Friday, November 22, 2013

The U.S. financial Panic of 1907 was the last century's equivalent of the 2008 global financial crisis. The large NY banks were virtually bankrupt and no federal system existed to provide a rescue. J. Pierpont Morgan, at the U.S. Treasury’s request, personally stepped in as arbiter to dole out $35 MM of Treasury capital, subject to a bank capital restructuring plan he approved, to end the crisis. In this era of tightly connected corporate holdings, a brokerage firm, Moore and Schley, was overleveraged in a bet on Tennessee, Coal, Iron, and Railroad (TCI) stock that led to a default on its bank loan. Were TCI to fail, dozens of other brokers and banks would have followed creating a cascade of bank failures. To shore up Moore and Schley, Morgan, who controlled U.S. Steel, decided U.S. Steel had to buy the TCI steel stock to provide Moore and Schley with liquidity. This purchase would have been a clear antitrust violation by U.S. Steel, but President Roosevelt promised to grant immunity from the antitrust statutes for the purchase. After the crisis ended Morgan and others advocated for the creation of a national plan to avoid a repeat of the crisis on the premise a towering figure like Morgan would not exist to address it. This plan became the Federal Reserve System.

The federal government's request for a private citizen to use his office and personal pulpit to help the nation avoid a financial calamity, even if it required waiving the law, was clearly in the national interest. In ways that are not easily measured, Morgan also benefitted financially as U.S. Steel became even more powerful and profitable while Morgan’s personal prestige and by association, his banks' soared.

Ironically, a similar situation arose in 2008 involving the institution that bears Morgan’s name. Early in 2008, Bear Stearns became the modern Moore and Schley as its leverage, and dwindling reputation caused it to lose its liquidity, pushing it to the brink of bankruptcy on a Friday afternoon. Over the ensuing weekend the Fed pushed Bear Stearns into the arms of JPM to avoid a national financial crisis. The purchase provided benefits to JPM in the form of prime Park Avenue real estate and other assets, but no sophisticated bank would have bought another, sunk by the mortgage debacle, on twenty-four hour notice without a major arm twist by the Federal Government, whose officials were widely quoted as advocating the merger. Several months later Washington Mutual Inc. was pushed into arms of the FDIC by its sloppy management of its mortgage underwriting. Again the federal government turned to JPM to avoid having to dismantle a massive troubled financial institution and JPM acquired WaMu. As in the Bear Stearns situation there were benefits to JPM, but massive benefits enured to the government and to the nation as the U.S. was able to keep a finger in the financial dyke.

Five years later, short term thinking appears to be the prevailing wisdom. A few predicates for national institutions are taught in high school civics: 1) It is important that the governed trust the governing and that the governing accept responsibility for the work of their predecessors; 2) A system of law exists to attempt to bring equity to those treated inequitably with equity typical being settled as payments to the harmed party; and 3) decisions made today should give significant consideration to their precedential effect on similar decisions that may have to be made in the future. These are not dissimilar ideas to the way one should run a private equity firm or any enterprise.

With all this in mind, we turn to the recent JPM settlements: one related to the $6 Billion loss on the London "Whale" trade and the other to mortgages. The $6 Billion trading loss was a loss entirely absorbed by the shareholders for which they can choose to react by voting out the JPM Board or by selling their stock. Yet, U.S. and U.K. regulators fined JPM $1.1 Billion, increasing the loss to the shareholders by a similar margin. These shareholders' only transgression was enduring the original loss of capital. (See civic's Rule number two above to wrestle with the equity of that fine.) Far more visible in recent weeks has been the $13 Billion the government fined JPM for its involvement, largely (80%, per the press) attributable to Bear Stearns and WaMu activity prior to JPM ownership, in poor underwriting and inadequate MBS disclosure. If anyone were damaged by these acts, they likely were either the investors who bought the mortgage backed securities or perhaps lenders forced to take back poorly underwritten loans. Yet the $13 Billion is being passed out to the following parties: $4 Billion to FNMA and to FMAC - arguably investors, $1.4 Billion to National Credit Union Associates to reduce the assessments they pay, $613 MM to NY attorney general, $299 MM to California attorney general, who happens to be the prosecutor's sister-in-law, $100 MM to New York homeowner assistance, $2 Billion to homeowners in Detroit, etc. In total about $9 Billion will be going to parties who were not purchasers of the questioned mortgage securities in what one might suggest is a shakedown by JPM’s regulator. (See Rules one & two) In short JPM's reward for helping out the government is the largest fine in American history.

It is impossible to estimate the size of the TARP the government would have had to create if Bear Stearns and WaMu fell as Lehman did, but it is reasonable to assume the attendant price would not have been small. I am in no way an apologist for JPM, but the question "to whom will the government next turn if there is another Lehman or a Chrysler to be saved" is a large public policy dilemma. (See Rules one & three). In the 2009 Chrysler and General Motors cases the government threatened and reduced the contractual recovery of bondholders, who attempted to enforce their legal rights, in order to put its preferred solution in place. The government also dismissed bankruptcy and corporate law to selectively enforce pension contracts, yet no private authority was able to fine them for these infractions. No CEO or Board of Directors will be willing to step in to buy a known Pandora’s Box, such as a Bear Stearns, if they believe the box itself may also later prove to be radioactive. We have seen examples of this in the PE world where a successful portfolio company has been "ordered" to buy a struggling company owned by the PE firm that owned both companies. Imagine the consequences if the CEO of the successful company lost his bonus if the combined entity didn’t profit.

I’m Rob Morris and I approved this blog.

The Financial Panic Of 1907