Wall Street History

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Wall Street History

05/01/2009

Jamie Dimon on the Crash

The other day I was watching hedge fund king James Chanos on CNBC and he casually mentioned that everyone should read JPMorgan Chase Chairman and CEO Jamie Dimon’s 2008 annual shareholder letter for a succinct explanation of just how we got in the mess we find ourselves in today. Amidst all the talk of the operating divisions at JPM and how each performed in ‘08, Dimon does indeed have a good summary. Following is the main body of it. 

After Lehman’s collapse, the global financial system went into cardiac arrest. There is much debate over whether Lehman’s crash caused it – but looking back, I believe the cumulative trauma of all the aforementioned events and some large flaws in the financial system are what caused the meltdown. If it hadn’t been Lehman, something else would have been the straw that broke the camel’s back. 

The causes of the financial crisis will be written about, analyzed and subject to historical revisions for decades. Any view that I express at this moment will likely be proved incomplete or possibly incorrect over time. However, I still feel compelled to attempt to do so because regulation will be written soon, in the next year or so, that will have an enormous impact on our country and our company. If we are to deal properly with this crisis moving forward, we must be brutally honest and have a full understanding of what caused it in the first place. The strength of the United States lies not in its ability to avoid problems but in our ability to face problems, to reform and to change. So it is in that spirit that I share my views. 

Albert Einstein once said, “Make everything as simple as possible, but not simpler.” Simplistic answers or blanket accusations will lead us astray. Any plan for the future must be based on a clear and comprehensive understanding of the key underlying causes of – and multiple contributors to – the crisis, which include the following: 

--The dramatic growth of structural risks and the unanticipated damage they caused 

--The pro-cyclical nature of virtually all policies, actions and events 

--The impact of huge trade and financing imbalances on interest rates, consumption and speculation 

Each main cause had multiple contributing factors. As I wrote about these causes, it became clear to me that each main cause and the related contributors could easily be rearranged and still be fairly accurate. 

It was also surprising to realize that many of the main causes, in fact, 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 and create the largest financial and economic crisis of our lifetime. 

Even the more conservative of us, and I consider myself to be among them, looked at the past major crises (the 1974, 1982 and 1990 recessions; the 1987 and 2001 market crashes) or some mix of them as the worst-case events for which we needed to be prepared. We even knew that the next one would be different – but we missed the ferocity and magnitude that was lurking beneath. It also is possible that had this crisis played out differently, the massive and multiple vicious cycles of asset price reductions, a declining economy and a housing price collapse all might have played out differently – either more benignly or more violently. 

It is critical to understand that the capital markets today are fundamentally different than they were after World War II. This is not your grandfather’s economy. The role of banks in the capital markets has changed considerably. And this change is not well-understood – in fact, it is fraught with misconceptions. Traditional banks now provide only 20% of total lending in the economy (approximately $14 trillion of the total credit provided by all financial intermediaries). Right after World War II, that number was almost 60%. The other lending has been provided by what many call the “shadow banking” system. “Shadow” implies nefarious and in the dark, but only part of this shadow banking system was in the dark (i.e., SIVs and conduits) – the rest was right in front of us. Money market funds, which had grown to $4 trillion of assets, directly lend to corporations by buying commercial paper (they owned $700 billion of commercial paper). Bond funds, which had grown to approximately $2 trillion, also were direct buyers of corporate credit and securitizations. Securitizations, which came in many forms (including CDOs, collateralized loan obligations and commercial mortgage-backed securities), either directly or indirectly bought consumer and commercial loans. Asset securitizations simply were a conduit by which investment and commercial banks passed the loans onto the ultimate buyers. 

In the two weeks after the Lehman bankruptcy, money market and bond funds withdrew approximately $700 billion from the credit markets. They did this because investors (i.e., individuals and institutions) withdrew money from these funds. At the same time, bank lending actually went up as corporations needed to increasingly rely on their banks for lending. With this as a backdrop, let’s revisit the main causes of this crisis in more detail. 

1. The burst of a major housing bubble 

U.S. home prices have been appreciating for almost 10 years – essentially doubling over that time. While some appreciation is normal, the large appreciation, in this case, and the ultimate damage it caused were compounded by the factors discussed below. 

New and poorly underwritten mortgage products…helped fuel asset appreciation, excessive speculation and far higher credit losses 

As the housing bubble grew, increasingly aggressive underwriting standards helped drive housing price appreciation and market speculation to unprecedented levels. Poor underwriting standards (including little or no verification of income and loan-to-value ratios as high as 100%) and poorly designed new products (like option ARMs) contributed directly to the bubble and its disastrous aftermath. 

Mortgage securitization had two major flaws 

In many securitizations, no one along the chain, from originator to distributor, had ultimate responsibility for the results of the underwriting. In addition, the poorly constructed tranches of securitizations that comprised these transactions effectively converted a large portion of poorly underwritten loans into Triple A-rated securities. Clearly, the rating agencies also played a key role in this flawed process. These securitizations ended up in many forms; the one most discussed is CDOs. Essentially, these just added a lot more fuel to the fire. 

While most people are honorable, excess speculation and dishonesty were far greater than ever seen before, on the part of both brokers and consumers 

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. 

As Jamie Dimon continues in his letter, he delves more into other causes such as excessive leverage: 

“Basically, the whole world was at the party, high on leverage – and enjoying it while it lasted.” 

“With great hesitation, I would like to point out that mistakes also were made by the regulatory system. That said, I do not blame the regulators for what happened. In each and every circumstance, the responsibility for a company’s actions rests with us, the CEO and the company’s management. Just because regulators let you do something, it does not mean you should do it. But regulators have a responsibility, too. And if we are ever to get this right, it is important to examine what the regulators could have done better. In many instances, good regulation could have prevented some of the problems. And had some of these problems not happened, perhaps things would not have gotten this bad.” 

My only addition to the above remarks of Mr. Dimon would be that regulators doing their job could have prevented a ton of the problems. But it was bad legislation, as well, that hamstrung the regulators, particularly when looking at both the repeal of Glass-Steagall and the maximum allowable limits by which some financial institutions could leverage up, part of which, as Dimon later points out, was the mess surrounding Fannie Mae and Freddie Mac. 

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