HEARD ON THE STREET
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May 17, 2012, 4:39 p.m. ET
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Peering Over J.P. Morgan's Hedges
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By DAVID REILLY
With big U.S. bank stocks again sliding, investors are wondering how much is due to Europe's woes versus blowback from J.P. Morgan Chase's JPM-4.31% trading debacle. One answer: The issues are intertwined.
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When J.P. Morgan revealed $2 billion-plus in trading losses, it said it had executed hedges poorly and failed to monitor them properly. This raised questions about J.P. Morgan's overall hedging abilities, including those meant to offset exposures to Europe. And, if J.P. Morgan could mess up, what about Citigroup, Bank of America, Morgan Stanley or Goldman Sachs?
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With investors in the dark on the degree to which the five banks are mostly buying and selling protection from each other, investors also have little way to assess contagion risks.
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Granted, J.P. Morgan and other banks have a record overall of hedging exposures. But one mistake can be enough to cause huge damage, so investors are still being asked to take a lot on trust.
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When speaking of European risk, J.P. Morgan chief James Dimon has often used hedged figures, guiding investors away from the bank's gross exposures. In his recent chairman's letter, he reiterated that the bank's exposure to Portugal, Ireland, Italy, Greece and Spain was about $15 billion. "And we estimated that, in a bad outcome, we could lose $3 billion, after tax," he wrote.
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But that exposure is after some $6 billion of "portfolio hedging," with $4.7 billion related to Italian sovereign debt. If hedges don't work as anticipated, losses could be higher. What also isn't clear is how much of those hedges are run through the bank's Chief Investment Office, which was responsible for the trading mess, although at least a portion of it likely is managed by that unit.
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For countries such as Germany, France and the Netherlands, J.P. Morgan said it had a net exposure of nearly $150 billion, yet didn't disclose the size of hedges or gross exposures. Muddying the waters further: Major country exposures reported in J.P. Morgan's quarterly report are based on its "internal risk management approach." This differs from cross-border exposures reported under regulatory guidelines, which J.P. Morgan reports only annually.
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Those regulatory figures show far larger total country exposures because of "commitments." These include undrawn lines of credit but also the value of credit derivatives, where J.P. Morgan has sold credit protection to other investors.
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The bank says this measure doesn't take into account offsetting purchases of credit protection. Still, the unnetted figure is interesting in case the offset doesn't work as planned or because a counterparty defaults.
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Including those commitments, the regulatory figures show J.P. Morgan had a combined exposure to those three, larger European countries of about $390 billion as of December. This data also show an exposure to Italy of $87.5 billion and to Spain of $57.5 billion, far larger than the netted figures. Similar differences can be seen at other big banks as well.
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Playing down the larger, gross figures, Mr. Dimon said on an earnings call last year that the numbers don't "include hedging. And we do a lot of hedging, both specific name and country hedging."
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Back then, that put investors at ease. Not so much today.
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