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Up and Down Wall Street
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TUESDAY, MAY 15, 2012
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What JPMorgan Isn't Saying -- Returns Are Lousy
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By RANDALL W. FORSYTH
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The need for income in a low-yield world may have produced a $2 billion loss for the bank.
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It's been several days JPMorgan Chase's disclosure of $2 billion of trading losses, we're all still wondering precisely what went wrong. In other fiascos, such as the mortgage meltdown or the dot-com bubble, the bear claims its victims when the market craters. But there was no big, single disaster to explain the red ink.
Chief executive Jamie Dimon shed little light in his Sunday morning appearance on NBC's Meet the Press. How did it happen and did you miss something, moderator David Gregory asked. According to the transcript, Dimon replied:
"No, I think -- somewhat -- first of all, it was one warning signal. If you look back from today, there were other red flags. That particular red flag, you know, we made a mistake. We got very defensive. And people started justifying everything we did. And, you know, the better thing in life is to say, 'Maybe you made a mistake, let's -- let's dig deep.' And the mistake had been brewing for awhile. So it wasn't just any one thing."
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Perhaps something clearer will emerge from JP Morgan's(ticker: JPM) annual meeting Tuesday. In any case,
chief investment officer Ina Drew, who oversaw the unit responsible for the
errant hedging strategy, left the bank Monday.
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She is succeeded by Matt Zames,
whose baptism of fire was as a trader at Long Term Capital Management, the hedge
fund that blew up spectacularly in 1998. The Wall Street Journal reports Zames
was in charge of LTCM's mortgage-backed securities trading, not the
emerging-market currency and credit trading that spectacularly sank the hedge
fund.
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Having a survivor from the Titanic ought to provide some hard experience to JP Morgan's trading operations. It should be useful in unraveling the presumed positions in credit-default swaps that caused the $2 billion in losses.
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How that could have come to pass when "credit" has been strengthening is puzzling. Credit is the market's shorthand for fixed-income securities whose value is largely determined by the creditworthiness of the issuer, mainly corporate bonds, both investment-grade and high-yield.
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CDS are, depending on your viewpoint, insurance policies against defaults by certain corporate credits or indexes of those corporate credits, or put options on those credits. To sell credit protection on a corporation is to write an insurance policy; if all goes well, the insurer pockets the premium and pays out nothing if there is no loss. Ditto the seller of puts; the sale of the options nets premium income, which the seller gets to keep if the price of the security doesn't drop below the strike price.
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Peter Tchir, a derivative specialist who heads TF Advisors, theorizes JP Morgan bought credit insurance in the form of CDS on high-yield credits, in order to protect against risks of economic upheavals that would threaten its credit exposure. The premiums on that insurance were high, so he hypothesizes the bank sold credit insurance on investment-grade indexes to earn income to offset part of the cost of the credit protection on high yield. If things got bad, the high-yield hedge would pay off big while the investment-grade long position would decline less or even appreciate. Obviously, if these were JPM's best-laid plans, they somehow went awry.
.What is likely is that JP Morgan's trading activities were not purely to hedge against risk but to generate income for the bank. The problem, according to David P. Goldman, is that there just aren't enough assets to produce all the income that banks and hedge funds need.
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Goldman, who was the head of credit research at Bank of America and now heads the MacroStrategy Advisory, writes poor risk controls and monitoring didn't cause JP Morgan's losses, as Dimon asserted. "The problem is that there is absolutely nothing he or anyone else can do to restore bank earnings to pre-crisis levels.
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Never mind that the rosy cheeks of bank profits were a tubercular flush rather than a hallmark of good health. There simply aren't enough risk assets out there to satisfy the collective demand of investors for returns."
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JP Morgan isn't different from the rest of the investment world, he continues. Institutions such as pension funds fall short of the returns they need to meet their bogies. In turn, they pile more money into hedge funds, which purport to provide higher returns, but have largely failed to do so.
"There isn't enough income in a low-return environment to generate $200 billion in returns on $2 trillion in hedge-fund assets, or to allow bank portfolios to earn enough money in liquid markets to compensate for the continued depressed state of banks' lending business," Goldman continues. To make up the difference, he posits JP Morgan was writing credit protection in CDS to generate income.
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Put another way, the world saves about one-third of its income of $70 trillion, so it needs $23 trillion in investments, he explains. "Of course, if a Chinese farmer builds a chicken coop, it counts towards the total," he observes. But securities markets can't keep up with the demand for liquid investments desired by the aging population of the developed world -- even with the enormous bond issuance to fund governments' budget deficits.
.The derivatives market has the advantage to be able to accommodate institutions that want to write credit insurance to gain income -- in excess of the amount of actual "cash" bonds or loans outstanding, Goldman continues. The expansion depends solely on the demand on the other side for the insurance and the buyers' comfort in buying insurance from that counterparty.
