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Source: Business News Network

Mother’s Day at JPMorgan by Peter Steiner

Hat tip Josh

Toronto-Dominion Bank Chief Executive Officer Edmund Clark talks about the Canadian firm’s approach to banking and industry regulation. He speaks with Erik Schatzker on Bloomberg Television’s “InsideTrack.”

Source: Bloomberg, May 14 2012

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Source: Convearth

Hat tip Bartcop

One correction: What’s labelled trash should really be marked iBanks.

There is nothing inherently wrong with speculation, derivatives, securitization, etc. I just don’t want to be on the hook for these as a taxpayer.

The claim is being made that JP Morgan’s $2 billion trading loss was in a trade that was a “a hedge.” It doesn’t take much review to easily disprove that position.

We first learned of this particular trade when they began to distort credit indices. Any trade so huge that it impacts its markets – that becomes the market – cannot be credibly thought of as a hedge. Simply stated, once you are the market, you are no longer a hedge. Sheer size of this trade makes it far more accurate to describe this as speculation than hedge.

Of course, the loss was the tell. A true hedge would have been offset by the underlying position that was being hedged — so any loss should have been insignificant. Even a minor correlation error should not lead to a $2 billion dollar hit.

Which begs the question, what is a hedge? It is a position taken in order to curb the risk of a specific (or arguably, general) trade. This is not a new concept: The word “Hedge” has been used as a verb in English since at least the 16th century (See Shakespeare’s Merry Wives of Windsor).

Looking at the question a little differently, what isn’t a hedge? There is always the other side of the trade, and that side (if not position) is what  you can theoretically claim to be hedging. Hence, for a huge bank with trillions on its book, there is the rationale that any trade, any position, any financial transaction, is potentially a hedge against some other position the bank is holding. Recall that Goldman Sachs, who has been rather silent on the JPM trade, used the same logic when arguing they were not betting against clients; rather they were “hedging other bank positions.”

Poppycock. Both the JPM and GS arguments fail, for a simple reason: If we are going to define this trade as a hedge, then there is no other conclusion to reach except that everything at a huge bank is a hedge.

And once you define everything as a hedge, well then, nothing is a hedge.

Jamie Dimon & Greece: Imperfect Together
David R. Kotok
May 13, 2012

“In hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed, and poorly monitored.”   Jamie Dimon

Janet Tavakoli speaks plainly.  See her column in the Huffington Post (May 12).  Here is a sample: “Jamie Dimon’s problem as Chairman and CEO – his dual role raises further questions about JPMorgan’s corporate governance – -is that just two years ago derivatives trades were out of control in his commodities division. JPMorgan’s short coal position was over sized relative to the global coal market. JPMorgan put this position on while the U.S. is at war. It was not a customer trade; the purpose was to make money for JPMorgan. Although coal isn’t a strategic commodity, one should question why the bank was so reckless.”

Markets will now see a series of political and regulatory initiatives.  Hearings and probes will abound.  JPM is about to spend a protracted period defending itself.  Whether stock weakness is a buying opportunity now remains to be seen.  As we quickly wrote on Friday, situations like this explain the value of diversifying within sectors by using ETFs.  All ten sectors are discussed in our book From Bear to Bull with ETFs.  In the book, we list the heavy weights within each of them and talk about managing the weights.  At Cumberland, we have used this technique to insure that JPM is a small weight in our US financial-sector portfolio positions.

And to think that part of the JPM rationale was to hedge against European developments.  We will leave that logic to be examined by shrinks.

Segue to Europe and to Greece

To understand the current state of the Greek tragedy, one must stand back and examine the big picture.  The private investor in Greek debt has been crushed.  His contract with the Greek government has been rewritten.  He has lost any semblance of legal recourse.  His recovery of loss cannot happen for years. Maybe decades.  Maybe never.  Greek equity investors have also been crushed.  The loss in the Greek stock market now exceeds the percentage loss that US stocks experienced in the 1929-1933, Great Depression bear market.  (hat tip Jim Bianco)

Greece is and has been bleeding.  Its banking system would completely collapse were it not for the Emergency Liquidity Assistance (ELA).  The Greek National Bank publishes these numbers with a considerable lag and with obscuring text.  It is a lot of work to ferret them out and estimate them.  We are doing it daily for all countries in the Eurozone.  ELA is an indirect form of assistance from the European Central Bank (ECB).  The mechanism is complex.  The ECB now lists the aggregate ELA for the Eurozone.  However, the ECB will not disclose it by country, because they fear triggering additional bank runs.  It took repeated requests to get this far.  The ECB has, at least, acknowledged that ELA is an indirect form of monetary assistance and stimulus.

