JPMorgan Chase: Out of Control

Josh Rosner (@JoshRosner) is co-author of the New York Times Bestseller “Reckless Endangerment” and Managing Director at independent research consultancy Graham Fisher & Co. He advises regulators, policy-makers and institutional investors on banking and financial services (a more complete bio appears at the end of this column).

This is part Intro, the first part of 5; We will be releasing a different part each evening and morning culminating in the release of Rosner’s complete report on Friday morning. On that date, the Senate Permanent Subcommittee on Investigations will release their final report on JPM’s CIO Group (aka the London Whale).

Enjoy.

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INTRO:

On Friday, the Senate Permanent Subcommittee on Investigations will release the final report on the losses associated with failures of internal controls in JPM’s CIO group. We expect that the findings will demonstrate significant failures of senior management and conclude that the Company’s own investigation was incomplete. It is important to remember that those losses, while the largest and most notable, are only one example of many such failures in recent years.

In this report we will focus on the risk management and internal control environment at JPMorgan Chase, a bank whose balance sheet is almost one-ninth the size of the United States economy. JPMorgan’s financial filings, its “Task Force” investigation of losses in the CIO’s office and its recent history of significant regulatory failures demonstrate that shareholders of are continuing to be called upon to pay for the firm’s inability to ensure an acceptable control environment.

We have intentionally chosen not to detail all of the many private or public actions settled or outstanding (which have driven almost $16 billion in litigation expenses since 2009) or, other than the multistate settlement and foreclosure review settlement, the agreed to or unresolved costs of actions related to mortgage putback demands, including those of institutional investors, insurers, the GSEs, FHA, or the costs of foreclosure-related actions. Moreover, the impunity with which the firm is seeking to transfer billions of dollars of Washington Mutual (WaMu) related losses to the FDIC demonstrates their unwillingness to accept the responsibilities for their own management failures.

Even without the inclusion of these items, since 2009, the Company has paid more than $8.5 billion in settlements for the various regulatory and legal problems discussed in this report. These settlement costs, which include a small number of recent settlements of older issues, represent almost 12% of the net income generated between 2009-2012. Banking regulations and laws are intended to protect stakeholders and the public but some portion of these costs may be tax deductible to the company allowing management to transfer to the public the costs of and future risks of these violations.

In addition, JPM’s ability to retain its reputation, its political power and support of investors in the face of financials that lack the details necessary for a proper analysis are reminiscent of another too-big-to-fail institution: Fannie Mae.

We are not suggesting that JPM will meet the fate that Fannie did. But there are notable similarities in the actions taken by these institutions. JPM appears to have taken a page out of the Fannie Mae playbook in which the company perfected the art of cozying up to elected officials, dominating trade associations, employing political heavyweights and their former staffers and creating the image of American Flag-waving, apple-pie-eating, good corporate-citizen, all of which supported an “implied government guarantee” and seemingly lowered their cost of funding. Additionally, rather than being driven by the strength of its operations and management, many of the JPM’s returns appear to be supported by an implied guarantee it receives as a too-big-to-fail institution.

JPM has a reputation of being the best managed of the biggest banks. In our reviews we could not find another “systemically important” domestic bank that has recently been subject to as many public, non-mortgage related, regulatory actions or consent orders. The firm’s pride in a disputable “fortress balance sheet” – which underestimates their off-balance sheet risks appears to have given investors false comfort, after all poor risk management and control failures are almost always the major drivers of capital destruction.

REPORT:  In this report we will focus on the risk management and internal control environment at JPMorgan Chase, a bank whose balance sheet is almost one-ninth the size of the United States economy. JPMorgan’s financial filings, its “Task Force” investigation of losses in the CIO’s office and its recent history of significant regulatory failures demonstrate that shareholders are continuing to be called upon to pay for the firm’s inability to ensure an acceptable control environment.

There are real risks of further regulatory or legislative changes to required leverage and capital ratios, and that the FDIC’s “single point of entry” approach to the orderly liquidation authority may result in new long-term debt issuance requirements at the holding company. Furthermore, other business risks appear under-appreciated, such as those associated with interest-rate risk management and also the collateral management of derivatives. While these fundamental issues deserve attention, they are not areas of focus in this report but will be addressed in a forthcoming report that considers the fundamental financial realities of “fortress JPM”.

The failures we highlight are not exhaustive but should nonetheless serve to demonstrate the ongoing strains in managing a firm the size of JPMorgan and the benefits that would accrue to shareholders from better oversight and a business plan more focused on core operations.

We have intentionally chosen not to detail all of the many private or public actions settled or outstanding (which have driven almost $16 billion in litigation expenses since 2009) or, other than the multistate settlement and foreclosure review settlement, the agreed to or unresolved costs of actions related to mortgage putback demands, including those of institutional investors, insurers, the GSEs, FHA, or the costs of foreclosure-related actions. Moreover, the firms attempts to transfer billions of dollars of Washington Mutual (WaMu) related losses to the FDIC demonstrates their unwillingness to accept the responsibilities for their own management failures.

