Congratulations, Federal Reserve! Your zero interest rate policy tempted the world’s most-sophisticated bank to create its own toxic blend of interest income in the derivatives markets.
JPMorgan made headlines late last week for a $2 billion trading loss that’s likely to grow over time. Today, the bank’s CIO fell on her sword for the trading gaffe. Ina Drew, a 30-year veteran of the firm decided today was a good day to “retire” from her trading desk.
JP Morgan’s costly error was the result of “reaching for yield,” just like retirees all over the US are doing. When traditional fixed income securities like Treasuries and CDs provide almost no yield whatsoever, the only remaining option is to reach in to riskier markets to try to find some yield. Reaching for yield – overpaying for income-producing securities in a low-rate environment – usually leads to a painful tumble off the proverbial ladder.
As part of the banking crisis fallout, the Federal Reserve pushed interest rates down close to zero, and is telling investors to expect zero rates until 2014. Savers will have gone six years without interest income, all so the Fed can implement its grand experiment to rebalance portfolios away from cash and US Treasuries.
“We’ll buy the Treasuries,” the Fed implicitly says to investors, “so you can push up the stock market to create a wealth effect for the economy.” This begs the question: What happens if the Fed decides to unwind its gigantic Treasury portfolio? Wouldn’t that reverse the stock market wealth effect at warp speed?
The answer is yes, but here’s the dirty secret: The Fed is never going to unwind its portfolio. It’s going to be forced by investors (and Congress) to keep the reserves it has injected into the banking system intact, so it can keep rates low on the US national debt. That’s why we’ve been looking for short ideas that would suffer in an environment of rising commodity costs.
It’s inevitable and unfortunate that retirees starved for yield are overpaying for risky assets like REITs, junk bonds and even financial products that create “synthetic” yield. A synthetic yield means a yield created by derivatives, rather than the underlying security.
These derivatives often cap upside returns in exchange for higher current income. As such, these structured products are essentially a slow return of capital masquerading as income. Some annuity products sold to retirees fit this description.
Back to JPMorgan, and the specifics of its $2 billion trading mishap. This is important, because it’s a consequence of our still-broken financial system…
JPMorgan warned in its 10-Q that it’s going to take an earnings hit in the second quarter from trades in its Chief Investment Office (CIO). CEO Jamie Dimon felt the need to schedule an impromptu conference call explaining the impending losses from CIO’s hedging activities.
JPMorgan’s Treasury and CIO department is tasked with investing the bank’s excess cash, while hedging the credit risk that exists on the rest of the bank’s $2.3 trillion balance sheet. Most people forget that banks are among the biggest fixed-income investors, and are suffering in a low-interest rate environment along with retirees. It’s hard to shed a tear, I know.
So JPM decided it was a good idea to play along with the Fed’s encouragement to exit low-yielding securities and move out along the risk spectrum to invest its excess cash to enhance shareholder returns.
JPM’s $1.1 trillion in deposits exceed its loan portfolio by $407 billion, so it has lots of excess cash looking for a return. At March 31, CIO managed a $374 billion portfolio of securities – presumably in a manner that hedges JPM’s credit risk. There is derivative exposure too, as we discover in the 10-Q.
The CIO can create synthetic credit risk by shorting credit default swaps, in which it would collect insurance premiums from underwriting the default risk on a specific entity. The result is synthetic interest income if everything is peachy and default doesn’t occur; if not, the result is repeated margin calls and a complete blowup if the reference entity defaults. Think a mini version of AIG in 2008.
Jamie Dimon refused to provide any detail about the derivative trades on the conference call, but we can guess. Here is my guess: JPM owns a boatload of credit risk. Therefore, if CIO were trying to offset this risk, it would probably sell short credit default swap insurance (CDS). Some of the biggest rises in CDS spreads since March 31 were in European banks.
If CIO was short a basket of CDS on European credit indexes that included European banks, then its hedging activities could wind up inflicting large losses. If so, the CIO would have had to post more and more margin with its counterparty as the trade went against it. At some point, Dimon was informed of this unpleasant reality and decided to unwind the losing trade and break the news in the 10-Q.
JPM’s conference call was a stark reminder that investing in large derivatives-trading banks (the “Too Big to Fails”) is investing in a volatile cocktail of credit risk. Executives manage this credit risk with minimal disclosure about what types of risk they’re taking. “Just trust us,” is what they say. “We have sophisticated ‘Value at Risk’ models managed by rocket scientists,” they say. As you recall from the financial crisis, this was a formula that blew up spectacularly.
Jamie Dimon was very defensive and combative in response to questions on the call. He couldn’t provide specifics about the mark-to-market loss lurking in the CIO trading books – for obvious reasons: Other traders on Wall Street, like sharks smelling the scent of blood, would make JPMorgan’s exit from these underwater derivatives positions an even-more painful experience, while pocketing derivatives trading profits.
We won’t know any more detail until JPM reports its second quarter, when Dimon promised to provide more detail – presumably after unwinding the losing trades. This episode is one of many flashing signs that the global banking system is more fragile than advertised.
JPM has built a reputation as one of the better risk managers among the world’s largest banks. If JPM had this surprise, what derivatives accidents lie in wait at other banks? With the eurozone on the verge of heightened drama and bank restructurings, I don’t think stock market bulls want to find out.
Finally, I’d be remiss to not mention our wonderful financial system regulators. Using the logic of the idiots (Dodd and Frank) that supposedly “reformed” Wall Street after the financial crisis, what we need now is another new regulatory agency. Dodd-Frank was a thin coat of paint over a cracked and broken banking system; since it failed to accurately diagnose the causes of the financial crisis, it was a dud and a nuisance from day one.
More legal complexity, more wasted money and red tape and more lack of regulator accountability is what we got, when in reality, a big part of the problem was regulators not policing activities at the Too Big to Fail banks. Here’s an idea – one that banking history expert Jim Grant has been pushing for years: It’s called “capitalism.”
Take away the subsidies and bailouts for banks, along with the regulatory red tape. If they want to blow themselves up, fine – but losses would fall on the risk managers making those decisions and bank shareholders, not taxpayers or depositors. Push to return the investment banking business back to the partnership model that worked much better. Then, with the senior partners’ capital on the line, we’ll see how many derivatives blowups occur.
for The Daily Reckoning Australia
From the Archives…
Is the Australian Economy… Booming…or Busting?
2012-05-11 – Greg Canavan
The Art of Value Investing: How to Value a Business, Not a Stock
2012-05-10 – Greg Canavan
When Financial Markets Decouple From Reality
2012-05-09 – Dan Denning
Low Interest Rates Are A Dangerous Addiction!
2012-05-08 – Satyajit Das
The Bear Hunters and the Trigger Event for the Aussie Dollar
2012-05-07 – Dan Denning