Friday, October 23, 2009

The best assessment of the financial crisis I've seen

Jamie Dimon, the CEO of JP Morgan, has been tremendously successful this recession - he's done a great job mitigating risk and helping JPM continue to grow. They repaid their bailout money the first day they could, with interest, and they've been very good about cooperating with the various government agencies that have required their attention (Obama is rumored to have called Dimon "my favorite banker").
Thus, when he talks, I listen. His 2008 shareholder letter is one of the best shareholder letters I've ever seen.
What I got from the letter:
1) While he's biased, it's a fair statement (from many sources) to say that the investment banks were stupid, not dishonest. There was plenty of dishonesty among the set of subprime consumers who started the crisis (the foreclosures then spread to more innocent homebuyers), and plenty of aggressive greed among the mortgage brokers (countrywide, etc), but railing on bankers for this crisis probably isn't the most accurate. They were dumb, they didn't know the risks they were incurring, and trust me, none of them would have done it if they'd realized the risk they were taking.
2) Headline numbers on TARP are way, way too high - it's not an $800 billion dollar bank bailout when a lot of it is just symbolic to help the weaker banks not die from the stigma associated with taking the money. All of the banks are repaying some of the TARP, and many will repay all, with interest.
3) Regulation was poor, and in many ways, it stoked the crisis instead of restraining it (see: Fannie and Freddie's mandate to lower lending standards to increase the number of people who could buy homes). It needs to be better coordinated. That said, the answer isn't "more regulation" - it's "better regulation". None of what happened was a shock to regulators, who allowed it to happen. The interactions and the magnitude were the surprises.
4) Illiquid and complex assets stoked the fire. They're getting phased out, slowly.
5) The US needs to reduce its trade deficit. Relatedly, it also needs to get off of foreign oil - natural gas, coal, solar, wind, geothermal, hydro, tidal - the US has abundant resources in all of these areas, and we should do whatever it takes, but foreign oil is a big problem. An appropriate response (using abundant US natural gas and coal as a bridge to clean and renewable energy) would have been incredibly valuable. Replacement of old infrastructure, industrial equipment and appliances with identical or better, but more energy-efficient, appliances would be key, but I don't think you can solve this problem by reducing overall energy demand (true carbon taxes or cap-and-trade). I am skeptical about the ability of Congress to tax or legislate our way out of this, except as a threat if replacement to more efficient equipment doesn't happen...  An appropriate response would make US credit flows much, much easier to manage, as well as managing global warming and improving national security.
 I've quoted interesting bits below.
"We believe we have corrected for the underwriting mistakes of the past. Essentially, by the end of 2008, we saw a return to old-fashioned home lending standards... in addition, we closed down all business originated by mortgage brokers. My worst mistake of the past several years was not doing this sooner. In general, the credit losses in the broker originated business are two to three times worse than that of our own directly originated business. Unfortunately, approximately 30% of our home loans were originated through the broker channel."
and more:
"On October 13, 2008, I went to Washington, D.C., with eight chief executives of other financial firms. There, we were asked by [government agencies] to agree to accept a package of capital from the government... the US... was proposing some powerful measures to help fix the collapse in the credit and lending markets. They prevailed upon the nine of us to set an example for others by accepting this capital infusion as a sign of our unanimous support of these measures... if any banks declined the TARP funds, then many of the additional banks might not want to be tainted by their acceptance of the TARP money because it might be viewed as a sign of weakness. We felt then that accepting the TARP funds was the right thing to do for the US financial system, even though it may not have been as beneficial for JPMorgan Chase as it was for some of the others... the TARP program had asymmetric benefits to those accepting it; i.e., it was least beneficial to strong companies like ours and vice versa. That said, we believe that accepting the TARP funds was the right thing to do for the US financial system, and that JP Morgan Chase should not be parochial or selfish and stand in the way of actions that the government wanted to take to help the whole financial system."
and more
"Simplistic answers or blanket accusations will lead us astray.... many of the main causes [of the crash] were known and discussed abundantly before the crisis. However, no one predicted that all of these issues would come together in the way that they did..."
he goes on to note a number of factors that caused the crisis, but in regards to the housing bubble...
"The combination of no-money down mortgages, speculation on home prices and some dishonest brokers and consumers who out-and-out lied will cause damage for years to come. This, in no way, absolves the poor underwriting judgments made by us and other institutions, and it certainly doesn't absolve anyone who mis-sold loans to consumers."...
and in regards to the excessive leverage and resulting liquidity crisis:
"Surely no one deliberately built a system with these fundamental flaws and imbalances. Clearer heads will understand that much of this was not malfeasance - our world had changed a lot and in ways that we didn't understand the full potential risk. But when the panic started, it was too much for the system to bear."
"Some banks, hedge funds, SIVs and CDOs were using short-term financing to support illiquid, long-term assets. When the markets froze, these entities were unable to get short-term financing. [Thus breaking the financial commandment, do not borrow short to buy long]."
"No major commercial bank that was regulated by the OCC wrote option ARMs (possibly the worst mortgage product). A very good argument could be made that the lower standards of the unregulated parts of the business put a lot of pressure on those players in the regulated parts of the business to reduce their standards so they could compete. In this case, bad regulation trumped good regulation."
"In a crisis, pro-cyclical policies make things worse. I cannot think of one single policy that acted as a counterbalance to all of the pro-cyclical forces... loan loss reserving causes reserves to be at their lowest level right when things take a turn for the worse... fair value [mark-to-market] accounting... may not reflect underlying values [and] can contribute to a downward spiral where losses deplete capital, and lower capital causes people to respond by selling more, at increasingly lower values... ratings agencies...continually downgraded credits, [which, because of how ratings agencies are treated by the law], required many financial institutions to raise more capital, thus adding to the vicious cycle."
"I suspect when analysts and economists study the fundamental causes of this crisis, they will point to the enormous US trade deficit as one of the main underlying culprits. Over an eight year period, the US ran a trade deficit of $3 trillion...Foreign countries took these dollars and purchased, for the most part, US treasuries and mortgage-backed securities... this process kept US interest rates very low, even beyond Federal Reserve policy, for an extended period of time. It is likely that this excess demand also kept risk premiums (i.e. credit spreads) at an all-time low for an extended period of time. Low interest rates and risk premiums probably fuled excessive leverage and the summer of 2008, [the] third energy crisis further [imbalanced] capital flows."
"Political agendas or simplistic views will not serve us well. Often we hear the debate around the need for more or less regulation. What we need is better and more forward-looking regulation...
(he lists a number of areas for improvements)
Certain vehicles like hedge funds and private equity funds need to be regulated but only to protect the system against risk. These vehicles do not need to be heavily regulated like a deposit-gathering bank... This all could be done without compromising flexibility or disclosing confidential positions while allowing these vehicles to move capital as freely and aggressively as they see fit."
...he talks about the changes in mark-to-market that would be valuable.

1 comment:

  1. Nice post!

    (I'll comment on health care when I have the chance :)