JP Morgan – Too Big To Manage?

“Taking on these greater risks raises the likelihood that an investor, even a major financial institution, suffers large losses.  If they suffer large losses, then they are threatened with bankruptcy.  If they go bankrupt, then the people, banks and other institutions that invested in them or lent money to them will face losses and in turn might face bankruptcy themselves.   This spreading of the losses and failures gives rise to systemic risk, and it is an economy wide problem that is made worse by leverage and leveraging instruments such as derivatives.  When people suffer damages, even though they were not counterparties or did any business with a failed investor or financial institution, then individual incentives and rules of caveat emptor are not sufficient to protect the public good.  In this case, prudential regulation is needed – not to protect fools from themselves, but to protect others from the fools.” Randall Dodd, Financial Policy Forum, Derivatives Primer.

It is nearly impossible today to read any financial newspaper or website without seeing continued coverage of the JP Morgan story.  However, I suspect that most folks do not really understand or appreciate the macro issue.  And rightfully so.  To the average person, another Big Bank Blunder is not really news.  After all, isn’t this what we’ve come to expect?  Unfortunately, yes – which is why I suspect most folks have stopped reading the post mortem reports about exactly what went wrong at JPM.

But let me explain why this story should be important to everyone, especially those who have suffered through the last five years of Big Bank B.S. However, to do so, I need to connect a few dots, since the JP Morgan story is actually symptomatic of a larger sub rosa story that has yet to become news on Main Street.[1]

Derivatives, Hedges, and other Jabberwocky. To understand JP Morgan’s bungled trading errors, it is first necessary to have a basic understanding of derivatives, since these were the financial instruments that were at the root of JPM’s problem.

Derivatives do not generally involve the conventional sale or exchange of an asset or conveyance of title.  Instead, they are contracts tied to the change in price of some underlying price change or event.  The pricing of a derivative contract is derived from the price of the security, commodity, index, interest rate, exchange rate, etc. upon which it is based.  Examples of derivatives can include futures contracts[2], forwards,[3] options[4] and swaps, such as credit default swaps[5].  [Footnotes 2, 3, and 4 come from ]

Derivatives can be very helpful in managing risk, through the use of hedges.  A “hedge” is simply a financial tool used to reduce the risk inherent in an investment in one direction, by making an offsetting investment in the other direction. This assures the investor that he or she will either profit – or at least avoid loss – regardless of the direction the first investment takes. [6]

The Good, Bad, and Ugly Sides of Derivatives. On a very basic level, banks need to use derivatives as a hedge against their risk.  A simple example would be to use them as a hedge against short-term interest rates paid to depositors rising in the future. They can limit that risk through the higher fixed interest rates earned on longer term loans made to their borrowers.

Derivatives transactions allow investors to place only a small amount of capital at risk in order to control a much larger price position in the marketplace.  Although some derivatives are traded through an exchange [i.e. there is a neutral entity handling the transaction between the parties] a large number are traded over the counter (“OTC”), which is entirely unregulated.  The OTC markets are very opaque, and there is no information readily available to other investors as to the specifics of the positions taken.  In this shadow world very little is provided by market participants or collected by regulators.  Moreover, OTC hedge markets have no margin or collateral requirements, so losses are not backstopped by an additional source of funds should the hedge goes bad.  Amazingly, as demonstrated by the Bear and Lehman failures,[7] derivatives trading is based upon an implicit assumption that both counterparties can absorb the loss, should one occur.

And while it is cheaper to reduce risk through hedges, it is also cheaper to speculate with them – i.e. using hedging as a wager, rather than as a means of managing risk. But more about this later….

What Was JP Morgan Up To? Of all the Big Banks, JP Morgan and Citibank have the greatest exposure to the European credit markets.  According to a Reuters article cited by the Huffington Post, they have loaned $18.8 billion to Ireland, $12.2 billion to Italy and $12 billion to Spain.  Next to Greece, these three countries are among the top contenders for financial disaster.  It appears that this may have been the risk JP Morgan sought to hedge against, using “credit default swaps” or “CDSs,” a type of credit derivatives contract.[8]

According to

“The buyer of a credit default swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the debt security. In doing so, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.”

