Dimon, JPMorgan Board Face Investor Judgment

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5-13-13_Jacks_Blog.pngJPMorgan Chase & Co.’s May 21st annual meeting in Tampa should be a doozy for Chairman and CEO Jamie Dimon and the company’s 11-member board. The country’s largest bank has come in for some withering criticism ever since it lost a reported $6 billion last year on a disastrous credit derivatives trading strategy. Early comments by Dimon that the loss was only $2 billion and the bank had the situation under control—only to see the loss estimates continue to escalate—most certainly hurt his credibility with banking regulators (who later ordered the board to improve JPM’s risk management processes) and Congress (where Dimon was summoned to testify about what went wrong.)

Now the bank’s large institutional shareholders—including the likes of BlackRock Inc., Vanguard Group Inc. and Fidelity Investments, which collectively own 12 percent of JPM’s outstanding shares—get to have their say. One measure that is up for a shareholder vote calls on the bank to divide the chairman and CEO titles between two different people. The vote is nonbinding but would be an embarrassment for Dimon and the board since the company has argued publicly and strenuously that he should continue as chairman.

Two influential shareholder advisory firms—Institutional Shareholder Services (ISS) and Glass Lewis—have recommended that JPM shareholders vote for the measure. Citing their dissatisfaction with the board’s risk governance performance, both ISS and Glass Lewis also recommend that three JPM directors who currently serve on the risk policy committee not be re-selected. Glass Lewis went even further and also recommended that three members of the audit committee not be re-elected as well, arguing that the trading loss revealed shortcomings in the bank’s auditing practices.

Taken together, the two advisory firms have come out against the re-election of over half of JPM’s board (there is no overlap between the audit and risk policy committees), and would strip Dimon of his chairmanship. If that’s not a stinging rebuke of the governance performance of JPM’s board, I don’t know what is.

Shareholders are voting on the proposals now and the results will be announced at the May 21st meeting.

Would separating the jobs of chairman and CEO really make a difference at JPM? It could, if the board brought in a new person to serve as the non-executive chairman—which no doubt is what ISS and Glass Lewis would prefer. The board does have a “presiding director” (essentially the same thing as a lead director), retired Exxon Mobil Corp. CEO Lee R. Raymond, but would Raymond be able to ride herd on a strong-willed CEO like Jamie Dimon as effectively as someone new from the outside? ISS says it met with Raymond after the trading debacle to express its concerns about the performance of the risk policy committee, but later concluded that any changes made to JPM’s risk management practices after the big loss were initiated by management and not the board—hardly an endorsement for his leadership.

I can think of two reasons why Dimon wants to hold on the chairmanship at JPM. One, he probably believes he deserves to. The bank has reported a profit for 12 consecutive quarters, its stock has been trading within a couple of bucks of its 52-week high, and unlike two other megabanks that are in many of the same businesses—Bank of America Corp. and Citigroup Inc.—JPM came through the 2008-2009 global financial crisis largely unscathed. Just two years ago, Dimon was hailed as something of an American (or at least a Wall Street) hero for how he managed the bank during that frightening time. While the trading loss was an embarrassment and revealed some serious flaws in JPM’s risk management practices, Dimon has enjoyed a long and successful career. Getting fired as chairman would be humiliating for this very proud man, especially when he has made relatively few mistakes.

But there’s probably another reason Dimon doesn’t want an outsider coming in as his new boss. In March 2012, Michael E. O’Neill, a former Bank of Hawaii Corp. CEO who was widely praised for turning that troubled company around some years ago, replaced Richard Parsons at the non-executive chairman at Citigroup. By October of last year, Citi’s CEO—Vikram Pandit, who had steered the bank through the 2008-2009 financial crisis when it required massive government support to survive—was forced to resign after O’Neill engineered his dismissal. It didn’t take long for O’Neill to turn Citigroup’s board against Pandit even though he had stabilized the company after the crisis and was gradually returning it to financial health.

Here’s why Glass Lewis believes the chairman and CEO roles should be separated: “Research suggests that combining the positions…may hinder a board’s decision to dismiss an ineffective CEO.”

I’m sure Pandit would agree—and no doubt Dimon would, too. Dimon might not be “ineffective,” but he could still be dismissed.

What will JPMorgan’s trading goof mean for regulation?

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jamie-dimon.jpgMuch has been made of the trading mishap at JPMorgan Chase & Co.’s London office, resulting in current estimates of a $3 billion loss to the company or more. But what is at stake here is not so much JPMorgan’s financial health, which doesn’t appear in question, but future regulation of the financial sector.

JPMorgan CEO Jamie Dimon has been arguing publicly against certain kinds of regulation, including the Volcker rule, which would limit proprietary trading by the big banks.

