MAY 12, 2012 1:59PM

Is J.P Morgan Perfect Storm Time? Could Be,Could Be Lemonade

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I taught economics and finance for a minute, and did a lot of research in the process, in which this is something of a re-post here, as the issues involved aren't trivial, but are important to understand.

First, as to the semi-good news from J.P. Morgan's $2 billion loss, if its a $2.8 trillion bank, in a set of derivatives trade like the one in question, as to "corporate bond synthetics," generally speaking, if there is no "counter-party failure," which hasn't been the case yet, and is a failure which is unlikely, then netting it all out, no one actually lost any money really, as the value of financial assets always sums to zero, if in this case not exactly to 100 per cent because of the market power of large banks.

Market power can work for you on the upside and downside, and it is on how the downide plays out that average people will care as to the consequences of this loss.

Market power is a potential issue here, as to hedge the exposure of a $2 trillion bank will move asset prices, and in a non-linear fashion.

Of course, like Keynes said, if a man owes you a pound, he is at your mercy, if a man owes you a trillion pounds... as to the bargainintgt over the unwinding that might favor J.P. Morgan: "got any beter ideas to avoid a meltdown than not trying to stick it to us on the downside? Didn't think so."

This is also possibly an argument against allowing banks to grow beyond the size where that starts to happen, since possibly they can't hedge as well, although as a factual matter, there are now 12 banks worldwide with assets over $2 trillion, and they usually manage to stay out of the papers.

It's therefore only possibly Perfect Storm time, although my bet is not, since what happens next depends on how J.P. Morgan unwinds its portfolio, if in the context of some things out of its control.

As to the things out of its control, the Market could be about to have a hissy fit over the election of a French Socialist and/or Greek electoral politics as to its fiscal deal, fundamentally with Germany, over the Euro.

Throwing in another crisis du jour, especially with the one big bank in America that came out well of the 2008 crisis, could be seen as "Perfect Storm time," especially in the context of Hollande and the Greeks.

On the other hand, and this seems to the author more likely, if participants/gamblers in the Market consider that a) Hollande's victory was probable once DSK got his Weiner stuck in the Le Zipper de Niger so to speak, and b) that Greece has really been something of a fiscal basketcase for the last 30 years, so no news is good news ever in that deparment from Greece, so why the worry therofre about Greece all day and night, so then J.P. Morgan at c) isn't as big a shock as it looks like on the surface, or so one could argue.

This is especially the case again because financial transactions under normal conditions sum to zero, as one person's financial asset is another person's liablility.

That's an important principle people don't remember enough, assuming of course no breach of contract, technically speaking what is known as value conservation, like energy, which is the case if there is no breach of contract/default, unless there is market power, which there was,however, and is an argument to consider at least for financial de-concentration per the last point, although there are now 12 banks of greater than $2 trillion in assets who don't seem to make the papers lately.

As long as value is conserved, i.e. no breach of contract, which it has been in this case, sort of, one person's financial asset is merely another person's liability, period, as are changes in their valuation, and so if Jaime Dimon is unhappy, there is no reasons for taxpayers to be unhappy, since Jaimie Dimon's the one taking it in the shorts.

Unless there is a breach of contract, it's really not a big deal per se, in this case, breach of contract being a counter-party failure of some form, which even as hedge funds line up to bet against J.P. Morgan, seems rather unlikely, given the size of that financial institution.

$2 trillion and $2 billion are a lot different numbers, unless you are a shareholder of J.P. Morgan, and thought Dimon's poop didn't stink and that he was right that financial journalists are overpaid.

All that happened in this matter is that J.P. Morgan gave money to some hedge funds betting the other way in terms of "did you think that the improving U.S. economy would be enough to lower the risk of corporate bonds, which one can earn money on in one way by going short credit default swaps, since if the economy improves, insurance against default is less expensive."

It's not really that big a deal, although obviously somebody making $40 million a year in London didn't understand certain parts of the risks in the international system, nor did that person in London making $40 million a year understand the need to hedge a little more strategically.

No big deal, as someone will come in, and be a rockstar and live like one too at $40 million by reading the moves correctly to unwind the thing in a way that doesn't alter prices too much, thereby conserving value for the financial system, and justifying being paid an upfront fee of $4 million, $40 million for the unwinding process, and 10 per cent of savings up to $400 million.

Someone will sign that deal with the devil, I mean Dimon. LMAO.