Thus, given JP Morgan’s exposure to European credit markets, it would not seem unreasonable that it would try to hedge that exposure through the purchase of CDSs. However, there is credible information to suggest that its activities were not merely a hedge against the European credit crisis.  According to one commentator:

“Trust me – that’s probably what the head trader told the risk department at JPM when he put on the Big Trade – the hedge position that the bank put on wasn’t a hedge at all. It was a bet designed to make money that was designed to look like a hedge. Which only was ever going to be called a “hedge” if they lost money on it. Otherwise, no one would have noticed that they made a ton of money on the position. It would have been buried in their financials as some income thing from something that was what they do that makes them oh so good at what they do. Did I say hubris?” Shah Jilani Wall Street Insights and Indictments, May 13, 2012.

The London Whale. The London Whale is a JPM trader named Bruno Iksil.  His moniker derives from the huge sums of money he bet in the derivatives markets.  Mr. Iksil’s positions were so large that it impacted the hedge funds on the other sides of the trades.  According to rumor, once the affected hedge fund managers “deduced the size of his positions, they determined that he would have inadequate liquidity to exit his position. In short, they smelled blood … and pounced.” [See the unabridged version of the feeding frenzy at Seeking Alpha, here.]

Quoting the Seeking Alpha article:

“So, if this is a prop [proprietary] trade that went wrong … so what! But if this is supposed to be a hedge, it’s a little more troubling. *** JPMorgan Chase CEO Jamie Dimon has called these trading losses a failed hedge. But how exactly does one “hedge” a book of commercial loans — JPMorgan’s traditional banking business — by writing protection on other companies’ paper, thereby gaining loss exposure to these other loans?*** Calling the trades complex, poorly monitored, and poorly understood is one thing. Calling the trades for what they actually are is another.”

OK, here’s the Readers Digest version of what some experts believe happened:  JP Morgan was simply making wagers using derivatives.  They were “house” bets, i.e. proprietary or “prop” wagers on the direction of the market, and were done solely to make the bank more money, not to hedge risk.  While both activities arguably have a place in a bank’s business model, calling a proprietary bet a “failed hedge” is exactly what Dodd-Frank and the Volker Rule are trying to prevent.

What Does The JP Morgan Fiasco Say About Big Bank Regulation? Slightly more than four years ago, in March 2008, Bear Stearns collapsed, and was “rescued” by JP Morgan for pennies on the dollar.  Their stockholders, whose share price had once been $156, received $10 per share from JP Morgan.  Bear Stearns was heavily invested in the derivatives market.  Before its collapse, it was a counterparty to $13 trillion in derivative trades.[9] Next in line was Lehman Brothers, which filed for bankruptcy in September 2008. The notional value of its derivatives portfolio was $35 trillion.

According to the Comptroller of Currency 2Q, 2011, the top four U.S. banks, JP Morgan, Citibank, Bank of America, and Goldman Sachs, account for 94% of total derivative exposure as follows[10]:

  • JP Morgan – $78.1 trillion
  • Citibank – $56 trillion
  • Bank of America – $53 trillion
  • Goldman Sachs – $48 trillion

Where Were the Regulators? After Bear Stearns and Lehman Brothers, one would expect that counterparty risk would be of some concern to the OCC, the Federal Reserve, and the Treasury.  Right?  However, according to a recent Wall Street Journal article, it wasn’t that they were asleep at the switch – they simply didn’t understand the information they were looking at.

“The Office of the Comptroller of the Currency, which oversees the J.P. Morgan unit that made the trades, says it has roughly 70 people monitoring the bank’s trading activities. But the outsize bet failed to raise alarms at the regulator as of late April, just weeks before the firm revealed its $2 billion trading loss.

On an April 13 conference call, J.P. Morgan Chief Financial Officer Douglas Braunstein, referring to trades put on by the so-called London whale, said that “all of those positions are fully transparent to the regulators.”

People familiar with the OCC’s standard monitoring activities say it’s unlikely that the regulator drilled down to the specifics of the trade. Rather, regulatory examiners were likely monitoring risk models—typically the same models that the bank itself was using.

The examiners tend to use models derived from and generated by the bank,” said Kathy Dick, managing director at Promontory Financial Group LLC and former deputy comptroller for credit and market risk at the OCC. “They want to look at risk through the same lens that the bank is looking at risk, although the regulator can always challenge the validity of the model, she said.”

