JP Morgan Chase 2008 Annual Report Download - page 23

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mortgage business. Mortgages are the largest financial
product in the United States, and while we do not want
to squelch innovation, the entire mortgage business
clearly needs to be regulated. This is not the first time
that mortgages and real estate have led this country
and many of its financial institutions into deep trouble.
Proper regulation would go a long way toward stan-
dardizing products, testing new ones, improving cus-
tomer disclosure and clarifying responsibility.
D. The need to fix securitization
We believe that securitization still is a highly effective
way to finance assets. But some securitizations, particu-
larly mortgage securitizations, had an enormous flaw
built into them: No one was responsible for the actual
quality of the underwriting. Even mortgage servicing
contracts were not standardized such that if something
went wrong, the customer would get consistent resolu-
tion. We cannot rely on market discipline (i.e., elimi-
nating bad practices) alone to fix this problem.
We have heard several reasonable suggestions on
how the originator, packager and seller of securitizations
could be appropriately incentivized to ensure good
underwriting. For example, requiring the relevant parties
to keep part of the securitizations, much like we do with
syndicated loans today, would help manage resolution if
something were to go wrong and could go a long way to
re-establish market confidence and proper accountability.
E. The need to fix Basel II — leading to higher capital
ratios but a more stable system
As discussed earlier, Basel II has many flaws – it has
taken too long to implement, it responds slowly to
market changes and it is applied unevenly across
global borders. Perhaps its worst failing is that, in its
current construct, Basel II does not include liquidity,
which allowed commercial and investment banks to
buy liquid or illiquid assets and fund them short.
While this practice did not appear quite so dangerous
in benign times, it created huge issues for many finan-
cial institutions during the market crisis. Basel II also
has relied too heavily on rating agencies and, by its
nature, has been highly pro-cyclical in its capital
requirements for assets. It would be easy to make these
capital requirements less pro-cyclical and require Basel
II to recognize the risk of short-term funding, particu-
larly that of wholesale funding. Finally, Basel II should
be applied consistently, reviewed continuously and
updated regularly. The world changes quickly.
F. The need to get accounting under control
We at JPMorgan Chase are strong believers in good,
conservative accounting. Accounting should always
reflect true underlying economics, which actually is
how we run the company. However, accounting prac-
tices are not widely understood, are changed too fre-
quently and are too susceptible to interpretation and
manipulation. Sometimes, they even inadvertently
determine U.S. government policy.
We generally like fair value accounting
For assets that are bought and sold, fair value account-
ing creates the best discipline. Fair value accounting
(often referred to as mark-to-market accounting)
already provides for some flexibility if recent prices are
under highly distressed conditions. In such cases, good
judgment and sound fundamental cash flow-type evalu-
ations can be employed to value certain assets.
However, in our opinion, the application of fair value
accounting for certain categories needs to be reconsid-
ered. For example:
• We now have to mark to market our private equity
investments by using potentially artificial bench-
marks. These investments, by their nature, are very
illiquid and are intentionally held for several years.
To mark them to market, proxies made up of compa-
rable companies are used, and appropriate discounts
and judgments are applied. Essentially, we write
these investments up when markets are good and
write them down when markets are bad. But I am
fairly confident that this approach is not always
right. In many instances, cost is the best proxy for
fair value. We would rather describe our investments
to our shareholders, tell them when we think these
investments might be worth more and, certainly,
write them down on our financial statements when
they have become impaired.