Managing and Avoiding Risks: A Wall Street Leader Shows the Way
By PATRICIA CRISAFULLI, a business writer and author of
"The House of Dimon: How JPMorgan's Jamie Dimon Rose to the Top of the Financial World, released by Wiley in April 2009
Back when the credit crisis looked like a run-of-the-mill cyclical event a couple of years ago, JPMorgan Chase CEO Jamie Dimon joked that his daughter called him and asked what the fuss was all about. The punch line, as he wrote in his letter to shareholders in the 2007 annual report dated March 2008, was, "It's something that happens every five or 10 years."
Dimon's daughter then replied, "So why is everyone so surprised?"
Since then, the credit crisis has caused a wave of losses and defaults, especially in subprime mortgages, and unleashed a tsunami of red ink across the financial services industry. The credit crisis spawned a financial crisis and contributed to an economic downturn that has become one of the longest recessions since World War II.
"I used to say, 'It's normal. Why are people surprised?'" Dimon said in an interview for a book profiling his leadership, "The House of Dimon: How JPMorgan's Jamie Dimon Rose to the Top of the Financial World" (Wiley 2009).
"I can't say that any more because it's gone beyond the normal every six- or seven-year convulsion," he confessed.
WHAT MAKES DIMON SPECIAL
In the wake of the crisis, the wreckage on Wall Street has been staggering. Among the casualties, investment bank Bear Stearns faced almost certain failure in March 2008, until it was purchased by JPMorgan Chase in an 11th hour deal that was brokered by the government. In September 2008, another investment bank, Lehman Brothers, went bankrupt. Although not unscathed from losses, JPMorgan Chase has stood out among financial services firms as one of the strongest.
The secret to JPMorgan's success appears to lie in its risk management philosophy, which is backed by deep knowledge of the various business lines at the highest levels of the firm. Even more important, the JPMorgan management team has demonstrated the fortitude to walk away from opportunities that later proved too risky for the reward.
"Living life without managing risks is like pretending we're invincible: it's adolescent and quite possibly very costly," stated David Trainer, CEO of New Constructs, an independent research firm.
He lauded Dimon for taking a more conservative path while competitors, at least in the short term, followed a more lucrative strategy that turned out to have unforeseen risks.
Thanks to its diligence in risk management, JPMorgan has suffered far less than many of its peers from losses due to structured investment vehicles (SIVs) and collateralized debt obligations (CDOs). The objective of SIVs was to make money on arbitrage, meaning the difference between two assets, by selling shorter-term debt and buying longer-term assets.
When the market for shorter-term debt dried up and income from longer-term asset-backed securities declined because of defaults, SIVs caused huge losses, and banks had to put the assets from these entities onto their balance sheets.
CDOs were created by bundling together debt instruments such as mortgages and then selling them off in pieces or tranches. Loan defaults, however, hit the anticipated returns from CDOs, including what were perceived to be higher quality portions of debt.
JPMorgan avoided SIVs altogether and had comparatively less CDO exposure than most of its peers. Making strategic decisions of this type is one of the hardest things to do.
"The best risk managers over time make the toughest decisions in the good times when everybody else--all the other competitors--are growing rapidly. Employees are saying, 'We can't be competitive without this product,' but the manager says, 'I'm not going to offer that because I don't like the risk/reward,' " observed Tom Brown, a former award-winning Wall Street analyst who today runs Second Curve Capital, a hedge fund that focuses on financial services stocks.
Dimon and his team could only make these decisions because they understood the risks in depth and in a highly detailed way.
"The first thing that comes to mind about Jamie Dimon is that he understands the risks that the firm is taking," Brown added. "I would have to argue that the vast majority of CEOs don't understand all the risks that their companies are taking. Occasionally, one of those risks that they don't understand comes back to bite them. Obviously, in this cycle, it was the CDO."
WALL ST. RISK MANAGEMENT IN ACTION
To be effective, risk management must also be part of a corporate culture, empowering people to speak up and making sure they are heard. Although financial services relies on complex risk models, they cannot replace the human element of being aware and understanding that even the best models will sometimes fail.
Other tenets of the Dimon risk management philosophy include:
-- Being self-critical, looking at what went wrong and what could have been done better
-- Transparency and sharing information through the ranks and across businesses. For JPMorgan, the first indication of deterioration in mortgage-backed securities came from its mortgage-servicing business, which provided a valuable heads-up for the firm's investment banking unit and its mortgage securities portfolio.
-- Be prepared for the worst-case scenario. As Dimon advised in a 2006 speech to students at the University of Chicago Graduate School of Business, "Always have a column called 'worst ever,' and make sure you can survive under that."
Another component of effective risk management is compensation, which admittedly is a touchy subject on Wall Street, with the government proposing curbs on executive pay for firms that accepted bailout money.
Donald P. Delves, principal of The Delves Group, a Chicago-based executive compensation consulting firm, sees a direct link between how people are compensated and the amount of risk that they will take on (including levels of risk that exceed what is prudent or within the company's parameters).
Delves cited Dimon's tenure as CEO of Bank One from 2000 until 2004 when the firm was sold to JPMorgan Chase.
"What I saw Jamie Dimon do at Bank One from a compensation standpoint was take a very sleepy, entitled, overpaid, overperked and overpampered management team and, in very short order, cut out all the elements of the compensation system that were excessive," Delves added.
The Bank One compensation system that promoted a sense of entitlement and complacency was quickly changed into one that was predicated on performance, urgency and a reasonable level of risk-taking, Delves said.
In his letter to JPMorgan shareholders in the 2008 annual report, which is dated March 23, 2009, Dimon stated the bank is "at the forefront of sensible compensation practices," with practices that include paying people for performing well over multiple years and always trying to properly account for risk being taken.
In the aftermath of a devastating financial crisis, such thinking may hardly appear to be revolutionary. What appears to have distinguished Dimon and his team is their consistency over the years, in good times and in bad.
"Manage risks during the good times especially--that's the secret to real success. Everything else is luck," Trainer added. "Discipline more than anything means risk management in the financial world."
September 15, 2009
Copyright 2009© LRP Publications