Saturday, April 16, 2011

Jamie Dimon Takes Up the Pen

JPMorgan CEO Jamie Dimon’s annual letter to shareholders spends a good deal of time on Dodd-Frank. None of his analysis is particularly insightful — the only thing I learned is that Dimon isn’t a great writer. Nevertheless, Dimon is an influential and ambitious figure, so it’s interesting to see how he presents his thinking on some of these issues. (As should be obvious, I don’t own shares in JPMorgan.)

On the CFPB, Dimon claims that JPMorgan was never really against the creation of a CFPB, just against the creation of a CFPB that might, you know, do stuff that JPMorgan doesn’t like:

We need to create a Consumer Financial Protection Bureau that is effective for both consumers and banks

It has been widely reported that we were against the creation of a Consumer Financial Protection Bureau (CFPB). We were not – we were against the creation of a standalone CFPB, operating separately and apart from whatever regulatory agency already had oversight authority over banks. We thought that a CFPB should have been housed within the banking regulators and with proper authority within that regulator. This would have avoided the overlap, confusion and bureaucracy created by competing agencies.

However, we fully acknowledge that there were many good reasons that led to the creation of the CFPB and believe that if the CFPB does its job well, the agency will benefit American consumers and the system. Strong regulatory standards, adequate review of new products and transparency to consumers all are good things. Indeed, had there been stronger standards in the mortgage markets, one huge cause of the recent crisis might have been avoided. Other countries with stricter limits on mortgages, such as higher loan-to-value ratios, didn’t experience a mortgage crisis comparable with ours. As recently as five years ago, most Americans would have called the U.S. mortgage market one of the best in the world — boy, was that wrong! What happened to our system did not work well for any market participant — lender or borrower — and a careful rewriting of the rules would benefit all.
Dimon is not a fan of Blanche Lincoln’s infamous Section 716 (and in spite of his rhetoric, he’s right about this). Remember when Blanche Lincoln had convinced people that a provision that her Ag Committee staffer threw in at the last second was The Most Important Banking Reform Ever? Anyway, here’s Dimon:

Finally, there is a truly misguided element of Dodd-Frank regarding derivatives. This so-called “spin-out provision” requires firms like ours to move credit, equity and commodity derivatives outside the bank. This requirement necessitates our creating a separately capitalized subsidiary and requiring our clients to establish new legal contracts with this new subsidiary. This is an operational nightmare (which we can handle) but makes it harder to service clients. It runs completely counter to recent efforts by regulators to reduce banks’ exposure to counterparty default. This provision creates a lot of costs and no benefits. We believe that it makes our system riskier — not safer.
On the Volcker Rule, Dimon claims not to care about the prop trading ban, but — surprise, surprise — is ultra-defensive of market-making:

The Volcker Rule needs to leave ample room for market-making — the lifeblood of our capital markets

The Volcker Rule has various components. We have no issue with two of these: the component eliminating pure proprietary trading; and the component limiting banks from investing substantial amounts of their own capital into hedge funds.

Our concern largely is with a third aspect regarding capital and market-making. It’s critical that the rules regarding market-making allow properly priced risk to be taken so we can serve clients and maintain liquidity. The recently proposed higher capital and liquidity standards for market-making operations — the new Basel II and Basel III capital rules — approximately triple the amount of regulatory capital for trading portfolios inclusive of market-making and hedging activities. For the most part, these capital rules protect against excessive risk taking. We don’t believe any additional rules are needed, under the Volcker Rule or otherwise. However, if there must be more rules, these rules need to be carefully constructed (e.g., they should distinguish between liquid and illiquid securities, allow for hedging either on a specific-name or portfolio basis, etc.). When market-makers are able to aggressively buy and sell securities in size, investors are able to get the best possible prices for their securities.
On the resolution authority, Dimon thinks preferreds and unsecured debt should be automatically converted to equity:

Resolution Authority needs to be properly designed

Simply put, Resolution Authority essentially provides a bankruptcy process for big banks that is controlled and minimizes damage to the economy. We made a mistake when we called this aspect of financial reform “Resolution Authority,” which sounds to the general public very much like a bailout. Perhaps a better name for it would have been “Minimally Damaging Bankruptcy For Big Dumb Banks” (MDBFBDB). Banks entering this process should do so with the understanding and certainty that the equity will be wiped out, the clawbacks on compensation will be fully invoked, and the company will be dismembered and eventually sold or liquidated.

When the FDIC takes over a bank, it has full authority to fire the management and Board of Directors and wipe out equity and unsecured debt — in a way that does not damage the economy. Controlled failure of large financial institutions should work the same way. It is complex because these companies are big and global and require international coordination. However, if the process is carefully constructed (and completely apolitical), controlled failure can be achieved.

In the process, the role of preferred equity and unsecured debt needs to be clarified. This may require corresponding accounting changes. My preference would be, at the point of failure, to convert preferred equity and unsecured debt to pure, new common equity. For example: When Lehman went bankrupt, it had $26 billion of equity and $128 billion of unsecured debt. If, on the day of bankruptcy, the regulators had converted that unsecured debt to equity, Lehman would have been massively overcapitalized and possibly able to secure funding to continue its operations and meet its obligations. The process to sell or liquidate the company would have been far more orderly. And the effect on the global economy would have been less damaging.

No comments:

Post a Comment