Your pedal extremities are colossal To me you look just like a fossil. – Fats Waller
Business executives like to talk about their “footprint”. When JP Morgan Chase and Bank of America were racing all around the United States to see which could be the first to have a full national presence in every important market, they would talk about how their footprint was expanding state by state. Then it was on to establish a full global footprint, including in all key emerging markets, which supposedly are going to provide double-digit earnings growth for these banks during the next twenty years.
The equity these banks carried grew as well, but the ratio of equity to assets did not. Banks still insist that they can function just fine with an 8% core equity to asset ratio. Holding up the inverse pyramid of each of these banks is the increasingly weary Federal Reserve, meaning ultimately the US taxpayers, whose strength is beginning to falter with these and many other burdens.
Is it right for the US taxpayer to be the backstop for JP Morgan Chase’s foray into Brazil, Russia, India, and China? If these countries are so important to the future of the Too Big To Fail banks, don’t they have central banks which can take on some of this burden? Why is the US taxpayer, and its agents the Federal Reserve and the FDIC, the ultimate bearer of the losses JP Morgan Chase just incurred in its investment office in London?
These transnational burden-sharing questions are becoming more important by the day, as the developed countries are at their limit of tolerance for the arbitrage games that have been played routinely by multinational corporations. Apple, we have learned in recent years, is superb at arbitraging labor by inventing products in the west, selling them to western consumers, but making them by using near slave-labor conditions in China. Apple is also very skilled at tax arbitrage, whereby it has reduced its tax burden in the US to under 10% as it shifts its revenues to countries which are willing to act as tax shelters (Ireland, for example). Within the US, this game has gone on for decades, as companies have gotten adept at playing off one municipality or state against another, extracting tax forbearance, zoning abatements, and other benefits from local governments, which are often abandoned a few years later as the company moves on to the next, more generous locale.
No finer example of global regulatory arbitrage exists than with the TBTF banks. Are US regulators being too strict? Citigroup will just shift some of its business to London. If London regulators aren’t willing to play by the banks’ rules, Luxembourg certainly will. All this works fine for the big banks unless something really bad happens to them; then they fall back on their mother regulator and the taxpayers of their home country. But what is the home country of JP Morgan Chase, Citigroup, Bank of America, Goldman Sachs, and Wells Fargo? It is rather like asking the question why Bank of America has its head office in Charlotte, North Carolina. That is merely an accident of history – the price Bank of America, based in San Francisco, had to pay to merge with Nations Bank, based in Charlotte, was to move its headquarters to Charlotte. As far as Bank of America is concerned, headquarters could be anywhere – or shall we say anywhere there were enough taxpayers to bail it out in an emergency.
Bank of America executives are not going to be consulting with the city council of Charlotte to discuss the bank’s expansion into China. To the extent the bank is willing to discuss such plans even with its regulators, it will be only in very basic terms. The fact is, as these multinationals establish true global footprints, they loose all mooring to their home base or their place of origin. Apple has about as much connection these days to Cupertino, California as Microsoft does to Seattle, which is not much. Boeing used to be associated closely with Seattle twenty years ago, but now has its headquarters in Chicago. Caterpillar, which was established in Peoria, Illinois, threatened to leave altogether if the state of Illinois didn’t give it special exemptions from recent increases in the corporate tax rate; the Chicago Mercantile Exchange successfully made the same threat.
The overwhelming number of jobs at Bank of America are certainly not in Charlotte. Boeing has a few floors of a building in Chicago to show for its presence in its headquarters city. Caterpillar has moved most of its production out of Peoria. We are reaching the point where the people in these cities just aren’t going to care anymore what these companies do or whom they threaten – the personal connection to the company will no longer exist. Multinationals are becoming global gypsies; the more successful they are at bullying countries, states, provinces, and cities into giving them what they want, the more rootless they become, and the less likely it is that any one nation or locale will want to come to their defense.
Banks Gets Special Privileges From the Taxpayers
Which brings us back to the question of the Too Big To Fail banks. Banking has a special privilege not granted to the average multinational – banks have direct support from a central bank, which de facto gives the bank access to taxpayer money in the form of preferential loans and emergency help. This means that it is much harder for the host country to extricate itself from the fortunes of a TBTF bank, no matter how large the global footprint of that bank becomes. JP Morgan Chase could be reduced to one head office in New York City, with 50 employees, and place all its other business in China or Brazil, and the Federal Reserve along with all US taxpayers would still theoretically foot the bill for the collapse of the bank, should that occur.
