JPM Proves My Point

As I’ve been saying for years now, the hidden leverage of over-the-counter credit swap contracts is the real problem here.  And playing hide-and-seek with underfunded regulators is a huge part of the problem.

I was even thinking about putting together a cheap e-book explaining this (I still might do it).

Put into a quick analogy for the 99.99% of the world that finds financial alphabet soup to be like trying to see the bottom of the bowl of split pea soup, I shared this with a friend who asked what I thought about the London Whale:

I think describing our five largest banks as deposit-taking and lending businesses is like calling Las Vegas the buffet capital of the world.

The latest “surprise” coming from one of the most visible profit centers of one of the largest banks in the world just shows us that this risk simply can’t be managed when it is ultimately a risk to the taxpayer.  Either we stop guaranteeing banks (bad idea) or we make the banks pay into a resolution fund for the inevitable next blowup (good idea).

Unfortunately for all of us, the fact is that paying former Congressmen and their staff members seven figure compensation to act as lobbyists is now the highest return investment any company can make.  For example, after all the caterwauling about America’s high stated corporate tax rate (35%), the reality is that the average American corporation pays just 15% in Federal income taxes.  What makes some pay nearly the full rate and others pay nothing?  Lobbying money.

I read a study last week showing that among the S&P 500 largest public American companies, the more a company pays in lobbying dollars, the lower its effective tax rate.

So Jamie Dimon pays tens of millions of his shareholders’ dollars to lobbyists, and they get to keep playing in the dark with their CDS book.  How does a bank get around the issue of the nearly-toothless “Volker rule?”

Simple.  Call it legitimate hedging (which it can be).

I’m reminded of how the commercial mortgage and project loan trader in my former department actually made most of his true “trading” profits.

The problem he had (as a trader) was that his loans and bonds changed hands very infrequently, with typical holding periods of six months or longer.  As with most traders, he was something of an action junkie, so what to do while the paint dries?  Even when a trade is agreed, the bankers and lawyers have to work through the piles of paper that constituted the mechanics of buying or selling a loan backed by commercial property.

I knew (and could even get my trader to admit) that he was actually a closet ten-year Treasury trader.  At the margin, because of the “basis” spread between commercial mortgages and Treasuries, he literally had to monitor and adjust his hedges many times more frequently than he was buying or selling the underlying commercial loans.  He might, for example, lighten up his short position in 10-year T-Notes the Thursday before the first Friday of a month where downside employment surprises might happen.  It was usually only 10% or so of the position, but completely legitimate if the Treasury market might take a sudden spike upward (a predictable reaction to lousy employment numbers).

As a nimble trader, he could put his short position back on in the few minutes after the announcement when the market spiked too high, and then over the next few days get back into a properly hedged position, which typically meant he had to be short about 70% of the face amount of his commercial loan position.

Over the course of a year, my commercial mortgage trader probably traded ten to twenty times as many Treasuries as he traded commercial mortgages or CMBS.

Same is true for banks with big books of corporate loans, like JPM.  They hedge with Treasuries, interest rate swaps, and with CDS basket trades like the high-grade corporate index the London Whale screwed up with at JP.

Without having any inside information, I can easily guess that their corporate bond basis traders and risk managers thought nothing of trading ten or twenty times the volume of those hedge contracts as they had in actual exposure.

So let’s stop and think about it:   The Volker Rule was supposed to stop banks from speculative trading using the bank capital, backstopped as it is by taxpayers.  But they set up a $70 trillion loophole (and that’s just for JPM, the total derivatives book is well over $250 trillion at America’s top banks).  That loophole was to allow hedging, and to allow non-disclosure of Credit Default Swaps that weren’t “plain vanilla.”

By the way, those five top banks in the US reported that 70% of their profit last quarter came from their derivative operations.  So now you see why I say the deposits, loans and branches are just a front for the casinos in the bank’s back rooms.  And why I say that the best investment Jamie Dimon made was the money spent on lobbying to keep the casino open, and make Dodd-Frank into a toothless tiger.