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The problem is that the derivatives market has shrunk even faster than the cash market, he concludes. Lacking income opportunities, hedge funds and banks performed poorly in recent years, he notes, and those who have tried to break out have had to take on "inordinate" risks.
"The banks are trapped in a low-return environment, and nothing they can do will get them out of it; the best they can hope for is to become low-yield, dull, public utilities. And that is what JP Morgan doesn't want you to know," Goldman concludes.
It's been several days JPMorgan Chase's disclosure of $2 billion of trading losses, we're all still wondering precisely what went wrong. In other fiascos, such as the mortgage meltdown or the dot-com bubble, the bear claims its victims when the market craters. But there was no big, single disaster to explain the red ink.
Chief executive Jamie Dimon shed little light in his Sunday morning appearance on NBC's Meet the Press. How did it happen and did you miss something, moderator David Gregory asked. According to the transcript, Dimon replied:
"No, I think -- somewhat -- first of all, it was one warning signal. If you look back from today, there were other red flags. That particular red flag, you know, we made a mistake. We got very defensive. And people started justifying everything we did. And, you know, the better thing in life is to say, 'Maybe you made a mistake, let's -- let's dig deep.' And the mistake had been brewing for awhile. So it wasn't just any one thing."
.
Perhaps something clearer will emerge from JP Morgan's
.
Having a survivor from the Titanic ought to provide some hard experience to JP Morgan's trading operations. It should be useful in unraveling the presumed positions in credit-default swaps that caused the $2 billion in losses.
.
How that could have come to pass when "credit" has been strengthening is puzzling. Credit is the market's shorthand for fixed-income securities whose value is largely determined by the creditworthiness of the issuer, mainly corporate bonds, both investment-grade and high-yield.
.
CDS are, depending on your viewpoint, insurance policies against defaults by certain corporate credits or indexes of those corporate credits, or put options on those credits. To sell credit protection on a corporation is to write an insurance policy; if all goes well, the insurer pockets the premium and pays out nothing if there is no loss. Ditto the seller of puts; the sale of the options nets premium income, which the seller gets to keep if the price of the security doesn't drop below the strike price.
.
Peter Tchir, a derivative specialist who heads TF Advisors, theorizes JP Morgan bought credit insurance in the form of CDS on high-yield credits, in order to protect against risks of economic upheavals that would threaten its credit exposure. The premiums on that insurance were high, so he hypothesizes the bank sold credit insurance on investment-grade indexes to earn income to offset part of the cost of the credit protection on high yield. If things got bad, the high-yield hedge would pay off big while the investment-grade long position would decline less or even appreciate. Obviously, if these were JPM's best-laid plans, they somehow went awry.
.What is likely is that JP Morgan's trading activities were not purely to hedge against risk but to generate income for the bank. The problem, according to David P. Goldman, is that there just aren't enough assets to produce all the income that banks and hedge funds need.
.
Goldman, who was the head of credit research at Bank of America and now heads the MacroStrategy Advisory, writes poor risk controls and monitoring didn't cause JP Morgan's losses, as Dimon asserted. "The problem is that there is absolutely nothing he or anyone else can do to restore bank earnings to pre-crisis levels.
.
Never mind that the rosy cheeks of bank profits were a tubercular flush rather than a hallmark of good health. There simply aren't enough risk assets out there to satisfy the collective demand of investors for returns."
.
JP Morgan isn't different from the rest of the investment world, he continues. Institutions such as pension funds fall short of the returns they need to meet their bogies. In turn, they pile more money into hedge funds, which purport to provide higher returns, but have largely failed to do so.
"There isn't enough income in a low-return environment to generate $200 billion in returns on $2 trillion in hedge-fund assets, or to allow bank portfolios to earn enough money in liquid markets to compensate for the continued depressed state of banks' lending business," Goldman continues. To make up the difference, he posits JP Morgan was writing credit protection in CDS to generate income.
.
Put another way, the world saves about one-third of its income of $70 trillion, so it needs $23 trillion in investments, he explains. "Of course, if a Chinese farmer builds a chicken coop, it counts towards the total," he observes. But securities markets can't keep up with the demand for liquid investments desired by the aging population of the developed world -- even with the enormous bond issuance to fund governments' budget deficits.
.The derivatives market has the advantage to be able to accommodate institutions that want to write credit insurance to gain income -- in excess of the amount of actual "cash" bonds or loans outstanding, Goldman continues. The expansion depends solely on the demand on the other side for the insurance and the buyers' comfort in buying insurance from that counterparty.
.
The problem is that the derivatives market has shrunk even faster than the cash market, he concludes. Lacking income opportunities, hedge funds and banks performed poorly in recent years, he notes, and those who have tried to break out have had to take on "inordinate" risks.
"The banks are trapped in a low-return environment, and nothing they can do will get them out of it; the best they can hope for is to become low-yield, dull, public utilities. And that is what JP Morgan doesn't want you to know," Goldman concludes.
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