“I think it’s unnecessary, especially when you add it on top of all the other [regulation],’’ Dimon reiterated this week before a U.S. Senate committee, where he spent two hours explaining his company’s trading mistake.

Welcome to the new age, where big banks will have to answer questions not just from their shareholders and customers, but from Congress as to what went wrong with their business and who knew what, and when.

Critics are using JPMorgan’s trading loss, which occurred in the division that invests customer deposits, to argue the Volcker rule ought to be strict and tough on banks.

Regulators have missed 67 percent of their rulemaking deadlines in implementing the Dodd-Frank Act, according to the Davis Polk law firm. Much remains to be written that will affect companies such as JPMorgan and smaller banks as well.

That’s why the public charades are so interesting.

“In the political world, it’s going to be hard for regulators to embrace a looser process rather than a stricter process,’’ says Harold P. Reichwald, a partner in Los Angeles at the law firm Manatt, Phelps & Phillips. “This incident with JPMorgan will have the effect of creating a heightened sensitivity on the part of regulators to pressure the banks they regulate to have a more formal approach to risk management.”

Michael Klausner, a professor with the Rock Center for Corporate Governance at Stanford University, thinks the JPMorgan trading loss really shouldn’t be a regulatory concern.

“Even if you had a 50 times greater hit to capital, you’d still not have a systemic event,’’ he says. “As a policy matter, what we worry about is a systemic event, or what would have an impact on other banks.”

JPMorgan says its capital levels remain strong and it will be profitable in the second quarter, despite the loss.

Klausner says that you can make the argument that the trading loss is serious enough threaten the CEO’s job and the value of the company’s stock, but as a regulatory matter, “it’s trivial.”

But nowadays, banks such as JPMorgan are addressing their business activities to a much wider audience than shareholders.

Among Dimon’s details about what went wrong with the risk management process at the chief investment office (CIO):

  • CIO’s strategy for reducing the synthetic credit portfolio [e.g. credit default swaps] was poorly conceived and vetted. The strategy was not carefully analyzed or subjected to rigorous stress testing within CIO and was not reviewed outside CIO.
  • In hindsight, CIO’s traders did not have the requisite understanding of the risks they took. When the positions began to experience losses in March and early April, they incorrectly concluded that those losses were the result of anomalous and temporary market movements, and therefore were likely to reverse themselves.
  • Personnel in key control roles in CIO were in transition and risk control functions were generally ineffective in challenging the judgment of CIO’s trading personnel. Risk committee structures and processes in CIO were not as formal or robust as they should have been.
  • CIO, particularly the synthetic credit portfolio, should have gotten more scrutiny from both senior management and the firm-wide risk control function.

Dimon detailed the company’s response to the “incident,” which included replacing much of its top investment management team and chief risk officer for the division. It also included establishing a new risk committee just for the chief investment office.

Sen. Charles Schumer, D-New York, asked Dimon during the hearing why the risk committee of the board missed what was happening in the trading office.

“Some questions have been raised about the oversight of your risk committee,’’ he said. “Why didn’t it do its job?”

Dimon said if management didn’t catch it, then the risk committee couldn’t.  That sounds reasonable, but now the risk committee must find out why it wasn’t learning about the risks that the bank was taking. Dimon said the bank will learn from its mistake. So the question is now: What will regulators make of it?

The fall continues for WaMu

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Full disclosure: I’ve long thought of Washington Mutual’s leadership team in high regard. During my “first tour of duty” with Bank Director, I had a chance to hear WaMu’s than-CEO Kerry Killinger speak at one of our Acquire or Be Acquired conferences and came away impressed with his enthusiasm and vision for the bank. We covered WaMu in the pages of Bank Director throughout the 00’s, so I’m well versed in their fall from grace. Yes, we’d seen their highs; sadly, history hasn’t been kind to this once-darling of Wall Street. As many know, JPMorgan Chase bought the functional assets of Washington Mutual in the fall of ’08. Once the nation’s largest savings and loan, the price tag was a mere $1.9 billion after the federal government shut down the bank and held a quick auction. But until last night’s news about the FDIC potentially suing former execs from the bank, I’d filed away their demise as product of the black hole many banks were sucked into. Now?

In preparing for yesterday’s post on the coming wave of M&A, I went on to the FDIC’s website to get a sense of where our industry is and where it might be heading. While I didn’t cite any of their press releases, these three are all up and featured:

  • First California Bank Assumes All of the Deposits of San Luis Trust Bank;
  • Bank of Marin Assumes All of the Deposits of Charter Oak Bank; and
  • HeritageBank of the South Assumes All of the Deposits of Citizens Bank.

If you read yesterday’s post, you’ll notice a common thread between what I wrote and what the FDIC has promoted: assisted transactions for healthy banks. Still, the third release gave me temporary pause — not by the size of the deal; rather, the name of the acquirer. If you’re on the board of any financial institution, I’ll bet $20 you know the name Heritage (Community) Bank.  No, not the one from above; rather, the failed bank whose executives and outside directors are under siege from the FDIC.

