- We now have to mark to market our private equity investments by using potentially artificial benchmarks. These investments, by their nature, are very illiquid and are intentionally held for several years. To mark them to market, proxies made up of comparable companies are used, and appropriate discounts and judgment are applied. Essentially, we write these investments up when markets are good and write them down when markets are bad. But I am fairly confident that this approach is not always right. In many instances, cost is the best proxy for fair value. We would rather describe our investments to our shareholders, tell them when we think these investments might be worth more and, certainly, write them down on our financial statements when they have become impaired.
- A new mark-to-market rule addresses "debit valuation adjustments." Essentially, we now have to mark to market credit spreads on certain JPMorgan Chase bonds that we issue. For example, when bond spreads widen on JPMorgan Chase debt, we actually can book a gain. Of course, when these spreads narrow, we book a loss. The theory is interesting, but, in practice, it is absurd. Taken to the extreme, if a company is on its way to bankruptcy, it will be booking huge profits on its own outstanding debt, right up until it actually declares bankruptcy - at which point it doesn't matter.
- It is becoming increasingly more difficult to compare mark-to-market values of certain instruments across different companies. While it's too involved to go into detail here, different companies may account for similar mark-to-market assets differently. This needs to be addressed by ensuring that companies adhere to consistent valuation principles while applying the rules.
- Fair value accounting does not and should not apply to all assets. Investments or certain illiquid assets that are intended to be held for the longer term (like real estate or plant and equipment) or loans and certain assets that are shorter terms (like receivables or inventory) all could actually to marked to market. There are, in fact, markets for some of these assets, and others could be calculated based on reasonable assumptions; for example, a farm would be worth more when corn prices go up, and a semiconductor plant would be worth less when semiconductor prices go down. However, if we marked these assets in this way, they would have wildly different prices depending on the health of the economy or the swings in prices for their output. While accounting should recognize the real impairment in the value of assets, marking the aforementioned assets to market every day would be a waste of time. Under this scenario, it would be quite hard for companies to invest in anything illiquid or to make long-term investments.
Monday, June 29, 2009
Jamie Dimon: The Future of Our Financial System
By Jamie Dimon, Chairman and CEO, J.P. Morgan
The extent of the damage and the magnitude of the systemic problems make it clear that our rules and regulations must be completely overhauled. Such changes to the regulatory system could have huge implications on the long-term health, and strategies, of our business.
While unprecedented actions have been taken by both the Federal Reserve and the Treasury, my hope is that new policies are grounded in a thorough analysis of what happened and what we need to do about it. 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. Someone has famously said that a crisis should not go to waste. But what is also true is that it shouldn't take a crisis to solve our problems. During a crisis, people panic. This can make it harder, not easier, to do the right thing. From our perspective, certain improvements would make a big difference. We would like to share with you some of our suggestions.
A. The need for a systemic regulator with much broader authority
We agree with our leaders in government that we should move ahead quickly to establish a systemic regulator. In the short term, this would allow us to focus attention on correction some underlying weaknesses in our system and filling the gaps in regulation that contributed to the current situation. It also is clear that U.S. policy must be coordinated with the proper set of international regulators. When the crisis emerged, the actions of individual countries had a critical impact on numerous other countries. International coordination is essential in resolving this kind of crisis.
There should be procedures in place to deal with systemically important institutions - failure is fine as long as it's orderly and controlled and doesn't cause systemic failure
Size is not the issue; rather it is when institutions are too interconnected that an uncontrolled failure has the potential to bring the whole system down. What we need is a resolution process that allows failure without causing damage to the whole system. In the case of Bear Stearns or Lehman - both investment banks - regulators did not have this protocol They do have it, however, for commercial banks. Even more important, regulators are going to need a resolution process for large, global corporations that operate in many jurisdictions around the world.
The first goal should be to regulate financial institutions so they don't fail. If they do fail, a proper resolution process would ensure that action is swift, appropriate and consistent. The lack of consistency alone caused great confusion in the marketplace. For example, when some of the recent failures took place, there was inconsistent treatment among capital-holders (preferred stock and debt holders were treated very differently in different circumstances). It would have been better if the regulators had a resolution process that defined, a priori, what forms of aid companies would get and what the impact would be on capital-holders. The FDIC resolution process for banks provides a very good example of how a well-functioning process works.
Various liquidity and "lender of last resort" facilities, like some of those put into place during this crisis, also could be in place on an a priori basis. These controls would reduce risk and maximize confidence.
