Morgan Stanley Analyst Discusses Ways for JPMorgan Chase to Recover
Amidst additional disclosures regarding its $2 billion loss and subsequent investigations, Morgan Stanley analyst Betsy Graseck painted a slightly brighter picture for the banking giant, noting that investors could see an “upside surprise.”
Although banking regulators, the United States Securities and Exchange Commission (SEC), and, reportedly, the Federal Bureau of Investigation (FBI) have opened inquiries into JPMorgan Chase’s hedging activities surrounding the loss, Graseck believes that answers to three questions could be “key to getting investors back into [JPMorgan Chase].”
First, “who knew what and when?” asks Graseck. This information is “critical to understand who in the organization” was aware of any accounting changes related to the loss.
Second, Graseck would like to see “more specific details on the components of the trade, size of the trade, strategy employed, and how that strategy was executed over time.”
Lastly, Graseck feels Dimon and JPMorgan Chase should provide “more detail on the latest mark-to-market of the position, size, max loss, and color on how analysts can potentially better forecast [the] ultimate loss.” The mark-to-market positions taken by JPMorgan Chase were seen as exceptionally risky for such a large bank, thus troubling investors.
HBR: Set Appropriate Company Policies to Mitigate Risky Behavior
In the wake of the JPMorgan Chase $2 billion loss and fallout, Harvard Business Review writer James Lam lays out various rules and guidelines for managing risky behavior.
As noted by Mr. Lam, “If risky behavior can happen at the house of Morgan under the watchful eyes of Jamie Dimon, it can happen anywhere,” and companies should have policies in place – at all levels – to protect from deceit.
Setting clear policies is one of Lam’s five most important rules for managing risky behavior. “For enterprise risk management, key policies include a statement of risk appetite and explicit risk tolerance levels for critical risks,” says Lam. But, “the right people have to be setting the rules,” he says.
As an example of unclear policies designed by those set out to deceive investors and regulators, Lam offers up the case of former Enron Chief Executive Officer Jeffrey Skilling.
Skilling, upon his hire, insisted upon mark-to-market accounting for Enron’s balance sheets. As a result of marking the company’s financial positions to market, Enron’s actual cash generated was a mere 3% of reported income. “Appropriate risk, compensation, and financial policies will set the incentives and boundaries for employee behavior,” Lam concludes.
Capital Requirements for Banks an Ongoing Battle
Nobel prize-winning economist Robert Engle has said that American banks, as a whole, are short $500 billion in capital, despite Basel III requirements that have increased capital requirements and tightened capital rules. In the Reuters “Counterparties” email, Ben Walsh describes the situation as laid out by Engle.
To make matters worse, European banks are even more capital-deficient according to Engle’s calculations. This is the result of derivative accounting rules that differ in Europe, notes Walsh.
Due heavily to the fallout surrounding JPMorgan Chase’s $2 billion hedge accounting loss, “there’s something of a bipartisan consensus for stronger bank capital requirements for America’s banks,” says Walsh.
Against the requests of banking officers like JPMorgan Chase’s Jamie Dimon, new capital regulations proposed by the Federal Reserve are likely to require that banks hold more equity. Additionally, with the Federal Reserve proposing mark-to-market accounting for banks’ securities portfolios, capital requirements are likely to climb even higher.
Federal Reserve to Issue New Capital Rules
The United States Federal Reserve is proposing new capital rules for banks. These rules, which are capital requirements put in place by the Federal Reserve to mitigate volatility, would set a standard for how much cash and capital a bank must keep on hand to offset its debts and loans.
Almost immediately, large U.S. banks and lenders like Citigroup and Wells Fargo have decried the proposal, saying that “the net effect of the change will force them to hold more capital over and above the stated requirements,” according to an article by Shahien Nasiripour in the Financial Times. Additionally, “because of different accounting treatments, their foreign peers will have their capital levels protected from changes in the market value of some securities holdings,” Nasiripour continues.
The accounting treatment that concerns U.S. banks involves those portfolios designated as “available for sale.” These holdings, according to U.S. accounting rules, are to be booked using mark-to-market accounting.
European banks, as Citigroup and others have noted, are not required to mark these portfolios at market value.
Bain: Mark-to-Market Helped Bolster Private Equity Gains
In a contribution to Forbes and in Bain’s Global Private Equity Report 2012, Bain & Company said that the private equity industry’s recent positive returns were a result of a transition to mark-to-market accounting rules.
Private equity firms, says Bain, “promptly and aggressively wrote down their portfolio company net asset valuations” when equities took a tumble in late 2008. But following that, portfolio companies continued to be conservatively priced despite a public recovery. Meanwhile, portfolio values marked at market value continued to rise, helping boost quarterly gains throughout most of 2010 and 2011 for the private equity industry.
Currently, private equity is facing a new set of challenges, says Bain. “With private equity assets now appraised close to their intrinsic value, returns will become more volatile as they more closely track the ups and downs of the public markets,” the article reads. “Gross Domestic Product (GDP) growth, multiple expansion and leverage,” says Bain, “do not look nearly as favorable in the current recovery as they had in past ones.”
Berlau: JPMorgan Chase Hedging Losses Magnified by Mark-to-Market
In a Competitive Enterprise Institute OpenMarket.org editorial, contributing editor John Berlau says that recent JPMorgan Chase losses may be magnified by mark-to-market accounting.