Hmmmm. This assumes that the regulator and the regulated both have the same perception of risk.  But using the bank’s “lens” to focus on the bank’s risk, is like giving an eye exam to a patient and using a chart prepared by the patient.  Of course they’ll have perfect vision.

So it sounds to me that the post-Lehman world is not much safer than it was before the financial crisis erupted in 2008.  You can have all the regulation, technology and know-how available at your disposal, but someone has to know what they are looking at.

What About Dodd-Frank? Currently, the Federal Reserve is writing regulations implementing Sections 165 and 166 of the Dodd Frank Act. According to a recent American Banker article, these provisions impose certain “…risk-mitigation and capital-enhancement standards on large banks and non-banks that have been designated as systemically important financial institutions.[11] The Fed issued a proposed rule a few months ago, and various provisions contained in the proposal have drawn the ire of the megabanks.

One of the chief complaints voiced by this group of banks has been over the SIFI Rule’s limits on counterparty exposure. Under Section 165 of Dodd-Frank, a covered company can only have a maximum credit exposure to another company of 25% of the former’s regulatory capital. The rationale behind this rule is straightforward and quite obvious given the recent financial debacle: imposing caps on counterparty exposure will reduce the likelihood of one financial institution’s failure leading to the sequential failure of others, like a stack of falling dominos. [Underscore mine. – PCQ]

And in a classic example of Karma, one of the most vocal critics of the Volker Rule, which seeks to limit proprietary trading, is …drum roll pleaseJamie Dimon, the CEO of JP Morgan.   Mr. Volker, do we see a smile on your face?

Conclusion. So, for the layperson, let me editorialize on my concern:  First, we have the 2008 financial meltdown, which was an outgrowth of  frenzied securitizations by Big Banks that culminated in the credit markets seizing up.  And given the incestuous nature of credit derivatives, where every Big Bank is both a debtor and a creditor to the other, we know that any single bank failure has the potential to go viral today.  This “systemic risk” is the elephant in the room that the Big Banks want to ignore.

As for JP Morgan, it has already lost approximately $25 billion of its market cap, leaving $127.5 billion today.  Some might say this not a death blow.  Though it has been punished by ratings downgrades, it will survive.

But the real “take-away” from the JPM story is this:  Given what we have been through over the past four years since the industry suffered a near-death experience, and was resuscitated – compliments of the American taxpayer – one must ask whether the Big Banks have learned anything at all.  It is clear that by repeating the same reckless activity with the same derivatives strategies of years past, they are inviting history to repeat itself.

It is also clear that with reckless derivatives trading – especially for profit rather than to manage risk – a single Big Bank crisis – even short of failure – would result in systemic risk rippling through the entire industry, and beyond.  If the London Whale had worked at Bank of America, with a market cap of $75.65 billion today, a $25 billion hit would be crippling.  In any event, the American public will not stand for another taxpayer bailout, which means that the patient will not be resuscitated again under any circumstances.

Although my concern is not for the failure of the institution, we know there will be widespread collateral damage, measured in human terms.  So even though I detest the idea of further government intrusion[12] it may  be necessary medicine for an industry that seems to be both constitutionally incapable of regulating itself, and incapable of learning from its own mistakes.  And as for JP Morgan and its CEO, one might ask if some Big Banks are simply Too Big To Manage?

UPDATE: See recent article posted on American Banker, here.

[1] Much like the “subprime crisis” that morphed into a much larger credit crisis, circa 2007, there were several decisions and events along the way that combined to create the problem JP Morgan now faces.

[2] Futures: A standardized agreement to buy or sell a certain quantity of an asset or commodity in the future at a specified price, time and place.  They are standardized as to the quantity, the specific underlying assets or commodities and the time.  Only the price and the number of contracts are negotiated in the trading process.  For example, party A sells 10 contracts that set the price of the S&P500 stock index at 1500 in October – if the price falls below 1500 then party A will profit by the amount the price is below 1500, and if the price rises above 1500 then party A loses by the amount the price exceeds 1500.

[3] Forward contract: The original and most basic form of a derivative contract, a forward transaction is an agreement to buy or sell a certain quantity of an asset or commodity in the future at a specified price, time and place.  For example, party A agrees to sell 1 million Euro in six months at $0.9402.