Caveat, caveat, and caveat: when a government agency of any type invokes confidentiality, it immediately invites scrutiny and analysis by those who wish to investigate.  The ECB has done that.  At Cumberland, we will be publishing details and methods of investigation once we finish our ongoing research.  Meanwhile, investors must understand that the banking system in the troubled periphery of the Eurozone is deteriorating on a continuing basis.

Therefore, Greece is now a ward of the ECB and the IMF and other European and global organizations.  They are all organized by governments.  In other words, now both the investors in and lenders to Greece are governmental institutions.  Private-sector involvement in Greece has been rendered irrelevant.

Therefore, if a government is owed by the Greek government and if the governmental body that provides the funds ceases to continue to provide them, then the Greek government cannot pay and it will default on the payments it owes to the other governments.  This has become perfectly circular.

Circularity is a financial condition we rarely see.  It means the government that supplies the funds must keep supplying new funds in order to avoid having the recipient government default on the payments it owes to the supplying government.  Since monetary policy-created funds currently have no cost (zero interest rates) and since they have no credit multiplier, this process can go on indefinitely or until monetary policy restores a cost to what is now free money.

Those who may disagree need only look at the United States for an example.  Fannie and Freddie are examples of circularity.  For years, they said they were independent firms.  Then they failed.  Then government came in so that a gigantic meltdown could be avoided.  Since then they have not been fixed and they have been sustained by the actions of the US Treasury.  Private mortgaging in the US has not returned, except for the high-end balances that were never covered by Fannie in the first place.

The lesson of circularity is that it does not easily end.  Politicians find it is easier to insert more incremental money and preserve a losing arrangement for an additional temporary period than it is to stop and experience the actual default.  This is the condition in Greece.  This is the condition in the US with GSEs.

In the Eurozone, the present concern is Portugal, Spain, and Italy.  All three economies are in recession.  Their banking systems have to deal with developing negative issues.  Their debt reflects higher risk, as measured by widening credit spreads. We track these spreads weekly at www.cumber.com.   The three countries are in downward spirals.  They have not retrenched their economies in order to obtain growth.

Italy is the key one to watch.  It is the third largest debtor nation in the world.  It is raising taxation and stifling growth in order to impose austerity.  It is a wealthy country, but its demographics and social promises render its budgetary situation politically impossible and fundamentally unbalanced.  We expect things to worsen in Italy.

We watch the two Iberian countries struggle.  They, too, are in downward spirals.  In sum, this Eurozone crisis is not over.

The only player that can assist is the ECB.  It cannot fix an issue of solvency.  However, it can offset the pressures of illiquidity.  It has done so and will do so again.  We expect the ECB balance sheet to expand again by a large amount as it attempts to use additional liquidity to stave off collapsing markets.

