It’s good to be JPMorgan

Good morning. The debt ceiling cliff-edge is but one month away, according to Janet Yellen. Luckily, having a looming disaster with a deadline attached is precisely when “Washington’s at its best”, in the words of one senator. If doing the bare minimum just in time is Washington’s best, we shudder to imagine its worst. Email us: [email protected] and [email protected].

Jamie Dimon gets a bargain

You know that JPMorgan got a great deal on First Republic because they were at such pains to emphasise that they did not get a great deal. “Our government invited us and others to step up, and we did,” said chief executive Jamie Dimon. “This acquisition modestly benefits our company overall,” he added. “We did not seek out this deal,” said chief financial officer Jeremy Barnum. “Accounting aside, on a net basis, the gain is quite modest.”

Patriotism! Duty! Maybe! The deal has three basic parts:

• On the asset side, JPMorgan received $29.6bn in securities, $150.3bn in loans and $5.9bn of bits and bobs (intangibles, branches and so on). Total: $185.8bn. 

• On the liability side, it assumes $92.5bn in deposits, $28bn in expensive Federal Home Loan Bank debt, $50bn in five-year fixed rate Federal Deposit Insurance Corporation funding, and $2bn of bits and bobs. Total: $172.8bn.

• Cash payment from JPMorgan to the FDIC: $10.6bn.

So JPMorgan has paid $183.4bn in cash and assumed liabilities for $185.8bn in assets, hence the “modest” accounting gain of a few billion dollars. (The only complicating factor, analytically, is that $5bn of the assumed deposits were its own; but JPMorgan taking on its own deposit does amount to a payment to the FDIC, because the $5bn cash asset they had at First Republic has, in effect, disappeared).

This does not look like a tremendous deal for JPMorgan on its face, inasmuch as they received a small discount on the assets in return for taking on a lot of stuff from a failing bank, stuff which may not ultimately be worth exactly what it seems to be worth. On a risk-adjusted basis, JPMorgan might argue, they got a merely fair price.

But there is another, probably better way to think about this, which is in terms of earnings power — the spread between the cost of the assumed liabilities and the yield on the assets.

Let’s focus on the loan book. JPMorgan now holds the loans at a discount to face value, which brings their yield in line with the market. Furthermore, if there are defaults, the FDIC, as part of the deal, takes 80 per cent of the losses. These are good-quality loans and default rates will be very low. The loss-sharing is important only because it decreases the amount of the capital JPMorgan has to hold against the loans. The loss-sharing, in other words, decreases its all-in cost of funding, and increases its profit margin.

But what makes the loans really interesting, though, is the $50bn in five-year fixed-rate funding from the FDIC. If that helps lock in a decent spread on these loans through 2028, the structure of the loans themselves will help ensure a profit for JPMorgan in the years after that. Because, as Charles Peabody of Portales Partners points out, nearly half of the First Republic loan book (most of its residential mortgages) is hybrid rate: they pay fixed for a certain number of years, and then pay a floating rate. If JPMorgan can just carry these loans profitably until their rate reset date, they’re in good shape.

But it is hard to assess exactly how good because, in what can only be described as an audacious move, JPMorgan declined to say what rate it was paying the FDIC on the money. It said only that it was a “market” rate, leaving observers to wonder why JPMorgan couldn’t just get five-year money from, well, the market.

The deal, in summary, takes First Republic’s loans, increases their effective yield by marking them to market, and then pairs them with a combination of low-cost FDIC funding and JPMorgan’s own cost of funds, which is lower than First Republic’s.

A bright analyst on the conference call neatly captured this point by pointing out that while JPMorgan said it expects that the deal will add $500mn in net income annually, First Republic generated net earnings at an annualised rate of more than $1bn in its last reported quarter — and that JPMorgan had a lower cost of funding, too.

The CFO responded, rather feebly, that deposit flight was a risk and they were being “a bit conservative”. It looks like they are being very conservative indeed. This deal is a home run for JPMorgan, but it would be indiscreet for it to say so when the FDIC insurance fund expects to take a $13bn hit on the deal.

Should the FDIC have been able to negotiate a better deal? Not necessarily. There was only one bidder with a big enough balance sheet to take on almost the whole of First Republic’s balance sheet, keeping the deal simple and clean, and the FDIC was in a hurry. It’s good to be JPMorgan.

What if margins stagnate?

Unhedged has yammered on in recent weeks about high margins and whether they’re due for a mean-reversion. One reader, Håkon Kavli, portfolio manager at Reitan Kapital in Oslo, wrote in with an important addition. Even if margins don’t mean-revert, instead flatlining at a high level, it could still be bad for stocks. The reason: earnings growth over the long bull market has been fuelled by margin expansion. If no more margin expansion is forthcoming, investors will have to accept much less earnings growth than they have come to expect.

The chart below shows inflation-adjusted per-share earnings and sales growth for both US stocks and global stocks. Since 1995 (as far back as the sales data goes), US real sales have risen 70 per cent, but real earnings are up nearly 400 per cent:

This chimes with how margins have grown since the great financial crisis. We showed you this chart, a broad measure of US operating margins that accounts for survivorship bias, a couple of weeks ago:

Here is one sweepy story you can tell. The post-GFC economy was characterised by weak labour power and cheap inputs. That is a good environment for profits, in large part because, as Bank of America’s Savita Subramanian put it in a note in August: “Labour is the most important, and most margin-negative, cost for corporations.” The pandemic shock did lend workers more leverage but, as we’ve written, it also gave businesses abundant room to widen margins. Meanwhile, until recently, falling interest rates and low taxes (including a big 2017 corporation tax cut) further juiced net margins. Kavli sent over this chart (bottom-left is the US):

So, for bumper earnings growth to continue, Kavli sees two possibilities (he makes the point in global terms but the broad point holds for the US, too):

1. The trend of falling tax burdens, interest burdens and improving gross margins must continue.

2. Revenue per share must suddenly start to grow in real terms, despite three decades of stagnation [in global sales; see chart above for US sales].

The first looks hard. It would require taxes to fall despite higher public spending; rates to return to rock-bottom; and labour markets to slacken. The second, in the US at least, seems more do-able. There are great companies aplenty that can generate sales growth in an expansion. But sales alone won’t be able to create the bull-market returns investors have become accustomed to. We’re reminded of this chart that Spencer Jakab published in The Wall Street Journal last year, decomposing S&P 500 returns by source. Notice that post-GFC sales have done much less for returns than margin or valuation expansion:

Markets care about rates of change rather than levels. If margins stagnate, which strikes us as an optimistic outcome, the next bull market may be far weaker than ones that went before it. (Ethan Wu)

One good read

Hedging your bets makes sense in finance. In politics, though, it’s “unforgivable”.