We build for the long term — we manage through–the–cycle, and we always are prepared for the toughest of times
Our paramount responsibility to society and to our clients is to be there in good times and bad times
We have a huge obligation to society — not only must we never fail, but we need to be steadfast. Never failing means having the financial strength, liquidity, margins, and strong and diverse earnings where you can weather any storm. It also means having the ability to adapt, survive and even thrive through the cycles.
Steadfast means that you will be there no matter what happens, and being there means that you can continue to properly serve your clients even in tough times. In the toughest of times, it is not about making a profit. It is about helping your clients survive. I should point out that in the toughest of times, particularly in 2009, JPMorgan Chase rolled over and extended credit to small and medium–sized businesses a total of $63 billion, to governments and nonprofits a total of $110 billion, and to large corporations a total of $1.1 trillion. I will talk more about this later.
We extensively manage our risks so that we can survive in any scenario. The Federal Reserve’s stress test is a tough measure of our survival capability — though our ability to survive is stronger than that test implies
We are fanatics about stress testing and risk management. It is in our best interest to protect this company — for the sake of our shareholders, clients, employees and communities. If you went to our risk committee meetings, you would see a number of professionals working to thoughtfully manage and reduce our risk — we don’t want a bunch of cowboys trying to increase it. We run hundreds of stress tests a week, across our global credit and trading operations, to ensure our ability to withstand and survive many bad scenarios. These scenarios include events like what happened in 2008, other historically damaging events and also new situations that might occur. Our stress tests include analyzing extremely bad outcomes relating to the Eurozone, Russia and the Middle East.
Regarding the Eurozone, we must be prepared for a potential exit by Greece. We continually stress test our company for possible repercussions resulting from such an event (even though, in our opinion, after the initial turmoil, it is quite possible that it would prompt greater structural reform efforts by countries that remain). Also regarding geopolitical crises, one of our firm’s great thinkers, Michael Cembalest, reviewed all of the major geopolitical crises going back to the Korean War, which included multiple crises involving the Soviet Union and countries in the Middle East, among others. Only one of these events derailed global financial markets: the 1973 war in the Middle East that resulted in an oil embargo, caused oil prices to quadruple and put much of the world into recession. We stress test frequently virtually every country and all credit, market and interest rate exposures; and we analyze not only the primary effects but the secondary and tertiary consequences. And we stress test for extreme moves — like the one you recently saw around oil prices. Rest assured, we extensively manage our risks.
The Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR) stress test is another tough measure of our survival capability. The stress test is good for our industry in that it clearly demonstrates the ability of each and every bank to be properly capitalized, even after an extremely difficult environment. Specifically, the test is a nine–quarter scenario where unemployment suddenly goes to 10.1%, home prices drop 25%, equities plummet approximately 60%, credit losses skyrocket and market–making loses a lot of money (like in the Lehman Brothers crisis).
To make sure the test is severe enough, the Fed essentially built into every bank’s results some of the insufficient and poor decisions that some banks made during the crisis. While I don’t explicitly know, I believe that the Fed makes the following assumptions:
- The stress test essentially assumes that certain models don’t work properly, particularly in credit (this clearly happened with mortgages in 2009).
- The stress test assumes all of the negatives of market moves but none of the positives.
- The stress test assumes that all banks’ risk– weighted assets would grow fairly significantly. (The Fed wants to make sure that a bank can continue to lend into a crisis and still pass the test.) This could clearly happen to any one bank though it couldn’t happen to all banks at the same time.
- The stress test does not allow a reduction for stock buybacks and dividends. Again, many banks did not do this until late in the last crisis.
I believe the Fed is appropriately conservatively measuring the above–mentioned aspects and wants to make sure that each and every bank has adequate capital in a crisis without having to rely on good management decisions, perfect models and rapid responses.
We believe that we would perform far better under the Fed’s stress scenario than the Fed’s stress test implies. Let me be perfectly clear — I support the Fed’s stress test, and we at JPMorgan Chase think that it is important that the Fed stress test each bank the way it does. But it also is important for our shareholders to understand the difference between the Fed’s stress test and what we think actually would happen. Here are a few examples of where we are fairly sure we would do better than the stress test would imply:
- We would be far more aggressive on cutting expenses, particularly compensation, than the stress test allows.