Regulation needs to be administered by product and economic substance, not by legal entity
We have experienced the unintended consequences of redundant regulation; i.e., different agencies regulating the same product in the mortgage business, in the derivatives business and in lending overall. If, on the other hand, similar products were overseen by a single regulator, that regulator would have much deeper knowledge of the products and full information that extends across institutions. The "regulatory competition" that could have caused a race to the bottom would be eliminated.
Hedge funds, private equity funds and off-balance sheet vehicles must be included in our regulatory apparatus without compromising their freedoms and positive attributes
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. We should consider requiring hedge funds over a certain size (say, $1 billion of equity) to register, provide quarterly audited reports, disclose total leverage and certain risk attributes - like volatility and investment categories - and outline operational procedure. They also could be requited to show their regulators (not their competitors) any concentrated "trades" that could cause excessive systemic risk. 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.
The systemic regulator needs the ability to anticipate risk and do something about it if necessary
There, undoubtedly, are financial products in the market today that - if unchecked - could have a destabilizing effect. A systemic regulator, had it been closely watching the mortgage industry, might have identified the unregulated mortgage business as a critical point of failure. This regulator also might have been able to limit the leverage of Fannie and Freddie once they were deemed to pose major systemic risks. Such a regulator might have been in the position to recognize the one-sided credit derivative exposures of AIG and the monoline insurers and do something about it.
A systemic regulator also should be on the lookout for new or potential structural risks in our capital markets, such as the structural flaw that grew in money market funds.
B. The need to simplify our regulatory system
Everyone agrees that the existing system is fragmented and overly complex. We have too many regulators and too many regulatory gaps. No one agency has access to all the relevant information. Responsibility often is highly diffused. This problem could be relatively easy to fix but only if we have the political will to fix it.
C. The need to regulate the mortgage business - including commercial mortgages - in its entirety
Many of the same gaps in regulation that helped lead us into this mess still exist today - for example, in the mortgage business. Mortgages are the largest financial product in the United States, and while we do not want to squelch innovation, the entire mortgage business clearly needs to be regulated. This is not the first time that mortgages and real estate have led this country and many of its financial institutions into deep trouble. Proper regulation would go a long way toward standardizing products, testing new ones, improving customer disclosure and clarifying responsibility.
D. The need to fix securitization
We believe that securitization still is a highly effective way to finance assets. But some securitizations, particularly mortgage securitizations, had an enormous flaw built into them: No one is responsible for the actual quality of the underwriting. Even mortgage servicing contracts were not standardized such that if something went wrong, the customer would get consistent resolution. We cannot rely on market discipline (i.e., eliminating bad practices) alone to fix this problem.
We have heard several reasonable suggestions on how the originator, packager and seller of securitizations could be approximately incentivized to ensure good underwriting. For example, requiring the relevant parties to keep part of the securitizations, much like we do with syndicated loans today, would help manage resolution if something were to go wrong and could go a long way to re-establish market confidence and proper accountability.
E. The need to fix Basel II - leading to higher capital ratios but a more stable system
As discussed earlier, Basel II has many flaws - it has taken too long to implement, it responds slowly to market changes and it is applied unevenly across global borders. Perhaps its worst failing is that, in its current construct, Basel II does not include liquidity, which allowed commercial and investment to buy liquid or illiquid assets and fund them short. While this practice did not appear quite so dangerous in benign times, it created huge issues for many financial institutions during the market crisis. Basel II also has relied too heavily on rating agencies and, by its nature, has been highly pro-cyclical in its capital requirement for assets. It would be easy to make these capital requirements less pro-cyclical and require Basel II to recognize the risk of short-term funding, particularly that of wholesale funding. Finally, Basel II should be applied consistently, reviewed continuously and updated regularly. The world changes quickly.
F. The need to get accounting under control
We at JPMorgan Chase are strong believers in good, conservative accounting. Accounting should always reflect true underlying economics, which actually is how we run the company. However, accounting practices are not widely understood, are changed too frequently and are too susceptible to interpretation and manipulation. Sometimes, they even inadvertently determine U.S. government policy.
We generally like fair value accounting
For assets that are bought and sold, fair value accounting creates the best discipline. Fair value accounting (often referred to as mark-to-market accounting) already provides for some flexibility if recent prices are under highly distressed conditions. In such cases, good judgment and sound fundamental cash flow-type evaluations can be employed to value certain assets. However, in our opinion, the application of fair value accounting for certain categories needs to be reconsidered. For example:
New accounting rules that have the potential to inadvertently affect how the capital markets function or change fundamental long-term U.S. government policies should be made thoughtfully, deliberately and with broad input
For example, we all believe that companies should have fully funded pension plans; i.e., the actual assets in the plan should be enough to meet a fair estimate of the liabilities. Years ago, if this wasn't the case, companies were allowed to maintain a "deficit" and fund it over several years. That deficit was not recorded on the financial statement of the company.
