Europe’s Trial by Crisis

Joschka Fischer
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28 September 2012

  

BERLINSome 2,500 years ago, the ancient Greek philosopher Heraclitus concluded that war is the father of all things. He might have added that crisis is their mother.

 
 
 
 
Fortunately, war between world powers is no longer a realistic option, owing to the threat of mutual nuclear destruction. But major international crises, such as the current global financial crisis, remain with us – which might not be an entirely bad thing.
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Just as in war, crises fundamentally disrupt the status quo, which means that they create an opportunity – without war’s destructive force – for change that in normal times is hardly possible. To overcome a crisis requires doing things that previously were barely conceivable, let alone feasible.
 
 
 
 
That is what has happened to the European Union over the last three years, because the global financial crisis has not only shaken Europe to its foundations; it has assumed life-threatening proportions.
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Compared to the beginning of 2009, we are now dealing with a significantly different EUone that has become divided between a vanguard of member states that form the eurozone and a rearguard, consisting of member states that remain outside it. The reason is not evil intent, but rather the pressure of the crisis. If the euro is to survive, eurozone members must act, while other EU members with various levels of commitment to European integration remain on the fringe.
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Indeed, almost all taboos that existed after the eruption of the crisis have now been abolished. Most were established at German instigation, but now they have been removed with the German government’s active support.
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It is an impressive list: national responsibility for bank rescues; the sanctity of the EU treaty’s proscription of bailouts for governments; rejection of European economic governance; the ban on direct government financing by the European Central Bank; refusal to support mutual liability for debt; and, finally, the transformation of the ECB from a copy of the old Bundesbank into a European Federal Reserve Bank based on the Anglo-Saxon model.
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What remains is the rejection of Eurobonds, but that, too, will ultimately disappear. The only question is whether that taboo will fall before or after next year’s German general election. The answer depends on the future course of the crisis.
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Germany, Europe’s largest economy, is playing a strange, sometimes bizarre, role in the crisis. At no point since the founding of the Federal Republic in 1949 has the country been so strong. It has become the EU’s leading power; but it is neither willing nor able to lead.
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Precisely for this reason, many of the changes in Europe have occurred despite German opposition. In the end, the German government has had to resort to the art of the political U-turn, with the result that Germany, though economically strong, has grown institutionally weaker – a dynamic exemplified by its reduced influence in the ECB’s Governing Council.
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The old Bundesbank was laid to rest on September 6, when the ECB adopted its “outright monetary transactionsprogramunlimited purchases of distressed eurozone countries’ government bonds – over the objections of a lone dissenter: Bundesbank President Jens Weidmann. And the undertaker was not ECB President Mario Draghi; it was German Chancellor Angela Merkel.
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The Bundesbank did not fall victim to a sinister southern European conspiracy; rather, it rendered itself irrelevant. Had it gotten its way, the eurozone would no longer exist. Placing ideology above pragmatism is a formula for failure in any crisis.
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Currently, the eurozone is on the threshold of a banking union, with a fiscal union to follow. But, even with only a banking union, the pressure toward political union will grow.
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With 27 members (28 with the approaching addition of Croatia), EU treaty amendments will be impossible, not only because the United Kingdom continues to resist further European integration, but also because popular referenda would be required in many member states. These plebiscites would become a reckoning for national governments on their crisis policies, which no sound-minded government will want.
 
 
 
 

This means that intergovernmental agreements will be needed for some time to come, and that the eurozone will develop in the direction of inter-governmental federalism. This promises to be exciting, as it will offer completely unexpected possibilities for political integration.
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In the end, former French President Nicolas Sarkozy has prevailed, because the eurozone today is led by a de facto economic government that comprises member countries’ heads of state and government (and their finance ministers). European federalists should welcome this, because the more these heads of state and government turn into a government of the eurozone as a whole, the faster their current dual role as the EU’s executive and legislative branch will become obsolete.
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The European Parliament will not be able to fill the emerging vacuum, as it lacks fiscal sovereignty, which still lies with national parliaments and will remain there indefinitely. Only national parliaments can fill the vacuum, and they need a common platform within the eurozone – a kind of “Euro Chamber” – through which they can control European economic governance.
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Federalists in the European Parliament, and in Brussels generally, should not feel threatened. On the contrary, they should recognize and use this unique opportunity. National MPs and MEPs should come together quickly and clarify their relationship. In the medium term, a European Parliament with two chambers could emerge.
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This crisis offers a tremendous opportunity for Europe. It has defined the agenda for years to come: banking union, fiscal union, and political union. What remains missing is an economic-growth strategy for the crisis countries; but, given mounting unrest in southern Europe, such a strategy is inevitable. Europeans have reason to be optimistic if they recognize the opportunity that their crisis has created – and act boldly and decisively to seize it.
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Joschka Fischer was German Foreign Minister and Vice Chancellor from 1998-2005, a term marked by Germany's strong support for NATO’s intervention in Kosovo in 1999, followed by its opposition to the war in Iraq. Fischer entered electoral politics after participating in the anti-establishment protests of the 1960’s and 1970’s, and played a key role in founding Germany's Green Party, which he led for almost two decades.