Cumberland has a low investment weight in Europe.  We do not own the periphery.  Our ETF strategies focus elsewhere.  My colleague Bill Witherell is heading to the GIC conference in Poland within a few days.  He will be writing about his observations when he returns.  Major European central bankers and analysts are attending.  See the GIC website for the lineup, www.interdependence.org.

~~~

David R. Kotok, Chairman and Chief Investment Officer

Exit polls in North Rhine Westphalia (“NRW”) indicate that the centre-left opposition of the SPD and Greens will gain a clear majority in Germany’s most important state. The CDU’s share of the vote declined to 26%, from 35% in 2010 and is the CDU’s worst result in the post-war period. The results also confirm a clear rejection by voters of the strict austerity measures proposed by the CDU. With a general election due in late 2013 and calls by the vast majority of countries in the EZ for growth measures and not just austerity, Mrs Merkel is losing control of the both the agenda and the situation. As most of us have banged on for a very long time, the German prescription to date has been nonsensical and way beyond it’s sell by date. Do the German’s have a plan B – personally, I don’t believe they have, but a number within the CDU must be scrambling around starting today to produce one.

A couple of chinks of light have appeared. The head of the economics department at the Bundesbank last Wednesday suggested that Germany would have to accept a higher inflation rate and Schaeuble called for higher wages in Germany, combined with a rate of inflation above the current 2.0% threshold. Schaeuble has proposed that an “acceptable” rate of inflation in Germany could be “in a corridor between 2.0% – 3.0%”. Personally, I believe inflation will end up higher.

A higher rate of inflation and increased consumption in Germany (resulting in a smaller current account surplus) is a basic necessity to begin to resolve the crisis in the EZ. The penny, finally, seems to have dropped in Berlin.

The recently elected French President Mr Hollande meets with Merkel this week. It’s going to be a particularly interesting discussion. The view was that Mrs Merkel would completely overwhelm him – given the recent political backlash against austerity measures, this is likely to be far from the truth, in my humble view. The reality of the situation, given that Germany wants the Euro/EZ (OK maybe without Greece) to survive, is that the current policies needs to be changed. Essentially, some growth measures are necessary, but I fear that what will be announced will be a joke. The most important issue is that the EZ population needs to believe that there is some “light at the end of the tunnel” – to date there has been none. Current policies have resulted in the ousting of Sarkozy, over 50% of the Greek electorate voting for anti bail out parties, the loss of NRW, a much less popular Monti and the new Spanish PM, Mr Rajoy, etc, etc. The situation will just get worse if not attended to promptly.

As a first step, EZ banks (including German) need to be sorted out. You cannot have a recovery in the EZ if banks are retrenching, given regulatory demands to increase their capital as a percentage of risk weighted assets and, most importantly, given the level of bad debts in the system. The private sector will not provide the funding necessary – EZ governments will have to provide the funding necessary. However, I believe that this time around, existing shareholders/bondholders will have to take the first hits. The tax payer cannot and must not take on the burden, wherever possible. Clearly depositors will have to be protected.

The ECB is really the only credible player around – it will have to reduce interest rates, quite possibly as early as June – a cut of at least 25bps, but quite possibly even 50bps, is certainly looking possible. A number have called for another LTRO. However, I remain unconvinced. The ECB should certainly restart its SMP programme, in size this time around, rather than the pathetically executed programme to date. The EZ, in addition, should establish sensible deficit cutting targets for countries in the EZ, over a longer period of time. The EU forecasts last week confirmed that a number of countries would fail to meet their targets, not just this year, but also next. There have been calls (will likely happen) for the EIB to finance infrastructure projects, but a similar US programme some years ago, proved that such programmes have little effect, particularly in the short term.

It is also clear that a framework to introduce Euro bonds (subject to countries strictly meeting certain pre determined fiscal criteria) must be introduced.

The EZ only moves at times of crisis and boy is one coming unless they move pretty soon.

Mrs Merkel is a particularly astute politician, devoid of dogma and remains popular with the German people. She can still turn this around, but she must act immediately. Critics within her party (one of her biggest problems) must realise that failure to act sensibly will result in the complete rout of the CDU at the next general election – today’s results in NRW proves that. That should help Mrs Merkel;

As Greek politicians fail to agree on a coalition, there are increasing calls by EZ politicians, EU officials and most recently an ECB governing board member (Mr Coene) and other central bankers which, in effect, suggest that Greece should leave the EZ – certainly my view. Whilst it will create some contagion risks, I believe such risks are manageable by the ECB, in particular. An exit by Greece will not be a surprise. Sure the market will test the resolve of the EZ/ECB to avoid contagion risks (which will require the ECB to buy bonds of peripheral countries in size) but such actions are very much needed in any event. In addition, the EZ, ex Greece will be a batter place for both the EZ and Greece. We will know later this coming week as to whether new elections will be necessary in Greece – analysts suggest that the odds are that they will and polls suggest that the anti austerity parties will increase their support.

Finally, I sense that change is likely in the EZ – certainly not before time. Easier monetary policy, accompanied with higher inflation, is coming. The net result should mean a sharply lower Euro – great for Germany anyway. In addition, the move towards fiscal integration is just one step away from political union.

