Like many others within the financial services world, I look forward to the release of Berkshire Hathaway’s annual report every year, which has started with a letter from their chairman and CEO Warren Buffett for the past half-century. In those 50 years, he has never failed to provide investment, business, and life advice that supersedes all other similar writings.
Over the past decade, however, I began reading closely an annual letter that, just like the one of Warren Buffet’s, is also full of life and business advice. This letter, which is more targeted towards the banking industry, has been the annual letter to shareholders from J.P. Morgan’s CEO Jamie Dimon. Since taking control of the bank in 2005, he has given his shareholders, and many other interested readers, profound insights into the banking and financial services industry – perhaps more than almost anyone else on Wall Street.
Jamie Dimon’s annual letters have covered topics from derivatives to recessions and credit card receivables accounting. The insights he provides in his letters are the only ones to come close to matching – and in some cases eclipsing – the letters of Warren Buffett.
Jamie Dimon always dedicates the first sections of his letters to the financial and economic performance of J.P. Morgan’s business segments and the work that has been done to make the once House of Morgan into the largest bank in the country. While each letter stretches far in its insights, the most powerful lessons from any banking institution come from their ability to get through a crisis and maintain the confidence their clients have built up with them over decades.
The Bank of Italy (the predecessor firm of Bank of America) did precisely this when an earthquake in 1906 caused Montgomery street – the California equivalent of Wall Street – to suffer from the massive destruction caused by both the rumble of the earthquake as well as the even more destructive fires that ensued afterward. The head of the bank at the time, A.P. Giannini, seized the opportunity to take advantage of the chaos by rapidly setting up temporary offices and running ads in the local newspaper saying that the bank was back open and ready to do business; all while other banks were struggling to survive the destruction and loss of their assets.
Jamie Dimon’s management of the 2007-2008 housing crisis deserves even more credit as the panic brought on by the financial crisis was the worst the world had seen since the 1929 crash.
Most individuals not actively engaged with the financial markets at the time may look back on the economic crisis and see 2008 as the year of absolute peril, which it undoubtedly was. However, before the peak of fear and panic, evidence of the mortgage crisis was evident much earlier.
Flashback: How Jamie Dimon Dealt with the 2008 Housing Crisis
As the real estate bubble started to burst, Jamie Dimon categorically laid out the different factors that led to such excessive housing prices in the early 2000s, from the increasing amount of Structured Investment Vehicles (a concept he deemed as having no value), subprime CDOs, and excessive lending against higher-priced houses.
The most critical lesson laid out in his letter is summed up by his statement that “having a fortress balance sheet is a strategic imperative, not a philosophical bent.” As house prices continued to rise and people wrapped up in the enthusiasm continued to refinance their homes and borrow increasingly large sums of money against their rising home equities, it seemed that the show would never end, and that the prices of their homes solidly backed the loans made to individuals.
When the inevitable day came, and the world realized this strategy and vision of the economy was far from the truth, the fortress balance sheet that Jamie Dimon insisted on proved to be essential when banks across the country were forced to take massive write-downs on their mortgage-backed portfolios.
In good times, the need for excessive cash and liquid assets seems to be an over-conservative philosophy for the likes of old-fashioned business people from Warren Buffett to Andrew Carnegie of the world. Even Bill Gates, in his early days with Microsoft, insisted on having enough cash on hand to pay all their employees for a year, even if none of their customers paid them. In times of crisis, it is indeed revealed that this conservative attitude is a necessity, not a luxury. As Buffett says, “cash is like oxygen to a business. You don’t notice it much when it’s there, but once it’s missing, it’s the only thing you can think of.”
Jamie Dimon’s second point shows the actions which lead to the first point being so important. As the mortgage frenzy continued, the underwriting standards that banks used became far too lenient, which ultimately led to banks writing mortgages with loan-to-value ratios (the ratio of the amount of the loan to the supposed value of the asset) of upwards of 90%, and in some cases doing so without any income verification.
At the time, these standards seemed perfectly reasonable, as people were operating under the assumption that home prices would continue to rise. Still, when prices eventually began to fall, banks’ loan portfolio value declined substantially. In 2007 alone, J.P. Morgan had to take a $564 million charge off on the value of their home equity portfolio.