Our editor wrote about this type of government action last month in our publication. And many service providers (namely, attorneys) have sent clients executive briefings about what this might mean to them.  Still, if you recall the S&L crisis of the late 80’s and early 90’s, the FDIC sued or settled claims against bank officers and/or directors on nearly a quarter of the institutions that failed during that time. And if the past is any indication of the future, then there is a significant risk that directors of failed banks from the recent financial crisis may see some type of action taken against them by the FDIC.

So who might be next? Well, it just came to light that the FDIC sent letters to former executives of the failed Washington Mutual Bank warning of possible legal action. According to a Wall Street Journal report I read last night, the regulator has already discussed damages of $1 billion in relation to the potential Washington Mutual lawsuit. So I have to wonder when and/or where this will all end… and who will be next.

Will 2011 be the year for bank stocks?

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The bad news seems endless. Unemployment remains high. Bad real estate loans continue to hurt banks. Increased government regulation and caps on fees will hurt bank income in the future. And yet, so many bank analysts are so bullish on bank stocks in 2011.

Why?

Profitability is returning or will return this year to many mid-sized or small banks, several analysts say.

Stronger banks will be able to buy weaker rivals and grow market share. Even the investors of struggling banks stand to gain after years of misery. Their banks will get bought out at premiums compared to the disappointing prices of the last two years. 

Here is a review of what bank analysts are saying about the outlook for bank stocks in 2011 and their favorite picks:

mmosby.jpgMarty Mosby, a bank analyst at Guggenheim Partners in Memphis, says he thinks all of the 15 large-cap banks he covers will be profitable by the middle of this year and he projects a 30 percent stock market gain on average for his group, which includes Winston-Salem, North Carolina-based BB&T Corp., Atlanta-based SunTrust Banks, and San Francisco-based Wells Fargo & Co. 

“We believe 2011 will be the year of the recovery,’’ he says. “We will finally see banks return to the norm.”

Some banks will be better off than others in the new normal, of course.  Banks such as Wells Fargo & Co., Pittsburgh-based PNC Financial Services Group and New York-based BNY Mellon have revenue potential and strong capital, he says, which means they could buy other banks or increase dividends, always a plus for the many dividend-starved investors out there. PNC Financial Services Group reported today record profits of $3.4 billion for 2010.

Jim Sinegal, associate director of equity research at Chicago-basedMorningstar, Inc. expects his top picks such as New York-based JPMorgan Chase & Co. and Wells Fargo to return 25 to 30 percent gains for investors. He hedges that a bit by saying it may happen in the next year—or two.

“We don’t see any surprises ahead that could derail something,’’ he says. “We’ll see a slow and steady improvement. Credit is slowly and steadily improving. A lot of banks already are benefiting from that. The worst loans on their balance sheets have already been charged off.” 

He even likes Charlotte, North Carolina-based Bank of America, even though other analysts are just too worried about an ongoing investigation into the bank’s foreclosure processes to recommend the stock. 

“We think the best values can be found in recovering banks,’’ he explains. “We think the stock is cheap.”

Bank of America was trading at $14.37 per share Thursday midday on the New York Stock Exchange.

jharralson.jpgJefferson Harralson, managing director in Atlanta for Keefe, Bruyette & Woods, says smaller banks might have a more difficult time seeing stock market gains this year than big banks. They could be hit hard by new regulations that limit fee income. New restrictions on debit card fees charged to merchants could limit that source of income by as much as 75 to 80 percent, he says. 

Plus, many small and even regional banks have not paid back the government for the Troubled Asset Relief Program money, which could weigh on stock prices this year as well. Investors worried the bank will be forced to raise more capital to pay back TARP won’t be eager to buy those banks.

kitzsimmons.jpgKevin Fitzsimmons, managing director at Sandler O’Neill & Partners in New York, says 36 percent of the group’s bank stocks have a buy rating, compared to 26 percent in January of last year. 

He also thinks there will be more risk in small bank stocks this year, because the heavy weight of regulation will move to smaller banks, as in rolling downhill, as regulators begin forcing those banks to recognize their problem loans.

“This is not going to be smooth going (for all banks),’’ he says. “(The market) will be selective.”

The good news is all that new regulatory pressure on small banks could lead more banks to sell out—for a premium this time.

Sinegal said recent acquisitions have netted prices at two times tangible book value for the acquiring bank, as opposed to no premium or 1.5 times book value during the last year.

“There is more optimism that the worst is behind us,’’ Fitzsimmons says. “There has been optimism that some banks will be able to go out and acquire more banks and the acquired banks can be bought at some sort of premium.”