at least hope for some payoff from the puts or short futures position.  It works sort of like business self-insurance; you spend x% of your monthly net revenues on insurance. 

In the case of JPM, they have all sorts of built in risk, particularly credit and interest rate risk and exposure to 'tail' events (sudden worsening of credit markets).  When these tail hedges are put on, you can't really point to any single loan or position that you say you are directly hedging.  It's much broader than that.  But the report states that since JPM / CIO people couldn't point to specific positions it was trying to hedge, that the SCP was in fact just speculation and not hedging.

The report also makes it seem like these derivatives are too complex and dangerous, but upon reading JPM's report and the Senate report, I find that that wasn't really the issue.  The investment bank had no problem pricing and managing similar positions.  The big problem was that the CIO didn't mark their books accurately and kept adding to losing positions.  This is not too different than Nick Leeson blowing up Barings; there is nothing too complex and difficult with simple, straight index futures contracts.  But there is a big problem if you don't mark your positions correctly and you keep adding to positions hoping things will turn around.

The problem seems to me what I initially suspected; Ina Drew was sort of like a teacher's pet and operated outside of the class rules.  If Ina is OK with it, Jamie is OK with it.  And noone messes with her or challenges her business.  THIS was the big problem.   The same trades would not have happened if it was in the JPM investment bank (or if it was, it would have been managed very differently).

And I don't think this will ever happen again. I don't think JPM set up all of these checks and balances just so that some people wouldn't have to operate within them.  It's very clear to me that that was the biggest flaw in this case; JPM had all the tools, expertise and understanding to prevent something like this, but it wasn't applied at all due to the above "teacher's pet" syndrome.

The Senate report wants to use this incident to prove that derivatives are too dangerous, that trading is too dangerous, that risk management models don't work (Dimon has always said for many years that he doesn't like VAR models) etc...    But my view is much simpler than that.

Having said all that, I am not saying there can't be more losses elsewhere in the bank.  There probably will be other derivatives losses, just as there will be losses on municipal bond holdings, sovereign credit holdings, credit card loans and mortgages.

On the contrary, I think Dimon and JPM handled this situation very well.  It did take the press to call management's attention to the problem position, but once they realized what was going on, they disclosed it, put a team on it and resolved the problem within the year.  And it's amazing to look at the above performance figures (earnings, tangible book growth etc.) and think that people are calling for Dimon's head (while many CEO's will make stupid mistakes that will cause their firms to book losses constantly without anyone calling for their heads!).   Dimon 'only' made 15% return on tangible book because of the dumb whale loss; off with his head!

I know many people will disagree with this view and that's OK.  I am just saying what I think and how I look at all of this.

Anyway, back to the annual report:

Port of Safety
Dimon said, "We want the public, our regulators and our shareholders to have confidence that we are the safest and soundest bank on the planet".

State of the World
And Dimon does spend some time talking about the state of the world.  I guess this is to illustrate how much potential business there is for JPM in the future (contrary to calls that investment banking is dead).

Not that I get macro advice from bank CEO's, here is what he sees:
  • World GDP is projected to grow +5%/year through 2017
  • Keeping pace with global GDP growth will require $57 trillion in infrastructure investment between now and 2030.  This is 60% more than $36 trillion spent in the past 18 years.
  • Emerging economies will likely be 40-50% of this infrastructure spending
  • The value of the world's exports grew an average +11%/year between 2001 and 2011.  This may continue "if not accelerate"
  • Global cross-border capital flows grew by 4x in the last two decades and that will likely continue
  • Foreign direct investment grew as a share of total global capital flows in the last five years from 22% in 2007 to 38% in 2012.  This trend will likely continue
  • In 1990, 19 of the top 500 multinationals were from developing economies.  In 2012, 125 were. In 2012, 32% of global capital flows went to developing countries versus 5% in 2000.  China and India will account for the greatest number of new multinationals in the next 15 years
  • Majority of world's population live in urban areas.  This will grow to 70% by 2050.  This will fuel demand for infrastructure, clean water, schooling, healthcare etc...
  • Total global financial assets of consumers and business were $219 trillion in 2011; this is projected to grow 6%/year through 2020 to $370 trillion.

U.S. in Great Shape But...
He points out the usual strengths of the U.S. (similar to Buffett's view) but points out problems too:
  • Needs good immigration policy:  it's a problem when 40% of foreignors who get advanced degrees in science, technology, engineering and math can't stay in this country even if they choose to.
  • Infrastructure:  we need a good 20-year infrastructure plan
  • Citizens need better opportunities:  problem when 50% of inner city high school students don't graduate
  • Need rational long term fiscal policy

Dimon also points out there are risks to the current global fiscal and monetary policies.  He says, "We don't know the outcome of these efforts".