Whilst markets may react negatively to increased uncertainty, the (very likely) introduction of accomodative/easy monetary policy in the EZ is positive.

I will continue to reduce my short positions.

Kiron Sarkar

13th May 2012

Bloomberg’s Dawn Kopecki talks about JPMorgan Chase & Co.’s $2 billion trading loss after what Chief Executive Officer Jamie Dimon calls an “egregious” failure in the firm’s chief investment office. Kopecki speaks with Erik Schatzker and Stephanie Ruhle on Bloomberg Television’s “InsideTrack.”

Source: Bloomberg, May 11 2012

Fascinating discussion from Bloomberg Briefings:

The ECB appears to be understating the similarities between the weak growth outlook in Japan after its domestic asset bubbles popped in the early 1990s and that for the euro area in the present crisis. The performance of the Japanese economy 20 years ago was better than that of the euro area more recently. The Nikkei 225 peaked at the start of 1990. GDP was 7 percent higher 4.5 years later, according to the IMF’s measure in constant prices.

The Euro Stoxx 50 peaked in the second quarter of 2007. Economic output was about 1 percent lower 4.5 years later and about 2 percent below its peak of 2008. The superior performance of the Japanese economy relative to that of the euro area occurred during a period of less fiscal deterioration. The gross government debt-to-GDP ratio of the Asian country increased by 10 percentage points – during the four years after its stock market collapsed – to 77.3 percent in 1993 from 67.3 in 1989. The experience of the euro area has been much worse. Its aggregate debt-to-GDP ratio rose by 21.7 percentage points to 88.1 percent at the end of 2011 from 66.4 percent at the end of 2007.

As Mark Twain reportedly quipped: “History doesn’t repeat itself but it does rhyme.” ECB economists, in their analysis of the Japanese experience in the central bank’s monthly bulletin for May, published yesterday, wrote: “As banks struggled with bad debt for years, they curtailed lending to new firms, which led to distortions in the allocation of credit and ultimately exacerbated the financial crisis and postponed a sustainable recovery.” That description would fit the euro-area situation if the words “bad debt” were replaced with “raising capital”.

European policy makers have failed to implement some of the reforms that also proved elusive in Japan. The staff economists stated: “The strong emphasis traditionally placed on job security in Japan may have reduced flexibility by hampering sectoral adjustments in the economy.” This time, only one word needs to be changed to describe the euro area. That is “Japan”. The fiscal problems are also comparable. The analysts in Frankfurt said “deteriorating revenues and rising social security spending also contributed to the increase in the fiscal deficit in the early 1990s. To consolidate public finances, the government raised value-added taxes in 1997 with the onset of the Asian crisis, which some observers regard as having postponed the recovery.” Demographic similarities are striking as well. The authors of the analysis wrote: “The Japanese economy faced unfavourable demographic developments from the 1990s onwards, as the working-age population reversed its previous growth trend and started to decline.” The staff economists should report their findings to the Governing Council. They concluded: “Despite initial room for maneuver before reaching the lower zero bound of interest rates, monetary policy responded slowly to the crisis, partly because – even two years after the stock market crash – the central bank (had not) anticipated a protracted slowdown of the economy. As inflation expectations also remained low…credit contracted. During this period, the effectiveness of the monetary transmission mechanism may have been impeded by the underlying problems in the private sector, which were not tackled by regulatory authorities.”

Click to enlarge:

Source:
Bloomberg BRIEF
Economics – News, Analysis & commentary

The disclosure by once future Treasury Secretary and current JP Morgan CEO Jamie Dimon of a sudden and previously undisclosed $2 billion dollar derivative loss should be a wake up call. It unwittingly reveals much about the present state of finance:

• The inherent tension between traders using leveraged risk with Other People’s Money in the pursuit of enormous bonuses is still weighed heavily towards excess risk taking;

• There is no bank in the United States that has demonstrated the ability to manage proprietary trading risks — if they use derivatives and/or leverage;

• It took less than 3 years after the financial crisis peaked for traders to engage in the same sorts of highly leveraged reckless speculative bets that helped crash the economy last time. Imagine the sorts of risks these mis-incentivized desks will be doing when the memories of the crisis fade 10 years after.

• Trades that are so enormous as to be “credit index distorting” are not hedges, but pure speculation. Within banks, apparently the word “Hedging” loosely translates as “speculation.” Actual hedging of existing positions appears to be nonexistent.

• VaR remains a mostly useless concept as applied by banks today. It is a false model of reality whose deviations have devastating consequences. (Call it physics envy)

• At these size trades, the asymmetrical preference for bonuses over risk management is such that even clawbacks won’t work;

• Jamie Dimon, formerly praised as the Capo di tutti capi of bank CEOs, apparently has been more lucky than brilliant. This quarter, his luck ran out.

• Derivatives, because of their enormous built in leverage, are inherently dangerous. They are still financial weapons of mass destruction;

• Too big to fail banks remain a threat to the stability of the global economy.

While this was “only” a $2 billion loss it easily could have been much greater. That banks such as JPM are still putting on trades that distort indices is quite bluntly, astonishing.

The solution to this risk is very very simple: The USA should reinstate Glass Steagall, and repeal the Commodity Futures Modernization  Act.

Until that occurs, the risk of catastrophic failure remains present in the financial system.

>

~~~

Disclosure: Long JPM