Last Man Standing

by Duff McDonald

  Steve Black, cohead of the company’s investment bank, has a joke he pulled out at the company’s “investor days” in both 2008 and 2009. As the market leader in making loans for leveraged buyouts—so-called leveraged lending—the bank had a chance to look at nearly every big deal that came down the pike. “The good news is that we turned down five of the last 10 deals,” says Black. “The bad news is that we took the other five.” JPMorgan Chase lined up with everyone else to make loans to Boots, a retailer in the United Kingdom; to the electric utility TXU; to Chrysler; to Home Depot’s supply unit; and to Sam Zell’s takeover of the Tribune Company.

  With $41 billion in outstanding leveraged loans when the market cratered in 2007, JPMorgan Chase saw that value plummet. Worse yet, the company had made the same mistake as it had in home equity, progressively loosening debt covenants and ceding an extraordinary amount of power to borrowers. It had, in other words, chased the market down when it should have held fast. By the end of 2007, it had its bearings again. JPMorgan Chase refused to finance the buyout king Steve Schwarzman’s $1.8 billion bid for the mortgage arm of the New Jersey-based PHH Corp. (In January 2008, Schwarzman was forced to back out of the deal and pay PHH a fee of $50 million. After initially pointing a finger at JPMorgan Chase and suggesting that the bank should share in the breakup fee, Schwarzman reportedly apologized to Dimon.) Still, the company wrote the value of its leveraged loan portfolio down $1.8 billion in 2008.

  One loan that the company did not make, but which still proved nettlesome, was financing for a buyout of a client, Dow Chemical, in early 2007. In April, it emerged that bankers at J.P. Morgan Cazenove—a joint venture half-owned by the firm—were working on a possible LBO of Dow Chemical without the approval of Dow Chemical’s CEO, its CFO, or its board. Winters pulled the plug on the project when he found out that the bankers were working with what appeared to be a rogue contingent of Dow Chemical’s executives.

  “It’s part of the job,” Dimon says about the mix-up. “You can’t expect to have a perfect batting average, and you can expect to make legitimate mistakes. When Bill Winters found out, as he puts it, we put our pencils down. Did that happen too late? Yes, it should have happened earlier. Our client did have a legitimate complaint.” Dimon had dinner with Andrew Liveris, CEO of Dow Chemical, the next month, to try to smooth things over. He later told Liveris that Dow director and former chief financial officer J. Pedro Reinhard and another executive, Romeo Kreinberg, had effectively been mounting a coup. Liveris fired the pair a few days later.

  Black and Winters are both irked that they saw the end of the credit bubble coming and talked about it incessantly, but failed to do enough to insulate the firm. “We missed it,” says Black. “It’s our fault. We did it. We said, ‘This thing is coming to an end, and we’re not going to be involved in these transactions,’ and then we end up in five of the last 10.”

  Black likes to say the company was smart twice (in avoiding SIV and CDO exposure) and unlucky once (in its leveraged loan exposure). One could invert the construction, however, and say it got lucky twice and was stupid once. It was well known on Wall Street that for some time JPMorgan Chase had had two warring mortgage factions—origination (at Chase Home Finance) and securitization (in the investment bank)—that prevented the bank from mounting a competitive end-to-end mortgage effort. Dimon even replaced most of the Chase mortgage team in hopes of reducing the friction. (The executives later showed up at Washington Mutual, where they were eventually fired by Dimon a second time.) The company was also lucky because it wasn’t competitive in big subprime markets such as California and Florida. Instead of a deliberate decision to avoid CDO underwriting, critics say, Dimon just hadn’t gotten around to knocking heads in his mortgage unit until shortly before disaster hit. “Jamie’s been very good, and he’s also been very lucky,” said Sanford Bernstein’s analyst Brad Hintz. “Was that a great skill, that he didn’t address [the issue of those warring mortgage teams] until [it was] too late? Or was it luck?” In other words, JPMorgan Chase’s good fortune in the summer of 2007 might have been an accident.