- We would quickly cut our dividend and stock buyback programs to conserve capital. In fact, we reduced our dividend dramatically in the first quarter of 2009 and stopped all stock buybacks in the first quarter of 2008.
- We would not let our balance sheet grow quickly. And if we made an acquisition, we would make sure we were properly capitalized for it. When we bought Washington Mutual (WaMu) in September of 2008, we immediately raised $11.5 billion in common equity to protect our capital position. There is no way we would make an acquisition that would leave us in a precarious capital position.
- And last, our trading losses would unlikely be $20 billion as the stress test shows. The stress test assumes that dramatic market moves all take place on one day and that there is very little recovery of values. In the real world, prices drop over time, and the volatility of prices causes bid/ask spreads to widen — which helps market–makers. In a real–world example, in the six months after the Lehman Brothers crisis, J.P. Morgan’s actual trading results were $4 billion of losses — a significant portion of which related to the Bear Stearns acquisition — which would not be repeated. We also believe that our trading exposures are much more conservative today than they were during the crisis.
Finally, and this should give our shareholders a strong measure of comfort: During the actual financial crisis of 2008 and 2009, we never lost money in any quarter.
We hope that, over time, capital planning becomes more predictable. We do not believe that banks are trying to “game” the system. What we are trying to do is understand the regulatory goals and objectives so we can properly embed them in our decision–making process. It is critical for the banking system that the treatment of capital is coherent and consistent over time and is not in any way capricious. Capital is precious, and it needs to be deployed intelligently in the business or properly returned to shareholders. If shareholders do not have a clear understanding of capital management and have unreasonable expectations, then that capital will be devalued. This is a bad outcome for all involved.
While there always will be cycles, we need to keep our eye on the important things, too — the outlook for long–term growth is excellent
The needs of countries, companies, investor clients and individuals will continue to grow over time. The chart below shows some of the long–term growth that is expected in some critical areas, including the underlying growth of gross domestic product and trade, investable/financial assets, infrastructure and capital markets activities. This is the fuel that will drive our business in the future.
Therefore, we take a long–term perspective on investing. How we currently view low net interest margins is a good example of making decisions for the long run
To capture our share of the growth in our underlying businesses, we need to continually invest in bankers, branches and capabilities (research, products and technology) to drive down our costs and better serve our clients. It is a lot of hard work that needs to be supported by all of our critical functions, from finance and human resources to operations and controls. This kind of investing should not be done in a stop–start way to manage short–term profitability.
Quarterly earnings — even annual earnings — frequently are the result of actions taken over the past five or 10 years. Our company continued to invest through the crisis — often when others could not — in order to capture future growth.
A very good current example of how we view investing and long–term decision making is how we are dealing with the squeeze on our net interest margins (NIM) due to extremely low interest rates. The best example of this is in our consumer business, where NIM has gone from 2.95% to 2.20% (from 2009 to 2014). This spread reduction has reduced our net interest income by $2.5 billion, from $10 billion to $7.5 billion — or if you look at it per account, from $240 to $180. Since we strongly believe this is a temporary phenomenon and we did not want to take more risk to increase our NIM (which we easily could have done), we continued to open new accounts. Over those years, we added 4.5 million accounts — and, in fact, very good sizable accounts. This has reduced our operating margins from 36% to 32%, but we don’t care. When normal interest rates return, we believe this will add $3 billion to revenue and improve our operating margin to more than 40%.
Our long–term view means that we do not manage to temporary P/E ratios — the tail should not wag the dog
Price/earnings (P/E) ratios, like stock prices, are temporary and volatile and should not be used to run and build a business. We have built one great franchise, our way, which has been quite successful for some time. As long as the business being built is a real franchise and can stand the test of time, one should not overreact to Mr. Market. This does not mean we should not listen to what investors are saying — it just means we should not overreact to their comments — particularly if their views reflect temporary factors. While the stock market over a long period of time is the ultimate judge of performance, it is not a particularly good judge over a short period of time. A more consistent measure of value is our tangible book value, which has had healthy growth over time. Because of our conservative accounting, tangible book value is a very good measure of the growth of the value of our company. In fact, when Mr. Market gets very moody and depressed, we think it might be a good time to buy back stock.