A change in accounting rules dictated that the deficit should not just be a footnote in the financial statements but that it should be reflected directly in the equity account of the corporation. Clearly, in very bad markets, these deficits grow dramatically, thus depleting the increasingly precious capital that companies have. (This is just another example of a pro-cyclical force). When companies realized they were getting enormous volatility in their capital account, they began to curtail or eliminate their pension plans in favor of 401(K) plans (where the individuals bears all the investment risk). This was a rational, precautionary step. But it, in effect, transferred the risk from the company to the individual. No longer did the large corporations assume the risk of providing a steady income stream to retired employee. Instead, the risk was passed to the individuals - many of whom could not afford it.
This is a perfect example of how accounting inadvertently sets policy. And, in my opinion, this was probably the wrong policy for the country. There would have been many ways to be true to the economic purpose of accounting without making a detrimental policy change. There are countless other example, and we hope regulators and accountants will eventually find better ways to apply accounting principles.
G. The need for appropriate counter-cyclical policies
During this crisis, it became evident that our system created enormous pro-cyclical tendencies. In fact, I can't think of one counter-cyclical policy at all (other than emergency actions taken by the government). Accounting policies such as mark-to-market and loan loss reserving are pro-cyclical. Basel II capital requirements are pro-cyclical. Regulatory and legal requirements are pro-cyclical. Repo and short-term financing are pro-cyclical. The one pro-cyclical tendency we probably can never correct is that of the market itself (i.e., the cost of capital goes way up in a downturn or investors refuse to finance less liquid assets). I have heard many good ideas about how to create some counter-cyclical policies and will focus on three here.
Loan loss reserving can easily be made counter-cyclical
I find it absurd that loan loss reserves tend to be at their lowest point precisely when things are about to get worse. As things get worst and charge-offs rise dramatically, one must dramatically increase loan loss reserves, thus depleting capital rapidly. This problem would be solved if banks were allowed to estimate credit losses over the life of their loan portfolios. Reserves should be maintained to absorb those losses. This would enable banks to increase reserves when losses are low and utilize reserves when losses are high. Transparency would be fully preserved because investors and regulators would still see actual charge-offs and nonperformers. This would require a rational explanation about the appropriateness of the lifetime loss estimates. It also would have the positive effect of constantly reminding CEOs, management teams and investors that bad times, in fact, do happen - and that they should be prepared for such events.
Repo and short-term financing can easily be made counter-cyclical
All banks now have access to the standard financing facilities for securities and loans via the Federal Reserve (i.e., the Fed will lend a specific amount of money against specific assets). A suggestion is this: If an institution provides financing to clients in excess of what the Fed would lend to the bank for the same securities, it would have to be disclosed to risk committees and the company's Board of Directors. The Fed then would have two major tools to reduce leverage and in a way that is counter-cyclical - it could charge higher capital costs to a bank when the bank is lending more than the Fed would lend or the Fed could reduce the amount it would lend to the banks. Market players would still be free to provide credit and leverage as they see fit.
Banks should have the ability to implement counter-cyclical capital raising with rapid rights offerings
Banks and possibly other companies would be aided by having the ability to effect rights offerings at a moment's notice. Regulations should facilitate such offerings - with the proper disclosure - in a matter of days rather than weeks. This would allow a company to raise capital and repair a balance sheet that might have been stretched by unanticipated market events and to do so in a manner that is fair and does not dilute the company's existing shareholder base.
H. The need for policies in health care, pensions, energy and the environment, infrastructure and education that will serve us well over time
Beyond the financial crisis, there are several important issues that will dictate whether or not the United States will continue to thrive over the next century. We believe our nation can and should be able to provide health care coverage for all. It is the right thing to do, it will help us build a stronger nation, and, if done properly and efficiently, we believe it ultimately will be cheaper than the current course we are on. On energy, we now have experienced our third major crisis, and we, as a nation, still have not executed a sensible long-term energy policy. Again, we believe that done right, an energy policy could be economically efficient, create great innovation, reduce geopolitical tensions and improve our environment. Similarly, we need to improve our nation's infrastructure and develop an education system that befits our heritage.
We can't fall into the trap of institutional sclerosis - now is the time to act. In the past, this nation has shown the fortitude to work together to accomplish great things, and we need to do that again. For our part, JPMorgan Chase are doing everything we can to be helpful to our leaders on all these issues.