Or maybe Las Vegas should be known worldwide for its inexpensive all-you-can-eat buffets.



4 Responses to JPM Proves My Point

  1. Conscience of a conservative says:

    This was not hedging. The positions taken by JP Morgan would not qualify as a hedge under FASB rules. When you look at the diverse mix and large loss associated with it and the justification that this was offsetting their longs in other parts of the business, you come to realize that the definition used is so vague that anything and everything is a hedge. The s&p 500 may correlate to the cost of ausie dollars in yen, but if you tell me that the currency position is netting out my stock exposure, I would tell you you are smoking something..

    We really do need to bring back Glass Stegall. The large banks are just too complex to manage. Commercial banking activities are not sufficiently profitable to justify a behomoth mega institution, That the Fed has lowered interest rates to zero killing bank Net Interest Margin and destroying the profitabilitiy of securities lending, in my view encouraged JP Morgan to pretend the London Business was a hedging unit in search of making a profit. It wasn’t a hedging business(perhaps it once was) but a hedge is something that goes up in price when the thing that is in need of hedging goes down in price and vice versa.

    Somebody in Treasury and the Fed needs to explain to me how extending Tax payer subsidies to businesses that do not benefit the greater economy in the way commercial banking does needs to be the beneficiary of FDIC insured deposits and lines to the Fed.
    Your point about swaps is equally valid. These instruments are quite nefarious. First for their opacity, and second because they are what they advertise to be “cheap exposure” except when the trade doesn’t work out the cost of the mistake gets monetized at full present value. And in the case of cds if margin is posted, due to the profile of the instrument, margin is either too much or never enough.

    • hhill51 says:

      You are absolutely correct. Your point about hedging (both needed and spurious) is why I used to run a “contra” account that lost several million dollars a year in my mortgage department. It was always long deeply out-of-the-money puts and calls on interest rates, just so our department wouldn’t become a smoldering hole in the bank’s balance sheet if long bond rates moved 20 – 100 basis points in either direction one day.

      I simply couldn’t make my traders hedge the “tail risk” and lose $10K or more in time value every day, so they just did the first two derivatives and basis. I did the third derivative.


  2. Taymere says:

    It’s horrible that these institutions are FDIC insured, and have permanent as needed taxpayer bailouts enshrined by the DFA. The DFA is worse than useless, it’s false security, it’s the best law bankster money can buy.

    Dallas Fed Fisher has it right in Choosing the Road to Prosperity
    Why We Must End Too Big to Fail—Now:

    And so did Andrew Jackson when he said:

    The bank is, in fact, but one of the fruits of a system at war with the genius of all our institutions — a system founded upon a political creed the fundamental principle of which is a distrust of the popular will as a safe regulator of political power, and whose great ultimate object and inevitable result, should it prevail, is the consolidation of all power in our system in one central government. Lavish public disbursements and corporations with exclusive privileges would be its substitutes for the original and as yet sound checks and balances of the Constitution — the means by whose silent and secret operation a control would be exercised by the few over the political conduct of the many by first acquiring that control over the labor and earnings of the great body of the people. Wherever this spirit has effected an alliance with political power, tyranny and despotism have been the fruit. If it is ever used for the ends of government, it has to be incessantly watched, or it corrupts the sources of the public virtue and agitates the country with questions unfavorable to the harmonious and steady pursuit of its true interests.

    Andrew Jackson, 7th Annual Address to Congress 1835

  3. Conscience of a conservative says:

    Not sure where I heard this, but perhaps with was re south west airlines. Company hires a few traders to hedge some risk, and then over time the traders realize they can earn extra money doing certain trades. Over the small unit delivers all of the returns, and the core business nothing. With JP Morgan you have a huge infrastructure with high over-head that can’t really deliver much in terms of profit, due to increased capital constraints, no net interest margin, inability to lend securities and lets face it plain vanilla banking activities are not high margin, so you have this little unit in London delivering all the profits with more risk than they realized they were taking..

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