I often have received bad advice about what we should do to earn a higher P/E ratio. Before the crisis, I was told that we were too conservatively financed and that more leverage would help our earnings. Outsiders said that one of our weaknesses in fixed income trading was that we didn’t do enough collateralized debt obligations and structured investment vehicles. And others said that we couldn’t afford to invest in initiatives like our own branded credit cards and the buildout of our Chase Private Client franchise during the crisis. Examples like these are exactly the reasons why one should not follow the herd.
While we acknowledge that our P/E ratio is lower than many of our competitors’ ratio, one must ask why. I believe our stock price has been hurt by higher legal and regulatory costs and continues to be depressed due to future uncertainty regarding both.
We still face legal uncertainty though we are determined to reduce it over time. Though we still face legal uncertainty (particularly around foreign exchange trading), we are determined to reduce it and believe it will diminish over time. I should point out that while we certainly have made our share of costly mistakes, a large portion of our legal expense over the last few years has come from issues that we acquired with Bear Stearns and WaMu. These problems were far in excess of our expectations. Virtually 70% of all our mortgage legal costs, which have been extraordinary (they now total close to $19 billion), resulted from those two acquisitions. In the Bear Stearns case, we did not anticipate that we would have to pay the penalties we ultimately were required to pay. And in the WaMu case, we thought we had robust indemnities from the Federal Deposit Insurance Corporation and the WaMu receivership, but as part of our negotiations with the Department of Justice that led to our big mortgage settlement, we had to give those up. In case you were wondering: No, we would not do something like Bear Stearns again – in fact, I don’t think our Board would let me take the call. The WaMu deal might still make sense but at a much lower price to make up for the ongoing legal uncertainty (including the government’s ability to take away our bargained–for indemnities). I did not, and perhaps could not, have anticipated such a turn of events. These are expensive lessons that I will not forget.
Part of the issue around legal costs is that banks are now frequently paying penalties to five or six different regulators (both domestic and international) on exactly the same issue. This is an unprecedented approach that probably warrants a serious policy discussion — especially if those regulators (as at least some of them have acknowledged) don’t take into account what is being paid to the others. For now, it’s simply a reality for big banks, and certainly for us, that when one or more employees do something wrong, we’ll hear from multiple regulators on the subject.
The good news is that our legal costs are coming down and, we hope, will normalize by 2016.
Uncertainty remains around regulatory requirements, though we believe this will diminish over time, too. That uncertainty is particularly acute around the extra capital that JPMorgan Chase will have to hold because of the new Global Systemically Important Bank (G–SIB) rules, the ultimate impact of the Volcker Rule, total loss–absorbing capacity, CCAR and Recovery & Resolution. And it’s because of that uncertainty that a majority of the time I spend with analysts and investors these days is devoted to regulation. Very little time is spent talking about the actual business, like client transactions, market share gains or other business drivers. Many questions still remain, and they are hard to explain or are difficult to answer, including: Why did American regulators simply double the G–SIB capital requirements for American banks versus all other global banks? Will higher capital requirements be added later? Given that much uncertainty, which is greater for JPMorgan Chase than for most other banks, it is understandable that people would pay less for our earnings than they otherwise might pay.
Having said all this, the contours of all of the new regulations have emerged, and we believe that regulatory uncertainty will diminish over time. And, we hope, so will the drag on our P/E ratio.
Think like a long–term investor, manage like an operator
So our ultimate goal is to think like a long–term investor — build great franchises, strengthen moats and have good through–the–cycle financial results. Achieve the benefits of scale and eliminate the negatives. Develop great long–term achievable strategies. And manage the business relentlessly, like a great operator. Finally, continue to develop excellent management that keeps it all going. As Thomas Edison said, “Vision without execution is hallucination.”