[4] Option: An agreement that grants the options buyer the right, but not the obligation, to buy or sell an asset or commodity at a specified “strike” price on or before a certain date.  A call option grants the right to buy at the specified strike price, and so it pays off if the market price for the underlying item rises above that mark.  A put option grants the right to sell as the strike price and pays off when the market price falls below the strike price.  On the other hand, an option seller or “options writer” has the obligation to pay when the options buyer exercises their right.  Options are traded on both exchanges and OTC markets.  For example, party A buys a call that grants them the right to buy 1 million Euros at $0.9400 in September.

[5] Credit Default Swap: The buyer of a credit default swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the debt security. In doing so, the risk of default is transferred from the holder of the fixed income security to the seller of the swap. For example, the buyer of a credit default swap will be entitled to the par value of the contract by the seller of the swap, should the third party default on payments. By purchasing a swap, the buyer is transferring the risk that a debt security will default.

[6] The following “Case Study” comes from “A hedge that limits potential losses is also likely to limit potential gains. In May 1997 Georgia entrepreneur and billionaire Ted Turner entered into an arrangement whereby Mr. Turner had the right to sell four million of his Time Warner shares to a brokerage firm at a price of $19.815 per share. At the same time the brokerage firm acquired the right to buy the same four million shares at a price of $30.45. This particular hedge, called a collar, established a minimum and maximum value for four million shares of Time Warner owned by Mr. Turner. In other words, the former owner of the Atlanta Braves, Atlanta Hawks, CNN, and superstation WTBS acquired the right to obtain at least $19.815 per share by agreeing to give up any increase in value above $30.45. Time Warner stock subsequently skyrocketed when America Online acquired the firm at a price nearly triple the $30.45 stipulated in the agreement. Thus, the hedge ended up costing Mr. Turner approximately a quarter of a billion dollars. On a positive note, the four million shares represented less than 4% of Mr. Turner’s total holdings of Time Warner stock he had acquired when the firm bought his Turner Broadcasting several years earlier.”

[7] This is not to suggest that the collapse of either investment house were “caused” by derivative trading.  But as discussed later in this post, derivative trading creates counterparty risk, and that creates the possibility that one bank’s credit problems can infect another bank’s ability to operate.

[8] These are contracts that seek to transfer credit risk (e.g. in a specific credit product or group of such products) to the other party, known as the “counterparty.”  The counterparty could be a single market participant, or, through the process of securitization, the capital market itself.

[9] This is not to say that Bear’s ignominious fall from grace cost its counterparties 13 trillion dollars.  It did not. Rather, this was the total value of its leveraged position’s assets.  This is referred to as its “notional value.” And since most banks “hedge” their exposure it is therefore bilateral. Thus, each counterparty will likely have a current credit exposure to the other at various points in time over the life of the derivative contract. This is known as “bilateral netting” and frequently used by some to incorrectly argue that the “net” risk from derivatives trading is zero. The reason it is wrong: bilateral netting assumes an orderly unwinding from bank failure – which is almost an oxymoron. See,

[10] Noticeably absent is Wells Fargo.  It was replaced in the first quarter of 2011 by HSBC, which had 3.9 trillion in derivative exposure.

[11] Referred to as “SIFI” throughout the article.

[12] With the exception of the necessary intrusion by the government in 2008-09 to stave off a complete collapse of the entire banking system, most subsequent “reform,” “regulation,” and “aid” have had either no effect, or the opposite effect.  HAMP has merely prolonged borrower pain by the “extend and pretend” charade of participating Big Banks;  HARP 2.0 is merely a tool used by Big Banks to cherry-pick their best customers and make refinancing offers to them, rather than to borrowers truly in need;  Notwithstanding all the hoopla over Dodd-Frank, that law was merely political window dressing that passed the buck to the administrative process to hammer out the tough rules – and so far,  a final decision on the tough rules is hung up by the banking industry lobbyists’ and politicians’ opposition; Has the SAFE Act registry made anyone safer?  Most of the unethical mortgage brokers left the industry years ago. Was MARS even necessary, given the fact that virtually every state in the Union had already passed legislation against unethical foreclosure avoidance scammers at least two years earlier?  And mortgage brokers are already regulated at the state level. Did the tax credit for first time buyers draw anyone from the sidelines besides those already intending to purchase a home? All it did was to artificially inflate residential sales for a short time, sucking the air out of the marketplace later in the year.  I could go on – but this is supposed to be a footnote….