In my estimation, the attached podcast provides a brilliant analysis of the $2 billion trading loss by JPM, and its implications going forward. (A very special thanks to Turd Ferguson at TF Metals Report and his guest Jim Willie from GoldenJackass.com)
First and foremost, what exactly happened at JPM last week for Jamie Dimon to make a surprise public announcement that it lost $2B over the last six weeks (and is at risk of losing more)?
Undoubtedly, this has received a TON of media attention, but have we learned ANYTHING about the details of how JPM actually lost the $2B? We deserve to know don’t we? They are a public company and they were given billions in bail-out cash via the taxpayer in the wake of the financial crisis.
Everywhere you look, we find CEO Jamie Dimon apologizing profusely taking full responsibility for this “mistake”, but within this barrage of apologies, there really has been very little disclosed about what these “bad trades” were and how they went bad.
See Exhibit A in Dimon’s public relations circus:
Essentially, the only thing the public has been fed is that Dimon is sorry for making this mistake, mistakes happen in business, and he will work tirelessly to avoid such mistakes in the future. Oh yeah, we may now need MORE REGULATION!
Those who are paid to look more closely at the situation really haven’t offered much more. The general assumption by analysts and pundits is that this massive loss was due to poorly managed hedging bets within its CDS (credit default swap) portfolio tied to European sovereign and corporate debt. Additionally, we are led to believe that that this loss was due in large part to a “bad seed” trader (or a couple of bad seeds), such as the “London Whale,” who’s team was reportedly trading a $200B package of CDS derivatives tied to European markets.
The public has clearly bought that story hook-line-and-sinker, as we are constantly being fed propaganda that Europe is imploding, and similar “bad bets” have been responsible for taking down other firms (i.e. MF Global). Europe may in fact be in serious trouble, but the point is that the public strongly associate this JPM mistake with poorly managed European risk, and the volatile sovereign bond market there.
The question remains though: Did JPM actually lose $2B in six weeks due to CDS derivative bets in Europe?
If you actually inspect the market over the last six weeks in Europe, both French and Italian bonds really only moved up slightly, and Greek yields actually IMPROVED!
Jim Willie suggests the key is to look at the elusive Treasury market:
Trillions of new debt has been issued over the last few years by the U.S. Treasury with foreign buyers stepping aside (i.e. China buying gold rather than treasuries), and YET, and this is a big YET…we have seen interest rates continuing to hit record lows nearly every month (the 10 year is yielding 1.84% and the 30 year is yielding 3%!!!)
We are simply told that there is nothing to see here, and this is simply a “flight to quality” given all of the uncertainty in Europe, global economy, etc.
So the question is: How is the US government able to keep interest rates so low while at the SAME TIME issuing record amounts of debt into the market, and simultaneously experiencing foreign demand for these bonds vanishing???
Aside from the implied answer of the Federal Reserve above, Willie points to: Interest Rate Derivatives.
Interest rate derivatives are the largest derivatives market in the world, with roughly $400-$500 trillion in OTC interest rate contracts floating around the financial system. In comparison, the CDS market that everyone is worried about (and was responsible for bringing down Bear Stearns, AIG, WaMu, etc.) is only about $40 trillion. According to the International Swaps and Derivatives Association, 80% of the world’s top-500 companies use interest rate derivatives to help control cash flows. The Bank of International Settlements even noted that the interest rate derivative market has even doubled in size since 2008.
According to Willie, 82% of JPM’s total derivative portfolio is tied to interest rate derivatives. So, while all of the focus and attention has been on the exposure of CDS (insurance on bonds) by these big financial institutions, JPM actually holds 7x the amount of interest rate derivative exposure compared to its CDS book (even Morgan Stanley added $8 trillion alone to its interest rate derivative exposure in December).
Looking at interest rate derivatives makes perfect sense because one of the most significant moves in the markets during this six-week period came in the Treasury market: check out the 10 year treasury yield move during the first half of March: yields surged sharply from 2% to nearly 2.4% (a roughly 40 basis point move less than two weeks).
They have since fallen back now to rock-bottom record lows of 1.8%, but what was the cause of that sudden move up in March? You may recall that back in March, things “appeared” to be improving economically here in the U.S. and all of the risks/fears were fenced off within Europe.
Naturally, the market here began analyzing how the Fed begins unwinding its enormous balance sheet, and more importantly, what effect rising interest rates will have from the existing illogical/artificially low rates currently in play. As has been the case since the onset of the financial crisis, the Federal Reserve has actively maintained its ZIRP (zero-interest rate policy) for an extended period to stimulate economic growth.
What has been less obvious is analyzing the extent at which financial institutions have been betting on these record low interest rates staying low for a long period of time.
While that may be the case for a Morgan Stanley or a firm like it, Willie notes how JPM is really the acting arm of the Federal Reserve. Not only is JPM actively betting on low interest rates forever, it has used these interest rate derivatives to help artificially keep interest rates low on behalf of the Fed.
With the economy in the U.S. appearing to get better recently, the Fed (according to Willie) let interest rates rise a bit as a trial balloon to see what effect it would have on the interest rate derivative portfolio of its active arm – JPM. This was an attempt by the Fed to try an exit strategy, returning rates to “normalcy,” where borrowing costs would drift back (higher) to normal range of interest rates.
Willie notes that this trial balloon failed miserably, and this is what we’re seeing play out with this recent trading loss announcement by JP Morgan.
The bottom line is that in an effort to help the Fed keep interest rates this low in this environment, JPM (and other banks) have taken on massive exposure to these interest rate derivatives, where if rates even rise slightly, the losses incurred will be astronomical.
Of course, Jamie Dimon and the media are not talking about interest rate derivatives because these are the very instruments used to help keep interest rates artificially low (beyond what the Fed has already done setting the benchmark Fed funds rate at 0%-0.25%). Talking about this area of its portfolio/balance sheet clearly exposes too much, and offers more proof that interest rates must remain as low as possible forever.
Think about it – if the economy was really improving, then why is the Fed not raising rates from ZERO?