This extreme example is theoretically possible, but will almost certainly never come to pass, because the US taxpayers and even the politicians will want to change the laws first to get out of the burden of supporting JP Morgan Chase. And that question is already in front of the US taxpayers and politicians, as we have seen with the recent scandal and confusion over the $2 billion trading loss in the bank’s London investment office.
People are asking all sorts of questions about JP Morgan Chase. Is it too big to manage? Are the risks of the bank too complex to understand and too substantial to hedge? Is the bank too big to regulate? Is the bank too large to earn a decent return for the shareholders? The fact is, the bank is all these things. Its footprint has gotten too large and too global; it has no one community that identifies with the bank. Even the good people of New York City are not rushing to defend JP Morgan Chase. Rather, people throughout the United States are asking, why are we backstopping the losses of this bank?
The London CIO losses are an example of all of these problems. Prior to this scandal, few people had ever heard of Ina R. Drew, the manager of this office. Yet with $360 billion in investment money to manage, Ms. Drew is one of the biggest hedge fund managers in the world. The corporate bond credit risks she was trying to hedge were so large that she couldn’t hedge them individually; she had to find an index to approximate the risks in her portfolio. Even then, this index did not have the liquidity to allow JP Morgan Chase a quick entry and exit for its hedge. The trader who was doing the hedging was moving prices in the index with each transaction he put on; this is how he got the name of “the Whale.” There is evidence that the bank has chosen to sit on the position for the moment because it is simply too big to remove without causing the bank more losses simply by eliminating the position.
When New York management began asking about the mounting losses, no one in London could give them straight answers. The position was too complex to describe or comprehend, and it is not clear even the people in London understood what they had done or why it was losing money. The models used to assess the risk had to be junked and the bank resorted to an earlier version of the model that came out with an amount at risk twice the size of the initial estimate. The regulators in London and New York seemed to know something of the position, but events happened so quickly in the market that the regulators were always a step or two behind the situation, unable to give any guidance or instructions.
Remember that the people we are talking about here are the best of the best. Jamie Dimon is considered the most capable and hands-on manager of any of the big bank CEOs. Ina Drew, judging from those who have worked with her over the years and are willing to speak about her to the press, is “scary intelligent.” She has a long history of managing large bank portfolios, a success record that stretches back to the 1980s, and she “does not suffer fools gladly.” The team under her was typically described as “brilliant”. There is of course some puffery in all these descriptions, and in any post mortem we are bound to hear about the flaws and weaknesses of the people involved. Even so, there is no other team of investment managers and hedgers in the banking business that rivals the profit record of this team.
This is interesting enough, but consider the oddest feature of all of this scandal: $2 billion is not that large a loss on a $360 billion portfolio. It is a little over ½ of 1% of the portfolio, which is to be easily expected as a gain or loss in any year. In fact, a much larger loss wouldn’t be a surprise either. So why all the anxiety over this loss? Why did the bank itself trumpet the problem to the press, with all sorts of apologies from the CEO for these failures?
The answer is that the loss might be insignificant compared to the portfolio size, and much less significant compared to the $2.2 trillion in assets that JP Morgan Chase carries on its balance sheet, but it is very significant compared to the much smaller amount of equity that the bank holds. Simply put, the bank’s footprint is way too large for an institution that insists it only needs 8% core capital (the most liquid kind) propping up $2.2 trillion of assets. In its annual report, JP Morgan Chase states as a fact that banks have always operated with slivers of capital supporting an enormous amount of leverage, but this is only true within the living memory of the people running these banks. From 1945 – 1982, US banks were not as leveraged; they had as much as 12% equity standing behind their balance sheets.
Of course, without all that leverage, banks earned a lower return on capital. Net income to equity tended to average around 8%. In the post Reagan environment, banks began to insist on their right to earn double-digit returns on their equity. They even set their internal guidelines to require their individual businesses to earn 15% ROEs or higher, which simply could not be done without higher leverage (in other words, without a lot more assets piled on top of the same amount of equity). At the peak of the housing bubble, banks were able to earn 20% returns on equity, with assets totaling 30x larger than equity. The most aggressive of the banks, Goldman Sachs, earned an incredible 30% ROE for several years running.
The problem here is that the higher your returns, the greater the gains or losses on your assets year by year – earnings volatility explodes because of the leverage. Bank shareholders don’t like earnings volatility – they continue to think of banks as sleepy utilities earning stable amounts of income and paying out nice dividends. To stabilize their earnings at a very high ROE, and continue to pay nice dividends, banks had to cheat nature, as it were, by cheating their customers. They had to find steady, and very large streams of predictable income, and the way to do that is to bend the laws and regulations or break them all together.