JPMorgan Chase recently reported a $2 billion loss from a “failed hedging strategy,” a hedge created by a synthetic credit portfolio operated by the firm’s Chief Investment Office. But, notes Berlau, the losses were reported by the Wall Street Journal and others as “significant mark-to-market losses,” wherein the value of the firm’s assets has dropped due to its current market value in addition to any poor hedging decisions made by fund operators at JPMorgan Chase.
“It seems that the primary reason for J.P. Morgan’s loss is that hedge funds bet against its position in certain securities,” says Berlau. “Mark-to-market losses like this are frequently paper losses that translate into much smaller actual losses, or sometimes even no losses at all,” he continued.
Additionally, such mark-to-market activities “can do significant damage when [they are] enmeshed in mandates such as regulatory capital rules,” Berlau says.
Mark-to-Market for Pension Plans Draws Closer Look from SEC
Companies that have recently switched to the mark-to-market method of pension accounting have caught the attention of the United States Securities and Exchange Commission (SEC).
The SEC has raised concerns that these companies may be using disclosures that are not consistent with U.S. Generally Accepted Accounting Principles (GAAP) and may be confusing to investors.
Major American companies like AT&T, Honeywell, and Verizon have led the change to mark-to-market, allowing them to recognize gains and losses immediately as opposed to “smoothing” gains and losses over a period of years, called cost amortization. This change allowed companies like these to retroactively apply losses of 2008 and 2009 to previously reported balance sheets.
“A number of companies that have done that [moved to mark-to-market pension accounting] have then gone on to select a non-GAAP method of disclosure for pensions, that then takes out the actual return on plan assets and adds back the expected return on plan assets,” SEC Chief Accountant Jim Kroeker said recently.
“Unfortunately in doing that, they haven’t then included the amortization of prior deferred losses.” The issue for investors, says Kroeker, is that these non-GAAP disclosures may seem to represent actual pension gains and losses rather than expected asset returns. Mark-to-market itself may not be entirely misleading, said Kroeker, but that it might be “useful to an investor” if companies disclosed more plainly whether numbers are actual performance or expected performance.
DVA and Fair Value Cloud Investment Bank Returns
First quarter 2012 results for the major investment banks suggest, on the surface, that the financial recovery may be sputtering out, says William Wright in a Financial News editorial.
However, a “closer examination reveals that the results across Wall Street have caught a nasty dose of ‘DVA’, a terrible accounting disease that distorts revenues and profits, eats away at investor confidence in the numbers, and wreaks havoc in the media’s reporting of them,” says Wright.
DVA, short for debt value adjustment, is a process by which a bank’s debt value determines – counterintuitively, some say – profit or loss for that quarter. If the value of a bank’s debt decreases due to a lack of perceived creditworthiness, the bank can actually book a profit based on the assumption that it could buy back its own debt cheaply. This is done, Wright says, “under the auspices of Financial Accounting Standard 159, part of fair value accounting,” since fair value requires that investment banks account for their debt at current market value.
The numbers, Wright says, are not necessarily to be trusted because the banks have been mitigated their recoveries by simply tightening their credit spreads.
“For the time being, it seems that investors, analysts and journalists will still require fog lights to compare the performance of one bank with another, or the performance of a bank from one period to the next,” says Wright. Investors may take this difficulty as an attempt to obfuscate true earnings, he says. But “if investment banks want to win back the trust of investors and regulators, making their performance – both good and bad – easier to understand is a fundamental first step,” Wright concludes.
This is a consequence of consensus. If you don’t understand, or can’t value the information, you can choose not to invest.
Sloan: Current Accounting Model is “An Incoherent Mix”
In a Bloomberg editorial, University of California Haas School of Business accounting professor Richard G. Sloan discusses current United States Generally Accepted Accounting Principles (GAAP) and the struggle companies are facing as standard setters begin to make rule changes regarding the adoption of fair value accounting.
Sloan uses the Bank of America example – the accounting scenario where despite the bank’s stock price plunge, accounting rules allowed it to book the market value decline of its debt as revenue – as the first example of some of the chaos on company balance sheets.
Another glaring issue facing companies, says Sloan, is that while fair value is not usually applied to nonfinancial assets, there are some significant exceptions.
Boston Scientific’s purchase of Guidant Corp. added billions in intangible assets. However, “the combination proved to be a dud, generating no significant increase in profit and free cash flows,” says Sloan.
Though investors were able to make note of this, and the market responded appropriately, an accounting procedure designed to increase transparency nearly did the opposite. “Perhaps this is why accounting rules have traditionally left the job of estimating uncertain fair values to investors,” Sloan concludes.
NY Times: Deleveraging Process Calls for Lenders to Deal with Losses
New York Times financial writer Floyd Norris, in a recent article, explores the United States debt crisis and subsequent rebound happening now. Both borrowers, faced with foreclosures and bankruptcy, and lenders, facing massive losses due to credit defaults, have been slow to recover.
But the situation has turned, says Norris, noting that in the first quarter of 2011, required debt service payments now account for only 10.9 percent of disposable income – the lowest since 1994.
However for the debt rebound to continue, the deleveraging process must be a key component, Norris says. The McKinsey Global Institute, in an analysis published in early 2012, called this phase “the good part.”
“Growth rebounds and government debt is reduced gradually over several years,” says the analysis. But for deleveraging to begin, says Norris, “it is important for lenders to face reality, admit losses and deal with them.” Though banks were tempted to obscure losses, mark-to-market accounting rules limited the extent to which this could be done.
Mark-to-market, weakened by bank lobbying, still had some positive effect on accepting losses as opposed to attempting to obscure them in hopes of a quick recovery, says Norris.
