Sunday, May 13, 2012

Unknown Impacts from JP Morgan

Since Thursday night, no single financial topic has gotten more print and airtime than the announcement of the unexpected net loss of an estimated $800 million, out of a $2 billion gross loss sustained in the Chief Investment Office (CIO) at JP Morgan Chase (JPM) London. With market participants and the media searching for more information and in some cases insight, one can perhaps benefit from former US Defense Secretary Donald Rumsfeld’s method of dealing with the press. He divided the questions he was asked between known knowns, known unknowns, and unknown unknowns. According to Rumsfeld:

  • There are known knowns; these are things we know we know.
  • We also know there are known unknowns; i.e., we know there are some things we do not know.
  • There are also unknown unknowns; these are things we do not know we do not know.

I will array my thinking using this pattern.

One should understand the biases of the sources one is using. Regular readers of this blog already know that I have investments in many financial services companies. These investments were largely obtained through stock-based mergers in my personal account as well as a selection, I think of the better ones, in a private financial services fund that I manage. While I have been a long-term investor in the JPM stock in my personal account, I do not own the company in my managed fund. This is the same distinction that Warren Buffett revealed at the recent annual meeting of Berkshire Hathaway (BRK-A), (BRK-B); he personally owns JPM, but invested heavily in Wells Fargo (WFC) and US Bank (USB) for Berkshire Hathaway. Up to this point my reluctance to add JPM to the fund is based on what I perceive to be a requirement to a higher standard of selection for the fund than my personal account. To the best of my knowledge, JPM has by far the largest single gross investment in derivatives of any publicly disclosed financial institution. My focus on the gross commitment, adding the long and short positions rather than netting them, is based on closely examining trading desks that have experienced simultaneous problems in both their long and short books. Further, I will admit I am not comfortable with my lack of full understanding of these instruments. Thus despite the fact my family has dealt with the JP Morgan organization for three generations and has great respect for some of its present leadership, my lack of sufficient understanding of the use of derivatives has prevented me from owning the stock of JPM in my managed fund.

Known knowns

On Friday after the Thursday evening announcement, the price of JPM shares crashed -9.28%, with a record 217 million shares traded. Shares of Citigroup (C) declined -4.24%, Goldman Sachs (GS) -4.19%, Morgan Stanley -4.17% and Bank of America (BAC) -1.95%. (Both Goldman Sachs and Morgan Stanley are in the fund and the others are owned personally.) At least as of this weekend, the combined wisdom of the marketplace is that JPM has a very specific problem on its hands. The two investment banks that have become bank holding companies may have somewhat similar problems. There is a view that Citi is similarly hobbled and Bank of America’s price already recognized lots of its problems.

Before this announcement, I was trying to better understand JP Morgan. Thus, I was reading its massive reports to the SEC. In a section entitled Treasury and CIO Selected Income Statements and Balance Sheet Data, a couple of items struck me as significant. The first was securities gains in the first quarter, which were up 344% from the prior year, to a total of $453 million. This item was footnoted to reflect repositioning of the corporate investment securities portfolio. Clearly this was a highly volatile component to JPM’s earnings and something of significance was going on. The post-quarter disclosure of an estimated $800 million loss in what may have been fifteen days (as reported by some) compared with the first quarter’s securities gains, is a further indication of the type of volatility that one could expect. The second figure that caught my eye in this table was that at quarter-end, the aggregate investment securities portfolio totaled $375 billion ($362 billion averaged for the quarter). While the size is staggering, the return for the quarter was only 1.3%, hardly a worthwhile return considering what we now know to be the early second quarter risk.

Known use of derivatives

Based on what we have already learned or suspected, the London CIO office was not primarily focused on making money, but on hedging the bank’s credit exposure. As of March 31, 2012, JPM had a total credit exposure of $798 billion, up from $776 billion at the end of the year (again relying on the report to the SEC). At the end of the quarter the bank had credit derivative hedges just shy of $30 billion to hedge their perceived credit risks. Perhaps one clue to the mid-April to early-May large losses is that JPM had net credit derivative hedges of almost $11 billion against $22 billion of credit exposure to central governments. During this period, the news flow and foreign exchange rates were negative to many central governments.

Known unknowns

The media has reported that very senior officers of the bank, including its much respected CEO, were involved with twice daily conferences about this unfolding situation. Some were dispatched to London to personally get a hand on the situation. Various government agencies were alerted to the growing problem. One of the issues to be determined is why JPM’s vaunted risk control measures did not alert or stop the mounting losses. One report has as a contributing factor the switch to a different index as a benchmark. This change proved to be faulty, and there was a switch back to the previous indicator. The Financial Times reports the index used is the Markit CDX.NA.IG.9 which is comprised of 125 North American credits that were investment grade at the time of their inclusion in the index. The net notional value for the index has surged from about $90 billion to $150 billion at the end of April, according to the FT.

Conjecture analysis

Note that the notional value of the reputed index at the end of April was about $150 billion. The size of JPM’s credit exposure (excluding its exposure to central banks) is approximately $776 billion. If, as is believed, JPM was trying through the CIO to reduce its overall credit exposure, the near-term market was too small to accommodate a safe withdrawal. If a swarm of hedge funds saw one big insistent player on one side of the market (as was reported in the news media) they could profit by being on the other side, and make the exiting more expensive. I believe this is the reason why JPM will take its time exiting its position and possibly exposing itself to greater losses.

Unknown unknowns

Various politicians and media pundits are calling for increased capital rules and size restrictions. If they are successful, they may cause more rapid and for some, disastrous change. I believe that we are in an early stage of radically changing the financial structure of our world. I believe we have insufficient equity capital to create sound long term jobs, and this has been true globally for many years. Whatever progress that has been made is largely due to individual, corporate and governmental borrowing. The money has been borrowed from different elements of retirement capital at each level. The net result in the current periods of interest rate suppression is that current retirement capital is insufficient to pay for our longer-lived lives. Anything that raises the costs of banks will raise the cost of borrowing at all levels, impeding meaningful long-term job growth. Higher interest rates will drive inflation higher, particularly hurting the non-working retired population. Over the last several years we have paid this group low interest rates, and now when rates recover to something like a normal level, the inflation-induced, devalued currency will hurt their real spending power. We are creating two new economic class sub-sets: first, those that no longer are earning their keep and second, their grandchildren with large education loans. Thus, the issues surrounding the losses at JPM have wider impacts.

Investment Implications

  1. As many of our readers are aware, I have a certain allergy to what I call crowded trades, where too many are trying to do the same thing at the same time. JPM is very much involved with a series of crowded trades. To some degree this fear, excluding the IPO dances, makes me more interested in smaller companies.

  2. Our political leaders are trying to repeal history. Throughout recent times, certain banks have failed. Their failure hurts their equity owners, some of their debt holders and possibly some uninsured depositors. These are momentary disruptions in people’s lives and practices. But in almost every case that I am familiar with, new or expanded banks replace the failed bank. Society, perhaps wounded, progresses.

I will be completing my 200th blog post in early June. Are there are any particular topics you would like me to readdress in my weekend musings? If so, please email me early in the week with your thoughts.

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