  Those on Dimon’s team reject this version of events, saying that although they had been overhauling their end-to-end mortgage capabilities, they didn’t act because they chose not to. In late 2005, they noticed that default rates on subprime mortgages were starting to pick up, and they therefore decided—just as they had when selling the SIV in 2004—that it might be better to sit this one out. Instead of adding to their subprime risk, they began reducing it, particularly through the use of mortgage derivatives.

  (One of the great ironies of the late stages of the mortgage bubble, Gillian Tett points out in Fool’s Gold, is that demand was so high for subprime mortgage product that it outstripped actual supply. Derivatives, on the other hand, could be made out of whole cloth. The only issue: like any financial product, a derivative needs both a buyer and a seller. There was no shortage of people who wanted to own subprime risk, but they’d have nothing to buy if there was no one who wanted to sell it. By seeking to hedge their own subprime exposure through the use of derivatives, then, JPMorgan Chase and others inadvertently helped prolong the insanity longer than it otherwise might have been had investors been limited to buying actual loans.)

  Then there’s the $2 billion CDO that no one seemed to have noticed, and which ended up taking $1 billion out of the company’s fourth-quarter earnings in 2007 when it lost half its value. Some executives at the company had proposed that the bank actually begin investing in subprime product, and while the decision was working its way through the appropriate channels, a unit of the bank went ahead and purchased a $2 billion subprime CDO. The proposal was ultimately rejected, but the CDO stayed on the books. Winters refers to the episode as “an outright control lapse” and “the biggest single mistake we’ve made in a long time.”

  • • •

  The International Monetary Fund estimates that stock market bubbles happen about every 13 years, and that housing bubbles occur every two decades. That’s what makes it so amazing that the majority of Wall Street firms were caught unawares by the credit debacle. Dimon’s daughter Laura called him in the fall of 2007 and asked, “Dad, what’s a financial crisis?” Without intending to be funny, he replied, “It’s something that happens every five to 10 years.” Her response: “So why is everyone so surprised?” (Dimon is fond of Mark Twain’s wry comment that history does not repeat itself, but it does rhyme.)

  One answer to Laura Dimon’s question is that this time around it wasn’t just one entity (such as Long-Term Capital Management) or one investment product (such as Internet stocks) that melted down. Almost every credit product out there collapsed—subprime mortgages, mortgage-related collateralized debt obligations, asset-backed commercial paper, auction-rate securities, SIVs, Alt-A mortgages, financial insurers, home equity.

  Among the large commercial and investment banks, only Goldman Sachs and JPMorgan Chase seem to have been in any way prepared for the possibility of disaster. In March 2007, Dimon had written in the company’s 2006 annual report, “Credit losses, both consumer and wholesale, have been extremely low, perhaps among the best we’ll see in our lifetimes. We must be prepared for a return to the norm in the credit cycle. We do not know exactly what will occur or when, but we do know that bad things happen. There is no question that our company’s earnings could go down substantially. But if we are prepared, we can both minimize the damage to our company and capitalize on opportunities in the marketplace.”

  And so, despite taking its own losses in leveraged loans and mortgage holdings, JPMorgan Chase reported record earnings in 2007 of $15.4 billion on revenues of $71.4 billion. The bank had also delivered genuine operating leverage. Between 2004 and 2007, the company’s top line grew by 67 percent, but income from continuing operations grew 260 percent. The cross-sell worked, too; gross investment banking revenue from commercial bank clients hit $888 million, up from $552 million in 2005. What’s more, the company’s return on equity
more than doubled, rising from 6 percent to 13 percent. While that was still below average for the industry, the change was certainly in the right direction. The bank now operated in more than 100 countries, had more than $1.5 trillion in assets under management, and held $15 trillion in custody agreements.

  Cost-cutting, too, continued apace. The company had shed 13 million square feet of excess office space since 2003. Since the acquisition of the Bank of New York branches in 2004, the number of computer applications used by the bank had fallen from 7,868 to 4,763. At the same time, the company’s computing power and storage continued to rise. At the end of 2007, JPMorgan Chase had 9.8 petabytes of online storage capacity, enough to house the entire Library of Congress online.

  A strong balance sheet, which used to be de rigueur among large U.S. banks, was now a major competitive differentiator. JPMorgan Chase’s tier 1 capital ratio—the ratio of equity capital plus cash reserves to total risk-weighted assets—was 8.4 percent, well above that of its primary competitors, Bank of America, Citigroup, Wachovia, and Wells Fargo.