Even without the inclusion of these items, since 2009, the Company has paid more than $8.5 billion in settlements for the various regulatory and legal problems discussed in this report. These settlement costs, which include a small number of recent settlements of older issues, represent almost 12% of the net income generated between 2009-2012. Banking regulations and laws are intended to protect stakeholders and the public but some portion of these costs may be tax deductible to the company^[i] allowing management to transfer to the public the costs of and future risks of these violations.

In addition, JPM’s ability to maintain its reputation, its political power and support of investors in the face of financials that lack the details necessary for a proper analysis are reminiscent of another too-big-to-fail institution: Fannie Mae.

We are not suggesting that JPM will meet the fate that Fannie did, nor that its actions will result in accounting problems. But there are notable similarities in the actions taken by these institutions. JPM appears to have taken a page out of the Fannie Mae playbook in which the company perfected the art of cozying up to elected officials, dominating trade associations, employing political heavyweights and their former staffers and creating the image of American Flag-waving, apple-pie-eating, good corporate-citizen, all of which supported an “implied government guarantee” and seemingly lowered their cost of funding. Additionally, rather than being driven by the strength of its operations and management, many of the JPM’s returns appear to be supported by an implied guarantee[ii] it receives as a too-big-to-fail institution.

JPM has a reputation of being the best managed of the biggest banks. This has enabled the Company to employ its muscle with elected officials and thwart regulatory efforts. Oft-cited arguments that strong regulatory actions in the midst of a recovery could destabilize the biggest banks appear to have helped minimize penalties for the many internal weaknesses that might otherwise have impacted market perception of the firm’s management relative to its peers.

In our reviews we could not find another “systemically important” domestic bank that has recently been subject to as many public, non-mortgage related, regulatory actions or consent orders. The firm’s pride in a disputable[iii] “fortress balance sheet” – which underestimates their off-balance sheet risks – appears to have given investors false comfort.[iv] Poor risk management and control failures are almost always the major drivers of capital destruction. Today, even the primary regulator to the largest banks recognizes that operational, compliance, strategic and reputation risks are more critical and a greater reason for concern than credit, liquidity, interest rate and price risk[v]. Unfortunately, not a single one of the 19 largest banks met the OCC’s requirements for internal auditing, risk management or succession planning.

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Disclosures: Neither Rosner nor Ritholtz have any position, long nor short, in JPM stock.

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[i] Should Companies’ Settlements with Uncle Sam be Tax-deductible? (Some of these fines may be tax deductible)

[ii] Quantifying Structural Subsidy Values for Systemically Important Financial Institutions, p.12 p.4 (See. “Using this and the overall rating bonuses described in the previous paragraph, we can evaluate the overall funding cost advantage of SIFIs as around 60bp in 2007 and 80bp in 2009.”, See also Remember That $83 Billion Bank Subsidy? We Weren’t Kidding

[iii] CAPITALIZATION RATIOS FOR GLOBAL SYSTEMICALLY IMPORTANT BANKS ( FDIC CAPITALIZATION RATIOS FOR GLOBAL SYSTEMICALLY IMPORTANT BANKS (G-SIBs) Financial data as of second quarter 2012 (See: “Adjusted Tangible Equity to Adjusted Tangible Assets Ratio – IFRS estimate (3.12 Percent)”)

[iv] The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It, Anat Admati and Martin Hellwig, Princeton University Press (February 2013), P. 83-87

[v] Big Banks Flunk OCC Risk Tests American Banker, “Big Banks Flunk OCC Risk Tests”, by Barbara A. Rehm DEC 13, 2012

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Josh Rosner is co-author of the New York Times Bestseller “Reckless Endangerment “How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon”, and Managing Director at independent research consultancy Graham Fisher & Co. He advises regulators, policy-makers and institutional investors on banking and financial services. Previously he was the Managing Director of financial services research for Medley Global Advisors, Executive Vice President at CIBC World Markets and a Managing Director at Oppenheimer & Co.

In 2001 Mr. Rosner authored “Housing in the New Millennium: a Home without Equity is Just a Rental with Debt” warning of the risks resulting from structural changes in the mortgage finance system. In 2003 Mr. Rosner was among the first analysts to identify operational and accounting problems at the Government Sponsored Enterprises. In 2005 he was among the first analysts to identify the peak in the housing market. In February 2007, warning of the likelihood of contagion in credit markets Rosner co-authored the Hudson Institute paper “How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions?”. In the co-authored May 2007 paper “Where Did the Risk Go? How Misapplied Bond Ratings Cause MBS and CDO Market Disruptions” Rosner identified the problems in structured finance. His “Toward an Understanding: NRSRO Failings in Structured Ratings and Discreet Recommendations to Address Agency Conflicts” was presented in the Winter 2009 Journal of Structured Finance.