Monday, March 24, 2008

JP Morgan Rolls the Fed of New York (and BSC) (Institutional Risk Analytics)

My reason for presenting these hitherto uncorrelated facts of financial history is the hope that they may dispel, in part at least, the miasma of propaganda created by the great minds of Wall Street to divert from themselves responsibility for the country's present plight. The Federal Reserve System did not fail to function through an inherent weakness. It was debased by minds that were as stupid as they were ruthless and greedy.

The Mirrors of Wall Street (Published anonymously by G.P. Putnam's Sons, 1933)

This week IRA launches our new compendium of Economic Capital and bank performance benchmarks (Click here to see more details about The IRA Compendium of Bank Risk).

Our timing seems to be good since events in the financial markets suggest that our assumptions about bank risk and capital adequacy, once widely viewed as Draconian, are actually right on target. We'll discuss same in the context of several large banks, but first we need to vent about the sale of Bear, Stearns & Co. (NYSE:BSC).

Here's our question: Why did the Fed of New York facilitate the rape of BSC by JPMorgan Chase (NYSE:JPM)?

The announcement by the Fed of a new lending facility for broker-dealers to borrow from the discount window, made just hours after BSC's board of directors apparently was forced by the Fed to sell for $2 per share to JPM, strikes us as clear evidence of an anti-BSC bias by the US central bank. Why not just lend directly to BSC under the new Fed loan facility?

One prominent New York lawyer who is very well acquainted with the Federal Reserve Act tells The IRA that the Fed of New York did two things last week: 1) approved a loan to JPM, which was then passed through to BSC; and 2), created a new facility to lend directly to broker dealers under Section 13 of the FRA.

"There is nothing new here," adds the lawyer, who notes that the Federal Reserve Banks made loans to individuals in the 1930s under the emergency provisions of Section 13 of the FRA and could have easily lent directly to BSC without involving JPM at all.

Thus again the question to Fed of New York President Tim Geithner: Why was JPM involved in this transaction? Why not simply extend liquidity support to BSC as you now offer to every other primary dealer? As and when BSC shareholders litigate over this mess, Geithner et al may be forced to answer those questions in public.

To us, even at $10 per share, the JPM buyout stinks to high heaven because of the conflicted role played by the Fed of New York. Does anyone believe that the Fed would force Lehman Brothers (NYSE:LEH) or Goldman Sachs (NYSE:GS) into such a fire sale? Indeed, it looks to us like the Fed of New York and BSC both got rolled by JPM CEO Jamie Dimon and his merry banksters. But the JPM crowd won't be laughing much longer.

The same forces that pushed BSC into insolvency are working on JPM and the other money centers as you read these lines, but JPM first and foremost. Just look at the range of valuations included in JPM's disclosure to Canadian officials regarding price estimates for illiquid structured assets and you can see why JPM's Dimon has been so upbeat in recent months.

To understand the grim outlook for JPM, start the analysis with derivatives. Because of its huge market share in all manner of OTC derivatives, JPM represents a "super sample" of overall OTC market risk. In terms of total size vs the bank's balance sheet, JPM's derivatives book is more than 7 standard deviations above the large bank peer group.

Because of this huge OTC derivatives book, the $1.6 trillion asset bank can tolerate just a 15bp realized loss across its aggregate derivatives position before losing the equivalent of its regulatory Risk Based Capital (RBC). And much like the GSEs, JPM's positions are too big to hedge - despite what Mr. Dimon may say to the contrary about laying off his bank's risk. And note that we have not even mentioned subprime assets yet.

Look at the balance sheet of JPM's three main subsidiary banks and the mounting stress from loans losses is apparent. At the end of 2007, JPM aggregated 97bp of gross loan charge offs, 1.25 SDs above peer, and produced a Loss Given Default of 85%, likewise well above peer. The Exposure at Default calculated by the IRA Bank Monitor using data from the FDIC was 202%, more than 2 SDs above peer.

At the end of 2007, JPM's Tier One Risk Based Capital held by its subsidiary banks was just $88.1 billion, a tiny foundation for the bank's vast trading operations. The Economic Capital ("EC") simulation in The IRA Bank Monitor generates an EC benchmark of $422 billion for JPM or a ratio of EC to Tier One RBC of 4.79:1, suggesting that JPM needs almost five times current capital levels to fully support its economic risks.

This EC produces a "Stressed" result for JPM under IRA's Counterparty Risk Rating and a RAROC of just 0.22%. Similar measure for all US banks are contained in The IRA Compendium of Bank Risk.

While JPM currently boasts the highest Tier One leverage ratio of the top three US banks by assets, in EC terms it appears to be the clear outlier in the marketplace with the highest levels of economic risk vs. capital of any large bank in the US -- with one exception: Commerce Bancorp (NYSE:CBH). The relatively large MBS holdings of CBH push its ratio of EC to Tier One RBC over 8:1 in the IRA Bank Monitor simulation.

Why do we take such a dim view of JPM and the US banking sector generally? First, because the US real estate market is not yet even close to the bottom. Second, the commercial real estate and corporate credit sectors are being dragged down by the same deflationary forces that are causing the US economy to slow dramatically. When you consider that US real estate markets and bank loan losses are unlikely to bottom before this time next year, you begin to understand our bearish outlook.

JPM has been lucky so far because its risk book is heavily weighted toward commercial rather than consumer risk, unlike our beleaguered friends at Citigroup (NYSE:C). But like last week's debacle involving BSC, the fast deteriorating situation at C could provide a catalyst that takes JPM down a couple of notches in the next few months.

We hear in the risk channel that the internal situation at C is going from bad to worse as veteran Citi bankers are in near-mutiny against the new, two-headed management team imposed by regulators. Meanwhile, former CEO Chuck Prince, who is a consultant to C, is leading the discussions with regulators on behalf of the bank and is, in effect, acting as shadow chief executive of C. One insider predicts that the C annual meeting in several weeks time will be "very messy" and notes that acting Chairman Robert Rubin is nowhere to be seen.

Keep in mind that C, JPM and many other large banks are still trying to get their arms around the full dimension of the risks facing their institutions, this even as bank loan default rates remain well-below long-term averages. All of the subsidiary banks of C, for example, reported 127bp of charge offs in 2007, a full 2 SDs above peer but well below 1991 loan loss levels.

Click here to see a loan default series for Citibank NA going back to 1989. Notice how low bank loan charge offs were in the 2006-2007 period compared with previous recessions. Of note, the ratio of EC to Tier One RBC for C at the end of 2007 was 3.46:1, significantly better than JPM, but still suggesting that C really needs more than 3x current capital to address its economic risks.

BTW, the maximum probable loan loss ("MPL") calculated by The IRA Bank Monitor for C over the next 12 months is 400bp or well above 1991 loan default levels. We expect to see the MPL for all of the large money center banks move higher as 2008 progresses.

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