Hence banks began to seek out pools of capital gains or cash they could access. The home equity gains that consumers had built up in the US over a century of investing in residential property was one very attractive target, and the Home Equity Line of Credit became a perfect product for tapping into this capital. The consumer would be enticed to remove $25,000 of “cash” from their home, while the bank took $5,000 on top of this in points and fees. All of this was relatively invisible to the consumer because the cost was buried in the large amounts of debt consumers were taking on, some of which wouldn’t become due until years later.
Banks turned themselves into hedge funds, so that they could extract 2% every year from the portfolios of their wealthy customers, and 20% from any gains the customers had in their investments. Even a product as boring as the checking account was turned into a cash cow. Banks created the debit card with overdraft privileges, and then they set up a system making it impossible for the consumer to manage the card. They did this by creating computer algorithms that were kept secret from the consumer, and which rank-ordered debits first and credits by the end of the day, forcing many consumers into automatic overdrafts that incurred fees as high as $35 per occurrence.
It has been estimated that the TBTF banks took in several billion dollars a year in fees on the debit card overdraft product, before it was finally regulated by the Federal Reserve (under pressure from consumers – the Fed would have done nothing otherwise despite the essential immorality of a product that forcibly extracts cash from consumer accounts). Over the ten years of active use of the HELOC product, it has been calculated that banks earned hundreds of billions of dollars in points and fees.
Turning a Hedging Operation into a Hedge Fund
It is no surprise, then, that Jamie Dimon in 2005 turned a hedging operation – the London Chief Investment Office – into a profit center. To do this, he has had to insist that the unit wasn’t really trading, just hedging; the obvious inconsistency in that statement seems to have escaped him, even after the office began racking up revenue of $5 billion in some years, which was 20% of all of the bank’s net income for the year. The even greater inconsistency – that he dare not allow this office to incur symmetrical losses of $5 billion in a year - has also escaped him.
This should be the very point, though, where he begins to understand that he has too many assets piled on to too small an amount of capital. Either he pares down his assets, or he increases his capital. The regulators won’t force him to do this – most of them used to work for the TBTF banks and are expecting to return to lucrative jobs with these banks. The politicians won’t force him to do this, because they need his lobbying contributions. The voters can’t force him to do this, because they are offered only two political choices, both of which are owned by the banks.
That leaves the shareholders. Jamie Dimon has been promising them for years that they will be receiving hedge-fund returns, at least 15% ROEs every year, but preferably 20% or higher. After all, the bank is stripping money from its investor accounts as if it is a hedge fund entitled to 2% fees every year. The volatility in bank earnings is exactly what hedge funds experience; the largest hedge funds wouldn’t blink at a $2 billion trading loss.
Unfortunately, JPM Chase has had trouble producing even double-digit ROEs ever since the credit crisis of 2007-2008. Last year, one of its best years in the past five years, JP Morgan Chase generated 10.15%, essentially failing at its promise to reward shareholders with hedge fund returns.
Any good hedge fund manager recognizes when the fund has become too large – when it gets harder and harder given the size of the assets under control to generate double digit returns, when sheer size makes it harder for the fund to enter and exit the market anonymously, and when liquidity no longer exists for the size trades that the fund must execute. At those moments, the management closes the fund to any further investment, and in many cases the management allows existing investors to take their money out of the fund, permitting it to scale back to manageable size.
Jamie Dimon should be at that point of recognition. If he wants JP Morgan Chase to continue to act like a hedge fund, to earn the ROEs of a hedge fund, and to pay him and his executives bonuses as if they were a hedge fund, he needs to scale back substantially. Somebody has to tell him “Your Feet’s Too Big!”
The reason he hasn’t had this point of recognition yet, despite all the obvious evidence, is that he and his bank are resting on the shoulders of the Federal Reserve, which in turn is depending on the shaky legs of the American taxpayer. The taxpayers have had enough; they just can’t do anything about the situation - at the moment. But as we have seen in Greece, France, and Germany, the taxpayers are beginning to find solutions through the ballot box. The American voters haven’t felt the brunt of austerity now common in Europe, but when they do, inevitably the props underneath JP Morgan Chase and the other TBTF banks are going to be chiseled down, if not knocked out altogether. Jamie Dimon won’t have any choice at that point but to face up to reality.
What Jamie Dimon should do is sit down quietly and listen to Fats Waller. Absorb the lesson: Your Feet’s Too Big! Do something now, while there are still suitors interested in you and willing to take you out on a date. If not, you are going to wake up one day to discover no one wants to dance with you.