Last Man Standing (36 page)

That explains why in 2007 the company wrote off $564 million in home equity loans, and added $1 billion to reserves. “We could have known and we should have known,” says Dimon. “Part of it was like the frog in boiling water, who doesn’t know it’s getting hot until it’s too late. But that’s no excuse. The fact is, it was bad underwriting. I’d like to write a letter to the next generation that says, ‘Even if you see home prices go up 100 percent over five or 10 years, don’t go past 80 percent loan-to-value!’”

In the rush to add mortgage volume, the company also embraced the wholesale “channel” in which outside mortgage brokers made loans and passed them on to the company. This was an added dimension of risk; the company had little control over underwriting practices that went on outside its own walls. Although such loans accounted for only 33 percent of outstanding prime mortgages at the end of 2008, they accounted for a whopping 78 percent of losses. Dimon had written in the company’s 2006 annual report that the home equity division had maintained “its high underwriting standards.” He was wrong about that, at least as far as its wholesale business was concerned.

Dimon considers the decision to use mortgage brokers the biggest mistake of his career. After a speech at the Chamber of Commerce in March 2009 in which he said just that, the National Association of Mortgage Brokers released a statement calling it a “senseless” attack. The bank made other grave mistakes as well, such as aggressively chasing market share in jumbo mortgages and credit cards even as the economy had begun to shrink, leaving it with billions of dollars in future writedowns.
Dimon’s vaunted ability to connect the dots failed him in these instances. The push to add market share in mortgages was successful—origination in the first quarter of 2008 increased 30 percent to $47 billion, doubling the company’s share from 5 to 10 percent—but it also cost the firm more than $500 million. “We were too early,” Dimon later said.

According to Scharf, he and his team made a serious miscalculation. “We didn’t think housing prices were going to go up forever,” he says. “We did say they could go down. But when we asked ‘What’s the worst it could be?’ we got that one totally wrong.” Dimon wrote in the company’s 2006 annual report that credit losses “could rise significantly, by as much as $5 billion over time.” He was off by several orders of magnitude.

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.

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.”