All wrong on JP Morgan

In our Pennies and Dimes blog in April, we identified that JP Morgan had US$70 trillion of derivative exposure at the end of 2011, of a total market of ~US$707 trillion.  So it had 10% of the market. 

We argued that if governments wacked these OTC derivatives onto an exchange and then taxed the market at 0.1% turnover then it would generate US$700 billion in tax revenue and is easily the slam dunk for the global debt problems (see tomorrow’s blog).  Taking it further, if the average life of each derivative was 4 months (qtr – but the total global portfolio of derivatives may well be a bit longer) then total tax revenue would be four times US$700 billion per annum = US$2.8 trillion.  Enough to bail out Italy I believe, and certainly enough to pay off some of USA government debts. 

Continuing this theme, we then blogged on the massive US$1.5 trillion in excess reserves held with the Fed by the US banks.  We raised the question “Why hoard expensive capital, with the toll on profits given there is little place to invest it with much return, unless you are (i) scared out of your wits about another mighty downturn and massive liquidity crunch or (ii) there is a lot of short term risk (OTC derivatives?) they may have but we do not know, against which they are holding this capital (and not required by prudential standards).”

And followed on with the distrust on counter parties being a rationale for this excess capital – and as it turned out for good reason.

Then of course we learnt of the rating agencies demands that (To Big To Fail) banks must hold much greater capital relative to that required for “prudential” guidelines to ensure that they have their derivative exposure covered in the event of loss.  Or indeed any margin call on their leveraged books.  Remember you and I bailed them out last time so this is a good thing.  Again, this is all about counter party risk and who gets shafted if one makes a blunder.  So we were correct on both fronts with respect to the excess capital: derivative cover and counter party risk. 

And as an aside, making the prudential guidelines for capital meaningless as clearly the market is dictating the terms of capital guidelines.

So, thennnnn………JPMorgan blows up US$2 billion.  As I said this story theme just keeps giving.  And of course it is now reported to be close to US$3 billion (in Bloomies) as the market vampires sink their teeth into the unwinding artery and suck.  Heh heh heh!!

There are several points here, again that I have not seen written about.  But first, if I had picked up this theme in April – and I am not in the market these days – then the market knew about JPM at least as early as April, and this has since been reported as correct.  

The second thing is that JPM was reputedly trying to hedge long tail risk in its book – or total portfolio.  And people have been jumping up and down about this being a hedging exercise rather than a portfolio (b/s) risk management exercise (and hence the Volker Rule in the USA must be passed).  Frankly I disagree with all of it.  There is nothing wrong with hedging your whole portfolio.  Fund managers do it by asset allocating (if they are long only) and insurance companies do it by laying off risk, either in tranches of value or tranches of time.  Perfectly acceptable.

But what possibly was happening at JPM which is unforgiveable was that it was only participating in a meme – an imitation of what is a very trendy risk management tool in investment banks at the moment: hedging out your long tail risk.  So, sadly, they were actually just doing it for trendy reasons rather than for strategic risk management.  Or maybe I am wrong and should give them more credit (no pun intended) for independent thinking.

The problem with all this is that long tail risk is meant to be covered by / with (i) today’s profits stored in reserves until the risk expires (ii) the pricing mechanism when the lending business (which in aggregate makes up the whole portfolio) is actually written, or struck.  That is, the margin above the risk free rate which is composed of credit risk, liquidity risk, etc.

So, to want to hedge your long tail risk, you should be reserving profits today AND pricing your risk (especially on long term business) correctly.  

So one of these two things at JPM must have changed if we are to give them credit for making sound rationale for hedging their long tail risk (and not just imitating the meme).   Either they are reserving insufficient capital for long tail risk, or they have miss – priced their book when the business was written.

OR we are completely wrong in all of this and they were just prop trading.  A big no no. 

But back to giving them some credit.  The (now) US$3 billion they have lost is just 0.004% of their reported derivatives exposure.  (Which leads my blood pressure to rise:  what if they had lost more?)  I mean, really, it is hardly risk taking is it?  That is, if you measure it against their total derivative exposure of US$70 trillion. And as a loss to book is concerned, it is still only 12 basis points or 0.12%.  Loose change.

Where the first problem comes in:  why do you need US$70 trillion of derivatives to protect a ~US$2.5 trillion book?  That is 28 times.  And if it is intended to be a hedge of their book rather than a punt, then it should in theory always be net neutral so it is highly unlikely – even black swan events – to be losing money.  (But you could argue that a .004% loss on US$70 trillion is virtually net neutral).

So why is everybody jumping up and down.  Frankly, I do not believe they have thought it through.  Just doing back of the envelope numbers; capital on the US$2.5 billion book would be US$250 billion assuming 10%.   So they have lost a little over 1% of capital. 

Which leads to the second: what if they lose 1% of their derivative book?  That would be US$700 billion, or nearly three times capital reserves.  So in theory, JPM would need to increase their capital base 3X to maintain an AAA counter party rating, if a 1% margin call was the criteria. 

When you are 10% of the total market – you are at multiplies of greater risk for it to move against you - whether punting or hedging.  This is the position JPM finds itself, and frankly should have been smart enough to price this illiquidity when hedging its book.  And there are other practical issues, such as the market turning for other unrelated reasons when you are in the process of placing your “net neutral” position.  I mean, their loss is so small on a relative basis, this is probably what happened, together with the market dominance risk above.

No, I think everybody is looking in the wrong direction.  Banks and other risk takers are meant to take and manage / mitigate their risk to optimise profits.  

The real problem is the scale of the derivative market.  JPM exposure (and every other bank) should have a limit on it (think of the concentration in AIG in 2008).  THAT would make them think how to use it more judiciously.  I mean US$70 trillion for US$2.5 trillion?  That’s the problem.