Sorry that Israel and Iran is a variable in your calculations, which is where the real issue came from, plus the euro, but tough tooey, as that what Dimon gets paid to do, see the big picture, and net, he's done a good job, even with this ... pimple.

Given a bank with $2 trillion in assets, $ 2 billion is hardly a serious loss, as its 1/1000 of the asset base, and that asset base protects against how much hedge funds can try to amplify the loss.

Second, as to why it could be semi-good news netting the whole thing out, the J.P. Morgan trader's actions in London that generated this result point to the possibility of an intelligent discussion of the "Volker Rule" as to firms doing proprietary trading, this form of trading being debatably the case here, but in any event, proprietary trading being when banks trade their own money for firm profit.

Banks aren't charities, although, when they take "heads we win, tales the taxpayers lose" gambles, that is an issue that does call for some regulation. Only libertarian fanatics don't see that, although the Keynesian-Bolshevik types don't think through the costs of regulation enough some times; it's a balance, like tonic with your gin.

Proprietary trading is a big money maker, although there are some real risks in having banks with "system risk," i.e. too big to fail risk, do that, although, to totally exclude such banks from that trading would put them at a competitive disadvantage viz other banks and financial institutions, thereby lowering their profitablitly, and quite possibly inducing failure by other modes as to extending themselves on loans.

Unless you want someone I know well's portfolio of rice, beans, water, gold, and a lot of guns, ammunition, knives, and a bad attitude... you get the idea, banks have to take risks, with their own money, and other people's money. You just don't want them taking crazy stupid risks with the taxpayer's money, silly geese.

Third as to the semi-good news in all of this, what it also is likely to do is get more serious consideration of Dallas Fed President Richard Fisher's proposal to break up the largest U.S. banks to reduce the risk of moral hazard by "too big too fail," if nothing in life is "risk free."

The argument of people like Fisher has been that the real regulatory issue is structural, in the sense that when you have taxpayer insured institutions of large enough magnitude, then they will take risks that they otherwise wouldn't take, because they know that since if they actually totally failed, they would take everyone with them, that therefore they won't be allowed to fail, and therfore take "heads the bank wins, tails the taxpayer loses" gambles that are socially inefficient.

Banks, financial institutions, and capitalism in general depend on relatively efficient risk-taking in general, including by financial institutions.

Since even if the loss doubled it wouldn't be such a big deal for a bank the size of J.P. Morgan, and doubling seems unlikely, since the bank has other assets that would increase in value from what one can infer from the public discussion if people got really nervous, the main news is that we can think about what kinds of risks do we want born by what types of financial institutions one more time, a modified Volker Rule with VAR and heavy tails especially included as part of that, as well as serious consideration of how big we really want banks to be in the first place, recognizing that historically speaking, American banks were usually considered on the small side in global comparative terms, the original argument for letting them get bigger, if of course the moral hazard risk in "too big to fail" isn't zero either.

finis

 

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Do you expect JP Morgan to go the way of Leaman Brothers??
No, as the amount involved is not large enough, and the bargaining position of Lehman's viz the hedge funds who bet the opposite way remains strong, as if they moved prices one way, that's power, given that at 2.8 trillion in assets, under Basel II rules, they have capital of more than 200 billion. Even the "notional" on their hedging position is unlikely to be that large, and the value of their positions will not go anywhere near to zero.
It does however point out to some fundamental issues in the structure of the banking industry, as to how we regulate insured depository institutions per the "Too big too fail" issue, although it isn't so simple as "just regulate more."
Their actually is an argument for a bank to hedge the entire portfolio of assets, rather than just one asset at a time, as there are cross-correlations in asset prices that in theory can be hedged more efficiently with the "synthetic" hedges that Morgan was using.
Time will tell, but they have an asset base and capital base that can withstand anything but an irrational panic, but, no levered institution or "fractional reserve" bank can withstand a run past a certain point. That is why deposit insurance exists, although one could argue that full insurance induced too much moral hazard, as depostitors all say,"It's FDIC insured, so why pay attention to my bank?"
Most depositors of course don't have thet time or energy to do that, but, there is an argument that too a point, with full deposit insurance, even "sophisticated" depositors" don't pay enough attention, hence the moral hazard of the bank taking too many "heads I win, tails FDIC loses" gambles, if the equity price and the bond yield, plus the CDS rate are signals of "sophisticated," read professional investors either for institutions or those with enough capital to invest for a living, of risk.
You are doing a fine job educating me on this Don.