  The company’s investment bank was showered with accolades at the end of the year. Institutional Investor, the trade magazine of investment bankers, named J.P. Morgan the investment bank of the year. Risk magazine named it the best derivatives house of the year as well as over the past 20 years. The company took the top spot in overall investment banking fees for 2007, and its lowest showing in the underwriting tables was a fourth-place ranking in common stock. The company led in convertible securities, high-yield corporate bonds, loan syndications, and leveraged loans.

  By carefully cultivating top talent from both the J.P. Morgan and Bank One teams, Dimon had largely avoided any meaningful conflict in the company’s executive suite. At the end of 2007, of the 15 top executives at the company, six had come from Bank One or Citigroup (Dimon, Frank Bisignano, Mike Cavanagh, Jay Mandelbaum, Heidi Miller, and Charlie Scharf), five from J.P. Morgan (Steve Black, Bill Winters, Todd Maclin, the asset management chief Jes Staley, and the chief investment officer Ina Drew), and four had been hired since the merger (Steve Cutler, Barry Zubrow, the credit card chief Gordon Smith, and the head of corporate responsibility, Bill Daley).

  And so Wall Street’s favorite parlor game began anew. Dimon told analysts in July 2007 that he was sick of answering questions about possible acquisitions, but that the party line remained the same. “I get tired of saying this,” he said. “But I’ll say it again. It’s got to have business logic, the price has to be right, and we have to have the ability to execute.” By the end of the year, however, analysts and investors saw the blood on the street, and they knew Jamie Dimon did, too. “Dimon has been preparing for this type of environment for the past two years,” wrote the UBS analyst Glenn Schorr in October.

  Fortune magazine once said that Jamie Dimon wouldn’t rest until he was recognized as “the world’s most important banker.” He was about to become just that.

  12. ALL THAT HE EVER WANTED

  At the start of 2008, Wall Street analysts had completely come around to JPMorgan Chase. Being boring was now a virtue. Although the company was facing the same gruesome economic environment as its competitors, it had suffered far smaller writedowns in 2007, and coverage of JPMorgan Chase practically demanded that the bank be “opportunistic” and on the watch to “scoop up some distressed assets or a distressed bank.”

  By one widely watched measure of financial stability—the amount of leverage on a company’s books—Dimon and his colleagues looked downright judicious compared with their freewheeling competitors. At the end of 2007, JPMorgan Chase’s balance sheet was leveraged 12.7 times, versus 19.2 times for Citigroup, 26.2 times for Goldman Sachs, 31.9 times for Merrill Lynch, and 33.5 times for Bear Stearns.

  The new year brought two milestones for Dimon. The first was professional. On January 16, JPMorgan Chase eclipsed Citigroup in market capitalization. The event was widely remarked by Wall Street, though Dimon claims it meant nothing to him. “I don’t look at market capitalization as a measure of success,” he says. “You’ve never heard me say a word about it. You’ve never read it in a press release, and you’ve never heard Mike Cavanagh [the chief financial officer] talk about it. You’ve never heard anyone in this company say that size is good, and you never will. I don’t want to be big and stupid. I want to be really good at what we do. Stock price is almost irrelevant to me, although I will admit I was surprised.” (Although his argument is persuasive to some degree, it strains belief that Dimon does not focus on both what the company does and where its stock price is trading. Not only is his net worth tied to the level of the company’s stock, but on Wall Street, stock price is the way the score is kept.)

  The second milestone was a little more personal. Dimon cochaired the annual meeting of the World Economic Forum in Davos, Switzerland, in January. Wall Street had long known of Jamie Dimon, but the wider world had known him less. News reports also confirmed that Dimon had hired the former British prime minister Tony Blair as an adviser to the company. (Blair was being paid either $5 million or $1 million a year, depending on whom you believe. JPMorgan Chase had no comment on the issue.)

  In the meantime, Barack Obama was catching up to Hillary Clinton in the polls for the Democratic nomination. As a board member of the Federal Reserve Bank of New York, Dimon was prohibited from making an outright endorsement, but his preference for Barack Obama was an open secret.

