This morning (Saturday May 11) brought Jeff Miller's excellent commentary on JPMorgan's (JPM) recent trading losses, as well as a host of articles focusing on the technical mechanics of hedges and what JPMorgan may have done. I suggested that JPMorgan was a good stock to buy a few months ago. Therefore it is, perhaps, useful for me to provide the results of my review, conducted along lines similar to what Mr. Miller suggested.
Because I come at banking stocks from the perspective of a former bank executive (though only for a few years) and a bank regulatory lawyer (for many years), my analysis tends to focus on the very big picture in the case of a company as complex as JPM. First, like most people who think about investing in bank stocks, I want to evaluate management. Jaime Dimon is not my favorite manager. But he has created a company that has excellent management overall. Mr. Dimon himself probably has drunk too much of the praise that has been thrown his way over the last decade. The recent losses, I am guessing, will sober him up and send him back to his more risk-averse roots.
In recent months, Mr. Dimon has devoted a great deal of his time and energy to fighting on the regulatory front. He has been fighting against higher capital requirements and against the more stringent aspects of the Volcker Rule, as it is being implemented by the Fed. His personal focus, therefore, may have been somewhat distracted from the day-to-day running of a great company. Indeed, he may even have been victim of a perverse desire to show the Fed how things really work. I think the experience of the significant trading loss will tend to make Mr. Dimon focus more on his own kitchen, which is all to the good.
The Likely Impact on the Volcker Rule
The losses also have given fuel to those -- particularly Fed Governors Daniel Tarullo and Sarah Bloom Raskin -- who believe strongly that higher capital requirements and a stringent Volcker Rule are in the public's best interests. Despite Mr. Dimon's protestations that the trades were "Volcker Rule compliant", I would forecast that Governors Tarullo and Raskin now will have the influence to prevail over the industry positions that have been championed by Mr. Dimon.
The Likely Impact of Tighter Regulation
Many analysts would find my forecast of more stringent rules on these two issues a negative for a company like JPMorgan. I am not of that view. I believe that JPMorgan will benefit from higher capital requirements and from a stringent Volcker Rule. I say this because I believe that banks with higher capital and lower risk levels have overall lower funding costs and will be rewarded by the equity markets will higher p.e. ratios. JPMorgan's business is well positioned in both the corporate and the retail markets-the trading losses and their likely fallout will not change that-and the lower risk profile will benefit both those strong positions.
Why do I believe that banks with higher capital and lower risk will, overall, have lower funding costs? A recent BIS study comes to that conclusion. But, frankly, my understanding of statistics is not good enough for me to be able to evaluate its methodology. And there is something about the way the article is written that does not give me confidence in its conclusions. My belief that higher capital requirements and a lower risk profile will lead to lower funding costs and a higher p.e. is based more on logic. Bank stock investors crave stability. That is especially true of those who invest in the debt of banking companies. It is only logical that a lower risk profile and a higher capital buffer will lead to lower funding costs. The cost of equity capital might increase, but equity capital is a smaller proportion of funding than is debt. And if I am correct about the higher p.e. that stability will command, it may be that the costs of equity finance may not increase.
I could be criticized here for apparently wishful thinking, since I have taken public policy positions in favor of Governor Tarullo and Governor Bloom Raskin's positions. I may, therefore, wish that those positions also will benefit my investments. I hope I am not guilty of that mistake. At least I am aware of the pitfall.
Money Market Mutual Funds and Bank Funding
One also might consider what will happen when (I say "when" not "if" even though much controversy remains) the SEC takes action on money market mutual funds. Such action is likely to make such funds less attractive to risk-averse investors. Such investors might well turn to JPMorgan deposits or bonds if JPMorgan looks like a truly safe haven. Funding costs for U.S. banks are low across the board at this time. But in a few years, more normal spreads are likely to prevail, and the strongest banks will have the lowest funding costs.
Is this the Full Extent of the Losses?
I know no more than anyone else about whether the size of the disclosed loss (about $2 billion) will widen. My expectation is that the loss will not threaten JPMorgan's overall financial strength. If the company cannot buy back as much of its own stock, so be it. I am not a big fan of stock buybacks, anyway.
As an investor, I feel better about JPMorgan after this trading loss event than I did before it. I believe it will restore management's focus on risk management and will lead to a more stable company for the long term. Good companies are made better by this kind of adversity. Bad companies fail instead. I have studied many of those bad companies. JPMorgan is not one of them.
I still believe that five years from now JPMorgan will be one of the premier banking companies in America and in the world, with strengths in both retail and corporate banking. That is why I want to own JPMorgan stock. If leverage and trading income both decline, I do not expect those events to alter the basic strengths of the company. I do not expect to get rich by owning this stock. But I do expect a return that, in the long run, will be better and less volatile than an index fund.
Disclosure: I am long JPM.