Fortune’s Shawn Tully has a highly complimentary profile of Jamie Dimon which tries to explain exactly how he managed to dodge the subprime bullet:
One red flag came from the mortgage servicing business, the branch that sends out statements, handles escrow, and collects payments on $800 billion in home loans, its own and others’. During a regular monthly business review for the retail bank in October 2006, the chief of servicing said that late payments on subprime loans were rising at an alarming rate. The data showed that loans originated by competitors like First Franklin and American Home were performing three times worse than J.P. Morgan’s subprime mortgages. "We concluded that underwriting standards were deteriorating across the industry," says Dimon.
In the investment bank, Winters and Black were discovering more reasons to be cautious. CDOs issue a range of bonds, from supposedly safe AAA-rated ones with relatively low yields to lower-rated ones with higher yields. Winters and Black saw that hedge funds, insurance companies, and other customers were clamoring for the high-yielding CDO paper and were less interested in the other stuff. That meant banks like Merrill and Citi were forced to hold billions of dollars of the AAA paper on their books.
What’s wrong with that? Doesn’t an AAA rating mean the securities are safe? Not necessarily. In 2006, AAA-rated CDO bonds yielded only two percentage points more than supersafe Treasury bills. So the market seemed to be saying that the bonds were solid. But Black and Winters concluded otherwise. Their yardstick, once again, was credit default swaps – insurance against bond failures. By late 2006 the cost of default swaps on subprime CDOs had jumped sharply. Winters and Black saw that once they bought credit default swaps to hedge the AAA CDO paper J.P. Morgan would have to hold, the fees from creating CDOs would vanish. "We saw no profit, and lots of risk, in holding subprime paper on our balance sheet," says Winters.
This is genuinely impressive: Dimon and his lieutenants saw clearly in late 2006 two risks which wouldn’t crystallize for most of us until the summer of 2007. Interestingly, both of them could be considered a variant of "model risk" — the risk that financial models which have worked in the past will stop working in the future.
The first was the credit risk on mortgages. It seems an obvious worry now, but back in 2006, almost no one in the world of mortgage bonds spent any time on credit risk. The only risk which people worried about was prepayment risk; credit risk was a minor issue, partly because the debt was secured and partly because it had never been an issue in the past. (Which made it almost impossible to model.)
The second was the market risk on CDOs. Most other banks happily outsourced that crucial risk-management function to the ratings agencies, who dutifully (and profitably) churned out the requisite triple-A ratings. JP Morgan refused to let the ratings agencies have the last word, and instead took the warnings of the CDS market seriously. Once again, it seems obvious now that investors with money on the line are likely to be more alert to big risks than ratings agencies who were paid to generate triple-A ratings. But it wasn’t nearly as obvious in 2006.
In general, it seems that JP Morgan, almost uniquely, demonstrated the kind of caution that one would expect from a highly-leveraged institution. Everybody else saw money and chased it: most of the time those bets exploded violently, while the traders at Goldman Sachs were either smarter or luckier and saw their bets pay off. JP Morgan, meanwhile, was voluntarily taking itself out of lucrative businesses.
Dimon’s stance was radical: He was skirting the biggest growth business on Wall Street. "Our employees wanted to know why we were being so conservative," says Black. "We lost a lot of structured credit people to hedge funds." J.P. Morgan also lost ground to competitors. It sank from third to sixth in fixed-income underwriting from 2005 to 2007, and the main reason was its refusal to play in subprime CDOs, which its rivals were gorging on.
And much as I’m skeptical of attempts by glossy magazines to lionize the CEO of the moment, I do think it’s reasonable for Dimon personally to take a lot of the credit. As Tully shows, Dimon sets the tone for the risk-conscious management of the bank as a whole: essentially everyone there is a risk manager, and that function isn’t outsourced to some marginalized and powerless group of resented risk officers.
Could Dimon have achieved something similar if he’d succeeded Sandy Weill at Citigroup? Frankly I doubt it: Citi really is too big and unwieldy to manage. But JP Morgan Chemical Chase Manhattan Bank One Bear Stearns Manny Hanny, it seems, isn’t.
(Via Carney, and please, Fortune.com people, allow us some way of reading the whole article on one page! Otherwise I either end up linking to the middle of an article, or else end up linking to a page which doesn’t include the passage I’m quoting. Either is unpleasant.)