Why JPMorgan is My Banking Choice

The day before Jamie Dimon was on the front cover of Barron's, I had just entered into a smaller JPMorgan Chase (JPM) position. For me, it was uncanny timing, however, it was a similar thought process that brought me to the conclusion and I figure "how to play the banks" is the exact same thought process that was going on over there and with me which drove the timing. I also figure that there are other people out there with similar thoughts, so I thought I'd write a bit about why I chose JPMorgan as my banking choice during this crisis.

Obviously, not all banks are well these days. Citi (C) holds something like $43 billion of exposures to the "most senior" tranches of CDOs. Unfortunately, the value of the super senior part is really highly defendant on exactly what the quality of the paper is beneath it, because overcollateralization of zero (because it may be tranches of early exposures in the actual original securitization), is still zero and there's no way to tell unless you know what underlies the CDO. I'm sure it's probably not zero. The deeper question is how close to zero. They're also now bringing back onto the balance sheet god knows what because it hasn't been on the balance sheet and I'm usually pretty skeptical about the exact quality of items that are chosen to be held off the balance sheet. Thus, Citi is for me, impossible to analyze.

But just because I think that banks are in for a huge storm doesn't mean that simultaneously that you can look around and say that there is no value out there. One always has to remember that you should be willing to buy everything for some price because this is really a game of probability and understanding price implied expectations. If it will survive to produce cash in the future, it's worth a number. So I've gone on a quest for a position in a bank (other than my best, IMO, bank idea, Bridge Capital (BBNK) - a much bigger sized position in my portfolio and maybe more on that in the future). So what is attractive to me about JPM?

Now, I do believe that at some point, I'm going to want to buy the weaker companies who have made it through the storm. But I don't think we're there yet. In fact, I think problems are going to last quite a while. Therefore, for now, I'm not looking for the screw ups. So the behavior of management leading into this situation to me is important. The balance sheet is extremely important. Questions like: How much subprime is sitting on the balance sheet vs. has been sold off? What kind of allowances are in the cookie jar to hold up in a storm? Exactly what kind of activities are going on off the balance sheet? How seriously do they take their capital ratios? How diversified are they away from mortgages? These are all important questions.

In JPM, there are some interesting answers. Dimon has claimed that they have about $1.5 Billion in CDO exposures and $6.8 B in warehouse holdings of the IB. None are collateralized by subprime. Taking a look at writedowns of subprime mortgages leads one to an estimate of about $10 billion total SP loans being held, which is peanuts for a company the size of JPM.

Taking a look off the balance sheet, we find exposure to multi-seller conduits. These are similar to a Structured Investment Vehicle, while simultaneously being pretty different. My understanding is that, SIVs are structured finance all over again, except it's an infinitely long lived investment vehicle instead of a security. The original securities are tranched by risk, maybe with some overcollaterization to possibly hide the quality of the underlying assets, maybe they're put in a CDO tranched by risk with some overcollateralization to hide the quality of the underlying assets (oops, I mean arbitraging extra spread) and maybe they're bought by an SIV which will structure itself all over yet again, to possibly hide the quality of the underlying assets (I mean arbitrage spreads), by which time, no one probably has any clue what the quality of the underlying assets are. But you know, it's all arbitraging value here, over and over and over again, so in actuality these things should be really valuable!! Or, turns out not so much, as the case may be. A conduit is a conduit, allowing participants to access the CP market to participate in the structured finance world as smaller players (at least this is my understanding). The assets are administered by JPM, who also provides credit enhancements, which appear to generally be in the form of liquidity agreements in say the case of disruptions in the commercial paper market. But these aren't entities restructuring all over again and there are real reasons to offer this structure to entities looking to sell assets into the conduit. One of the footnotes reads:

The Firm views its credit exposure to multi-seller conduit transactions as limited. This is because, for the most part, the Firm is not required to fund under the liquidity facilities if the assets in the VIE are in default. Additionally, the Firm’s obligations under the letters of credit are secondary to the risk of first loss provided by the customer or other third parties – for example, by the overcollateralization of the VIE with the assets sold to it or notes subordinated to the Firm’s liquidity facilities.

While I do feel somewhat uncomfortable with this assertion, they are real and this isn't structured finance all over again, putting fuzzy math models into equations repeatedly, which ultimately casts quick doubts on the real underlying worth of the assets. There seem to be valid reasons why the structure exists. My belief (maybe call it hope) is, this will limit loss to liquidity agreements they may be forced to provide. Admittedly, I'm not 100% comfortable with this and is one of the reasons my position remains smaller.

Their Tier ratios are also, in fact the highest of any immediate peers I compared and their allowances are generally larger in comparison to ratios between chargeoffs and peer chargeoffs/allowances or NPA/allowances. So there's a bucket to take some heat for what's coming and a better bucket than most other banks deem necessary. So some things to quickly take away are that the management of JPM likes a big balance sheet, they've avoided the worst paper and off-balance sheet ideas, (they do have a bunch of LBO stuff hanging around though) and they take their provisioning seriously. These kinds of differences are big deals to me.

Digging down further, one begins to realize that JPM actually has pretty high levels of Tier capital in relationship to say Bank of America (BAC) and C vs. their respective market caps (or previous market caps anyways). Now, there's a couple of things to interpret from this. One is that when looking at earnings levels, JPM comes out as an underperformer, that continues to perform better. At BAC, the difference primarily seems to relate to cost of funds (difficult to replicate and a huge competitive advantage for BAC) and non-interest expenses. But the expenses side of the ledger seem to have been improving at JPM in the last few years under Dimon and it seems like there's room to run. I'm not one much for turnarounds unless I really believe in management. This actually provides another interesting catalyst. Dimon is an extremely well regarded CEO at the helm of the slight underperformer. That means, that JPM, potentially has some water in the sponge that could be squeezed if management figures out how to get it out and the evidence is that they have been doing so. In fact, the distress in the credit markets may be an ultimate catalyst to make difficult changes to make it a top tier performer, though I believe this can only happen over a longer time frame. They also are quite diversified in their lending and the real outstanding issue of what's on their balance sheet appears to be their HELOCs and there is the matter of $40 billion in their trading portfolio labled "Other". But we also have an disclosure about what they believe is the worst paper (SP and especially CDOs backed by SP) that seems relatively limited. As well, I've modeled a fat tail credit event scenario that only a small number of banks seem to hold up well to (of which I'm sure there's no remote coincidence in that Buffett owns the ones that shine when you run these sims). But JPM holds up big time too. Taken together, the market therefore hasn't really tagged them. Which also gives them currency and that also gives Dimon the chance to go shopping for me as the wreckage unfolds.

So that's basically it. At some point, I'm going to want the weak survivors who are straggling up to shore. Until then, I don't. I want a management who hasn't been the dumb money. I want a big balance sheet and a bit of a war chest for allowances. Of course, this means their price hasn't gotten tagged like many of the others and perhaps is therefore offering less opportunity. But in an asset class that is dropping like stones, quality isn't such a bad thing. Because ultimately, JPM seems like a company I wouldn't have minded owning in the first place. All you have to do to understand that is to look through the paperwork at Washington Mutual (WM) and Countrywide (CFC). Even though I believe 50% of that equation will survive, it's hard to discount probabilities when you don't believe in management and the balance sheet and you can't help but think "Why other than the price do I want to own this company?"

Disclosure: Author has a long position in JPM