  Although the bank had performed admirably in 2007, Dimon was concerned about weakening results in both the investment bank and the company’s loan portfolios. The price of a barrel of oil had hit $100 on January 3, the U.S. dollar was cratering, and the Fed once again cut rates three weeks later in an effort to stave off the recession that had become all but inevitable. After all their work to keep the company’s balance sheet strong, executives at JPMorgan Chase faced the likelihood that they might be the good house in the bad neighborhood, dragged down with the broader economy.

  The turmoil had already claimed another victim. On January 8, the chairman and CEO of Bear Stearns, James Cayne, who had been at the firm since 1969, resigned from the CEO job, under pressure. (He held on to the title of chairman of the board.) Alan Schwartz, the company’s sole president since the firing of Warren Spector in August, replaced him. The market was becoming increasingly skittish regarding the viability of Bear Stearns. By mid-January, the price on credit insurance for $10 million of Bear’s debt had risen to 2.3 percent annually: $230,000—double that of Morgan Stanley and four times that of Deutsche Bank.

  At JPMorgan Chase’s “investor day” in February, the mood was mixed. The company had record revenues and earnings in 2007, yes, but the economy was looking grim. Also, the company sat on $94 billion of home equity loans, and delinquencies were headed skyward. Losses on the home equity portfolio had surpassed Dimon’s stress-testing scenarios, and the CFO, Mike Cavanagh, said that in the future the company would be assuming a more conservative stance. He dropped a bomb on the audience by explaining that the firm could add as much as $450 million more to loan-loss reserves in the first quarter alone. “We did not see the magnitude of the housing crisis coming,” he admitted. Though it had sold off much of its subprime portfolio, the company still owned $15.5 billion worth, and more than 12 percent of those home owners had been delinquent for 30 days or more.

  The company also shifted $4.9 billion of leveraged loans from “held for sale” to “held to maturity” on its balance sheet; this shift allowed it to delay taking losses on the loans. “We are going to be cold-blooded economic animals on [these loans],” Dimon told his investors. “If we don’t mind holding [them], we’re going to put [them] in the portfolio.” Cavanagh insisted that the company viewed the loans as good investments, but JPMorgan Chase nevertheless tacked on an additional $500 million to its loan-loss reserves. In 2008 alone, Cavanagh added, it had already determined to mark the leveraged loan book down another $800 million.

  Dimon was his usual self—confident, vaguely dismissiv
e, a little funny—and spent time after the presentation joshing with his lieutenants about the fact that Charlie Scharf’s presentation had sent the company’s stock down the most during the morning. (The sessions are broadcast over the Internet, and investors react to the presentations in real time.) During cocktails after the full day schedule, his penchant for analysis was again on display. He suggested to Steve Black, cohead of the investment bank, that they chart the day’s presentations to see who inspired the market and who did not.

  Earlier in the day, Dimon had voiced irritation with what he considered the overdone concern among investors about the state of the markets. “This is not the first crisis that ever happened,” he told the assembled crowd. “We shouldn’t be all atwitter over this stuff. Life goes on. Recovery will come … for most.” He was right in suggesting that some would not recover. A few weeks later, the first major victim of the financial crisis was knocking on his door, begging for help.

  • • •

  The first week of March seemed quiet on the surface, but chaos reigned inside Bear Stearns. Even though the company was on track to report solid earnings in its first quarter, trading partners were increasingly skeptical that it was a reliable counterparty. Not only did Bear have its own substantial mortgage exposure; it was also a significant lender to a few hedge funds—Carlyle Capital, Peloton Partners, and Thornburg Mortgage—that were also looking wobbly because of their own bad mortgage bets.

  When the end came for Bear Stearns, it came hard and fast. By March 5, the annual cost of credit insurance on $10 million worth of Bear bonds had risen to $350,000 and was heading higher. On March 6, the Dutch firm Rabobank told Bear’s executives that it would not roll over a $500 million loan coming due the next week. At the same time, Moody’s downgraded a number of mortgage-backed securities issued by Bear. The company’s stock slipped to $62.30—less than half its October levels. On March 7, the cost of credit insurance rose to $458,000. By the next Monday, March 10, the cost was $626,000.