What Dimon's Letter To Shareholders Really Says

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In early April, JP Morgan Chase (NYSE: JPM) paid a $20 million fine to the Commodities Future Trading Commission in connection with JP Morgan's handling of its business affairs with Lehman Brothers as that firm collapsed in 2008. The very next day, JP Morgan released its annual letter to shareholders from its CEO, Jamie Dimon. And while long and detailed, the report's overall theme is that shareholders are lucky to be involved in such an outstandingly ethical and profitable organization. The fine itself was hardly noteworthy, yet it occurring less than 24 hours from the release of the annual letter was ironic.

Dimon and Warren Buffett have a healthy amount of respect for one another, and I view Dimon's letter as channeling his inner Buffett, without the homespun humor that is Buffett's style. The rambling, 38 page document touches on all aspects of JP Morgan's business and even contains a healthy dose of commentary on fiscal policy and new federal regulations. I will summarize the highlights.

Sure, JP Morgan had record profits last year of about $19 billion, up about 9% from the $17.4 billion recorded in 2010. Let’s take a slightly closer look. Net interest income was down about $3.3 billion in 2011 from 2010. Non interest income was down about $2.4 billion. On the other side of the ledger, non-interest expense was up about $1.7 billion in 2011 compared with 2010. So, if we have key revenue amounts down $5.7 billion, and key expense amounts up by $1.7 billion, how in the world did JP Morgan increase earnings? Its loan loss provision in 2010 was 16.6 billion, and in 2011 it was $7.6 billion. Add a little assist from an income tax rate down by 50 basis points (0.5%), and that is how it was done.  This is not sustainable income growth, and I am not sure I would have been bragging about it.

I am not going to dispute Dimon's assertion that JP Morgan is a huge, integrated part of the international economy. It is the largest American bank by assets, and among the Financial Stability Board's list of 29 banks too big to fail. Global Finance recently named it the safest commercial bank in the United States, and the overall 38th safest bank in the world.

Next was Dimon's reminder that JP Morgan has not been shy about returning capital to shareholders. Its dividend is now an annual $1.20 per year, for a current yield of 2.7%. It bought back 9 million shares of its common stock in 2011, and has received Federal Reserve approval to buy back another 12 million in 2012. Dimon states these purchases will be immediately accretive to earnings so long as shares are bought for near or below tangible book value. The problem is, JP Morgan carried over $15 per share of intangible assets, comprising fully 1/3 of its book value at the end of 2011. If JP Morgan is buying stock right now, it is paying a premium of over 25% to its tangible book value. Perhaps, Dimon is right that if anything JP Morgan understates the value of its considerable intangible asset base. Yet, given the history of all banks in the past five years, I trust no one's estimate of intangible assets, and cannot get around the fact JP Morgan needs more capital to comply with Basil III. JP Morgan's dedication to share buybacks is a huge opportunity cost as well, as the bank, according to Dimon, will not consider acquisitions that require capital in 2012.

The one other part of the lengthy letter that really jumped out at me was Dimon's whining about regulators in general and the Federal Reserve in particular. When the going got tough in 2008 and 2009, where did JP Morgan turn? To the Treasury for $25 billion in TARP money, and it took billions more in loans from the Federal Reserve Discount Window. JP Morgan's need for these funds was largely the results of some of its own sloppy underwriting, a fact that Dimon does not dispute, as well as its ill-timed acquisitions Washington Mutual and Bear Stearns. Because of the conduct of JP Morgan and its peers, the industry faces additional regulation to prevent those issues from arising again. I see that as only logical, and shame on Dimon for seeing only one half of the equation.

Only once in the past 10 years has JP Morgan posted a return on assets of greater than 1.0%. In fact, only twice has the ratio even been over 0.90%. Somehow, JP Morgan has gotten a reputation of being a large and profitable bank. At least the “large” part is correct.

There are some reasons for optimism going forward. JP Morgan spent nearly $5.0 billion on litigation and fine expense last year, and that will trend down in the next year or two. Its large investment bank operations will not stay down in the dumps for long, and I expect a pickup in merger and acquisitions activities by the second half of 2012. JP Morgan is working to continue growing its loan base, especially in the area of commercial loans, and has promised not to abandon the mortgage market.

Perhaps the biggest reason why JP Morgan looks like a good bet is that it is, at least relative to its peer group that includes Bank of America (NYSE: BAC) and Citigroup (NYSE: C). Bank of America reported a modest profit in 2011 on the back of one time asset sales and revaluations. One analyst likened the bank's financial reporting to a science fair project, “built of pipe cleaners and paper machete for the Wall Street Science Fair.” It will take me years to come to terms with the tragedy of how Citigroup has treated its shareholders, between the reverse stock split and spinning the majority of its loans into its City Holdings facility.

One needs to look a little further down the rankings of the largest domestic banks, to Wells Fargo and U.S. Bancorp, to find institutions that are truly growing their loans, and managing to post annual returns in excess of 1% on assets. If one also wants top notch income and safety in their bank investments, any of the large Canadian banks will do nicely, especially Bank of Montreal and the Toronto Dominion Bank.


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