Still, the points laid out in his 2007 letter only served as a slight warning to what happened the following year.
2008: The Housing Bubble Crisis
When it comes to economic troubles, one of the most important lessons is acknowledging that when things get bad, they may get much worse. In his 2007 annual letter, Jamie Dimon said that troubles with mortgages might get much worse, but even he couldn’t predict how bad things were going to get and how important his bank would prove to be to the United States financial system.
The troubles that transpired in 2008 caused J.P. Morgan to make three monumental moves that indeed proved beneficial to the bank’s shareholders, but even more important to the citizens of the United States.
Move #1: Bear Stearn
The first of J.P. Morgan’s monumental moves was the acquisition of Bear Stearns. This happened at a time when the bank was on the brink of bankruptcy and the U.S. government pleaded with J.P. Morgan to take over the bank’s assets and liabilities, given that it was one of the only private institutions capable of doing so at the time.
The assets on Bear Stearn’s balance sheet were reported at $400 billion, which after the acquisition had to be consolidated into J.P. Morgan’s financial statements, an extremely daunting task. While the government assumed risk for a large part of the mortgage assets that J.P. Morgan was taking over from Bear Stearn, they still paid $1.5 billion for the company, which they hoped would result in an additional $1 billion of annual earnings.
Move #2: WaMu
The second move was yet another acquisition of a troubled bank, Washington Mutual, which again was done in part to try and prevent the collapse of the U.S. financial system and further proved that J.P. Morgan’s fortress balance sheet would let them not only survive the crisis but take advantage of a profitable opportunity as well.
The deal added an enormous group of assets that helped J.P. Morgan expand their reach across the United States as a commercial bank, with the acquisition providing them with 2,200 branches, 5,000 ATMs, and 12.6 million checking accounts, all of which continue to offer massive earnings to the shareholders of J.P. Morgan.
Move #3: TARP
The third, and most controversial move, was the acceptance of funds from the Troubled Asset Relief Program, which was essentially government bailout money for the country’s largest financial institutions.
J.P. Morgan, unlike many other companies, would have fared well without any acceptance of the funds. Still, the problem with the approval of TARP money, however, was the fear that if one firm did not accept the funds because they did not need it, other banks who did need it might not be inclined to take it as it might tarnish the bank’s and the executive’s reputation. As Jamie Dimon points out in his letter, without TARP money, the bank would still have had a Tier 1 capital ratio of 8.9%. In 2009, J.P. Morgan became one of the first banks to repay the TARP money.
Learning From Failures
More than anything, though, what sets Jamie Dimon’s letters apart from others, particularly during the financial crisis, was his acceptance of the mistakes he and J.P. Morgan had made during the years preceding the housing bubble bursting. The mistakes made are uncountable, but three stick out more than any others, which Dimon says the bank had to learn the hard way:
- We underestimated the size of the housing bubble and the rapid rate of depreciation.
- We misjudged the impact of more aggressive underwriting standards.
- We would have been better off had we imposed tighter controls on the outside mortgage broker business.
While the more liberal underwriting standards were no secret to anyone at J.P. Morgan, the extent to which excessive lending could lead to a bubble in housing prices was drastically underestimated. Making the loans even riskier were the brokers that J.P. Morgan employed outside of their firm. They mistakenly used the same underwriting guidelines as the mortgage underwriting done internally, even though they knew mortgage writing done externally produced twice the losses. The result was an unprecedented rate of depreciation of mortgages and mortgage-backed securities.
In the midst of the panic and fear, there was unquestionably plenty of blame to be spread around, but eventually, the blaming had to stop, and the repairing had to begin. Thanks to Jamie Dimon and other executives of the troubled banks, as well as regulators on both sides of the aisle, the U.S. was able to act quickly and save the U.S. from an absolute economic collapse.
The trust that has been built between consumers and the name J.P. Morgan has been consistently worked on for over two centuries. When the bank was run by the great John Pierpont Morgan and his son of the same name, the bank was renowned for being the titan of the financial world, which not only clients relied heavily on but governments across the globe as well. During the financial crisis of 2007 and 2008, we saw yet again that the bank, and its uniquely capable CEO, could still be relied upon by the citizens and government of the United States.
This article has been reprinted with permission from William Douthat’s LinkedIn page.