Back in 2008, Goldman got rid of not one but two main competitors when first Bear and then Lehman quietly went into that good night when a Goldman-controlled Fed refused to bail these banks out, in the process unleashing the biggest taxpayer-funded, and still ongoing, wealth transfer to bank executives in history. 7 years later, banks have proven surprisingly resilient to the massive commodity deflationary impulse even as the global growth is slowing to a pace not seen since the events in 2008, which is why Goldman decided it is time to take matters into its own hands with what may be the most "modest proposal" of the day, if not year: it may be time for JPM to break itself up voluntarily... a process Goldman (and its bonus-receiving employees, not to mention shareholders) would endorse wholeheartedly as it would remove its biggest and most connected competitor in the US financial landscape today.
The Fed’s recent G-SIB proposal raises JPM’s capital requirement to 11.5%, 100-200bp higher than money center peers, reigniting the debate about whether a breakup could unlock shareholder value given that size is now a regulatory negative. A breakup could create value by reducing or removing JPM’s 20%-plus discount to pure play peers and increasing capital returns and ROEs, as each standalone business would face a lower G-SIB surcharge. While a breakup thus looks accretive, we would weigh this against the execution risk associated with a breakup of this magnitude, likely reductions in JPM’s estimated net income synergies of $6-7bn and the consideration that each standalone business would likely still be subject to CCAR (although perhaps not asset management), which remains the binding capital constraint for most banks. And despite its higher G-SIB requirement, JPM’s current ROTCE potential remains higher than that of most peers, which face similarly high capital requirements as JPM after factoring in CCAR.
A victim of its own success? Standalone strength enables breakup
JPM is somewhat unique among the money center banks, as nearly all of its business lines are top quartile performers. This is a double-edged sword as it suggests synergies from JPM’s business model do exist but also implies enough strength to operate as standalone companies. Our analysis suggests that a breakup – into two or four parts – could unlock value in most scenarios, although the range of outcomes we assessed is wide, at 5-25% potential upside. Upside is sensitive to the magnitude of the multiple rerating, the speed and size of potential capital returns from each standalone business, and reductions in estimated synergies.
We view a JPM breakup as a “put option” if regulation gets tougher
Capital requirements could move higher again if the Fed adds G-SIB surcharges into CCAR, something it is considering. If this were to unfold, we believe JPM (and other money centers) would strongly consider strategic alternatives, providing shareholders with a breakup “put option” if capital requirements get tougher. In the meantime, we see valuation support at ~9.5x 2016E EPS and re-iterate our Buy rating.
With JPM now facing materially higher capital requirements than peers on a spot basis (although we would argue its capital requirements are similar to peers once CCAR is factored in), investors are thinking through:
A complete breakup : Under this hypothetical idea, JPM’s four operating segments would become independent companies, enabling a multiple re-rating (as the discount to pure play peers is reduced) and capital efficiencies (and thus a higher ROE) as G-SIB requirements are reduced. Offsetting this would be lost business synergies. We provide this analysis for illustrative purposes and acknowledge that a wide range of potential outcomes exist.
Our view: Our analysis indicates that even accounting for lost synergies, a JPM breakup would be accretive to shareholders in most scenarios. That said, breaking up a company of JPM’s size into four pieces (all of which would still be very large financial intuitions) would carry considerable execution risk. An inability to return excess capital (owing to CCAR limitations) or a lack of multiple re-rating could likewise meaningfully reduce potential upside.
A spin-off, or split down the middle: Under the Fed’s methodology for calculating G-SIB buckets, as a bank shrinks its G-SIB buffer declines. This could incent JPM to spin-off one (or multiple) of its businesses to drop down one or more G-SIB buckets and bring its required capital level in line with peers. We provide this analysis for illustrative purposes and acknowledge that a wide range of potential outcomes exist.
Our view: We estimate “minor surgery” like spinning off the trust business alone would only result in modest capital relief (~50bp) and likely not justify the execution risk. That said, we believe a split of JPM in two (a traditional bank and investment & trust bank) would result in considerable capital synergies while likely keeping half of JPM’s synergies intact. While the benefit of this scenario (vs. a full breakup) is higher retention of synergies and less reliance on capital return, a reduction of the discount to pure play peers would be at greater risk if the company were only being split into two pieces.
The synergies of JPM’s businesses: JPM has disclosed it receives $6bn+ of net income synergies from its business model. Determining how much of these synergies would be eliminated in a breakup (the answer varies according to how the new companies are divided) and how JPM’s business lines would perform as standalone companies are key factors in any breakup analysis. We provide this analysis for illustrative purposes and acknowledge that a wide range of potential outcomes exist.
Our view: While synergies are tough to verify from the outside, our analysis shows that most of JPM’s business lines are top quartile performers, providing some credence to the numbers. That said, strong performance by business lines also provides credibility to the idea that these businesses could function as standalone companies.
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And Goldman's clearest reco that the time to break up its biggest competitor is nigh:
A breakup into JP Morgan & Chase could be accretive with less risk
Similar to our math around a complete break-up, we run through the hypothetical exercise of splitting JPM into two companies: (1) the trust bank, investment bank and asset management business (which we will call the institutional businesses) and (2) everything else (i.e. the more traditional banking businesses). We use the capital requirements outlined on the page above (i.e. a 300bp G-SIB buffer for the institutional business and a 150bp G-SIB buffer for the retail business) plus 100-150bp (to account for a conservative CCAR cushion). From a valuation perspective, we use MS, BK, STT, BLK, AB, TROW, LM, and IVZ as P/E comparables on the institutional side, and WFC, PNC, USB, STI, HBAN, COF, DFS, BBT, CMA, FITB and ZION on the traditional banking side.
Is Goldman's hint about to be taken seriously by JPM? If so, expect an update on the status of Jamie Dimon's throat cancer, currently said to be in remission as the bank prepares to call it a day on its current layout, one which happens to host some $65 trillion in derivatives.
Alternatively, if JPM sees this as a hostile act by the FDIC-backed hedge fund, then the gloves are about to come off between the world's two most important banks. In short: it's popcorn time.