He points out that in 1994 and 2004, short term and long term interest rates went up 300 basis points within one year and a lot of people got hurt.

He is not predicting a similar rise in interest rates but he says the bank is prepared for one.  The bank is positioned such that if rates went up 300 basis points in one year (and all else equal which they are not!), JPM's pretax income would be $5 billion higher.

He says, "You should know that it costs us a signicicant amount of current income to be positioned this way.  But we believe it is better to be safe than sorry".

Dimon doesn't seem like a guy that listens to management consultants, but he does quote McKinsey estimates to show the opportunities for the bank:
  • Corporate equity and debt issue demand could grow 25-30% over the next five years
  • Global investor client demand could grow 20-25% by 2017
  • Loans outstanding for small to mid-sized enterprises projected to grow 6%/year through 2020.  JPM grew middle market loans 14%/year from 2009-2012.
  • Investable assets of high net-worth individuals globally rose almost 9%/year from $33 trillion to $42 trillion between 2008 and 2011.  This is projected to grow 6%/year through 2020.
  • U.S. consumer financial assets grew 6%/year in the last decade. McKinsey thinks this will continue through 2020.

So JPM is looking pretty good to me.   At $49.40, it's trading at around 1.3x tangible book so it's not such a table-pounding buy anymore, but it's still a pretty solid hold if not buy.   If it can grow tangible BPS at 10%/year and trade at 1.5x tangible BPS in two years, that's a $70 stock and a 20%/year return (before dividends) without heroic assumptions.   (Tangible BPS has grown at 13%/year in the recent past, but dividends may go up in the future so I used a lower BPS growth rate.  But some of that dividend payout will be offset by improving ROE if the environment continues to improve).

As Dimon said, JPM has been "able to grow it's business, increase dividends, buy back stock AND materially increase capital ratios" in recent years.  But you can also add, "and absorbed the whale loss with barely a blip on the income statement and balance sheets".


  1. You quoted "Steve Jobs" to make an investment case against Apple some time ago (given their dependency on the man).

    Re: JPM, read Zuckerman's "Greatest Trade Ever", the part where Jeff Greene meets Dimon and tells him what he's doing to try and protect himself against the RE bubble. Dimon just stares at him with a blank face and has no clue what he's talking about. This is in 2006-2007, mind you, when the music had all but stopped playing.

    Frankly, after reading that, I'd take anything Dimon says with a pinch of salt.

    1. Hi,

      I haven't read that book yet as I got sort of 'financial crisis fatigue' having read many of the other books. As for Dimon, that may be the case but there could have been many reasons why he had a blank face. Maybe he thought it was too soon, or maybe he was wondering, "who the hell are you and what are you talking about?".

      Given Dimon's experience over the years, it's hard to imagine him not understanding what's going on. I've heard many direct experiences with Dimon from people around him over the years and most stories illustrate how much on top of things he is and how he does understand the details of everything.

      In any case, the proof is in his performance; not how he interacted with some of the heroes of the crisis. The bank came through the crisis having done very well and that's the best test for me...

      Thanks for reading.

    2. It looks like JPM is up for some spanking or worse, would be great if you could add some color on that. For me it is starting to smell
      as if it's a systemic issue within the company, not just a one off. Hope I'm wrong.

    3. Hi,

      I don't have any particular insight into the latest, but I am not overly worried about it. It's a concern for sure, but I don't know what the story is at this point. One thing for sure is that the regulators are being more aggressive recently so these things will come out.

      Oftentimes, regulators will come out with all these allegations and if you dig further it's not as bad as it sounds. This is the impression I got reading the senate report on the whale loss. Many of the points they mention aren't really 'problems'. For example, they make it sound like JPM lied because the CFO said that the SCO was done within the firmwide risk management and then mentions that JPM risk management didn't know the details of the whale trade. This is not inconsistent; if JPM firmwide risk management set parameters and the CIO worked within it, then the CFO's comments would be true and not misleading at all.

      I found a lot of things like that in the report, and I do think that a lot of the problems that regulators (not all of them) turn out that way too. I found this to be true during the Goldman Sachs hearings too.

      So we'll see how these things develop.

      Part of it too is that regulators are being more aggressive and assertive, and there might be a little bit of moving the goal post now too after the fact since it seems to be open season on JPM and banks.

  2. Thank you for writing such a good blog. I found your blog by accident and have learned a lot. I hope you continue to keep up the good work, I will be checking your blog often since i like your analysis.


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