JPMorgan Chase And The Banking Industry

Jun.28.12 | About: JPMorgan Chase (JPM)

The morning papers reported that JPMorgan Chase's (NYSE:JPM) loss on it bungled trading could reach as high as $9.0 billion.

Many of the large “universal” banks find their market value trading below, and sometimes substantially below, their book value. And many of the 5,700 banks whose asset size is less than $1.0 billion in asset size are struggling to keep their heads above water.

The banking industry remains troubled and the financial markets recognize this fact. Yes, there are banks that are stronger than others, but there are sufficient problems to raise questions about the banking system and how banking is conducted here in the 21st century. And, the existence of these problems causes many in the financial markets to be skeptical of the banking industry in general - stay away from it!

Given the JPMorgan situation, risk management is certainly at the top of the list of concerns about the banking industry. Capital adequacy and financial leverage are two other issues that are also on most everyone’s minds.

In addition, there is concern over just what products and services a bank should be dealing in. The question is asked about returning to a separation of functions like the ones legislated by the old Glass-Steagall Act required.

To me, the questions are more complex because finance has changed so dramatically.

Many of the proposed solutions look backward to a more stable time and a more stable banking industry. In this former environment, markets did not change as quickly as they do now and institutions were not as capable of moving things around as they are now.

Historically, banks held originated assets, loans, and held onto loans until they either paid off or were charged off. Bank assets were generally longer term in length than were the liabilities that were used to finance them. Consequently, one of the major problems banks had to face was that rising short-term interest rates tended to cut into the interest-rate spreads the banks earned and threatened profitability.

In a previous life, there was something called “Regulation Q” that allowed bank regulators to limit the rise in what the banks could pay on their time and savings deposits in order to protect interest rate spreads, but this caused another problem called “disintermediation.”

Yet the banks held onto their loans (there was no place else to put them) and they either borrowed, short-term, from the discount window of the Federal Reserve, or they sold their investment securities, doing either or both to handle any outflow of funds they experienced. Almost all banks were “asset management” banks in this environment, as funds were primarily obtained from deposits.

Given this environment, there was not much need for mark-to-market accounting or any “real-time” valuation of assets. The environment was such that this issue never really became crucial in the running of banks.

As far as bad loans were concerned, well, the tendency was to postpone recognizing or writing down troubled loans since the lending officer could always make the argument that the bank was holding the asset to maturity and that the bad economy or the troubled industry or the individual business would correct itself and that all the loan needed was time. Loans were only charged-off as a last resort, but this never really created major problems in the relatively stable environment of the past.

This has all changed. With all the financial innovation of the past fifty years, the credit inflation that drove the financial markets resulting in a large majority of the banks - even relatively small ones - becoming “liability management” banks, and with the advances in information technology, financial institutions became basically “information processors.”

I have often written that finance is just information. Almost everything that can be done in finance can be done with 0s and 1s. For the more advanced organizations, primarily the larger ones, this has become true of a large part of their business. This is another reason for the smaller banking institutions to be absorbed into larger ones or to just go out of business. (Note: my banking is all done electronically; I have little or no use for a branch, and I have little or no use for anything other than my iPad when it comes to my banking. Most of my friends and business associates operate in a similar fashion.)

JPMorgan Chase got involved in some very complex and complicated transactions that were supposed to hedge certain positions against interest rate risk. Unfortunately, due to the complexity of the transactions, the hedge did not work as expected and, in fact, worked to create more risk. The hedge, according to the New York Times, “exposed the bank to greater risks even though it had been intended to minimize them.”

The size of the positions taken were quite large. And it has already taken several months to unwind the position, the reason why the exact amount of the loss is not known more exactly. The new estimate of the loss, $9.0 billion, was projected from internal models. It will still take several more months to determine what the exact size of the loss will be.

The crucial point, however, is that this is what financial institutions do these days, and can do. It is not just a matter of the bank using “federal insured deposits” to fund a hedge fund, which some professor stated was the case.

In the environment banks work in today, it is hard to know where the money comes from and where it goes to because of the ease of moving money around and moving it so quickly. Funds may seem to come from “here” for a while but then they go “there” in an instant and where things are depends only upon the time at which you try to measure them.

This is not the way all banking is done these days, but it is the direction in which banking is going.

It is also the reason why many banks in the U.S. are not in such good shape these days, because they were playing a game they were not trained for. Many smaller banks, seeking growth, looked for loans that they could “scale up” on…like commercial real estate loans. Buying funds, becoming “liability managers, " became the thing. How easy it became to buy money in these days. However, many of these banks did not have the talent or the experience to handle such transactions.

And what about the smaller banks originating loans and selling them off, buying back mortgage-backed securities and trading in futures markets? I was asked to turn around a small bank (which I did successfully) that had an investment policy that allowed the bank to deal in financial transactions that I would think only a major Wall Street bank should be allowed to do. The investment policy had been approved by the bank examiners.

Bottom line: To me it is no wonder that the banking system is in the condition it is in. Given this conclusion, I would argue that investors should be shy about having any banks in their stock portfolios - any banks! (JPMorgan Chase was supposed to be the “best of the best.”) We still don’t know what is the real value of assets in the banking system. And our regulatory system is still designed to regulate commercial banks coming from the 1970s and 1980s.

No wonder bank valuations are so low.