It's all Greek to Me
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by Doug Noland
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September 28, 2012

  

The focus of analysis this week shifts back to Europe. My thesis remains that the unfolding European debt and economic crises provide a potential catalyst for a bout of problematic global de-risking/de-leveraging. An argument can be made that the recent rally and short squeeze throughout global risk markets actually heightens market vulnerability.


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I have expected that policy would have little success in halting the bad debt cancer spreading methodically from Europe’s periphery to its core. I have also posited that with core country Spain enveloped in Credit tumult, crisis momentum had passed a critical juncture. It is worth recalling that Spanish 10-yr yields reached 7.5% in late-July, as Italian yields surged to 6.6%.
 

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An important part of the thesis, as well, has been that the European crisis would expose Bubble fragilities fermenting in the “developingeconomies, especially in China, Brazil and India. There has been important confirmation in the thesis, both from financial and economic perspectives.



Not unexpectedly, global policymakers have responded to heightened systemic risk with extraordinary vigor. In Europe and the U.S., central bankers have introduced the world to the idea of open-ended liquidity creation and market intervention. Global risk markets have responded strongly to the latest iteration in New Age monetary management, only widening the gulf between securities prices and fundamental prospects. Markets now anxiously anticipate the implementation of the Draghi Plan and Bernanke’s big monetization. At the same time, there is justified caution with respect to the impact all this liquidity is going to have on already problematic economic imbalances.



Last week’s CBB focused on the premise that “economic structure matters – and it matters tremendously.” This is one of thosemaster of the obviouscomments, yet these days one sees essentially no attention paid to such analysis. The evolving European crisis has provided important confirmation of this analysis. We’ve watched how Greece’s tiny little economy evolved into a formidable financial black hole. Why? Well, years of Credit excess fomented deep structural maladjustmentmaladjustment that remained largely concealed so long as ample Credit/spending power was forthcoming. Post-Bubble, the Greek economy is just not capable of creating sufficient real economic wealth to support its populationnot to mention its debt load. Greece’s economy remains in a steep downward spiral – and in desperate need for bailout #3 and ongoing outside assistance. Meanwhile, the social fabric badly frays or worse.



A critical question today – for Europe, for international markets and for the global economy - is whether Spain is following in Greece’s footsteps. According to IMF (2011) data, Greece ranks just below Venezuela as the world’s 35th largest economy (GDP of $303bn). About five times the size of Greece, the Spanish economy ranks #12 in the world at $1.494 TN. While not as debt-ridden as Greece, Spanish federal and regional government debt now exceeds 100% of GDP – and is rising rapidly.



Spain will require enormous financial support. It has both a substantial economy and substantial banking systemboth today in serious trouble. Similar to Greece, a prolonged Credit boom has resulted in a terribly maladjusted economic structure.


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Literally hundreds of billions of euros will be required – and I fully expect the bailout tab will, in Greek fashion, expand on an annual basis. Fear for Spain and Italy was the impetus behind the creation of large bailout facilities (ESM joining the EFSF) and, more recently, commitments for open-ended bond purchases from the Draghi ECBOutright Monetary Transactions (OMT). In a sign of the times, global markets to this point have viewed Spain largely in a positive light, as a likely catalyst for hundreds of billions of governmental and central bank market interventions/liquidity operations.


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Developments this week provided a hint that complacency might be unjustified. With an unemployment rate of almost 25%, social tensions have reached the boiling point. Public protests that had been peaceful turned violent this weekrecalling a critical crisis inflection point in Athens. At least Greece has not had to deal with regional governments calling for independence.


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This week, Artur Mas, President of Catalonia, called early elections for November 25. Catalonia is the wealthiest of Spain’s 17 regions, accounting for about one-fifth of Spanish GDP. From the Financial Times: “Catalonia has a proud tradition of self-rule dating from the Middle Ages. In recent times a decisive moment came in 2010 when Spain’s constitutional court largely rejected a new statute of autonomy for Catalonia approved by the national parliament in 2006. The statute was favoured by Spain’s former Socialist government but opposed by the centre-right Partido Popular, which now holds power in Madrid.”


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There’s no love lost between Mr. Mas and President Rajoy. In recent meetings, Rajoy rejected Mas’ request for more financial independence (including control of local tax receipts) from Madrid. Catalonia’s economy has faltered badly, and the heavily indebted region was forced to seek bailout assistance from the federal government. The Rajoy government has been seen as using the crisis backdrop to wrest control from the regions, something that has inflamed latent animosities – especially in independent-minded Catalonia. Catalonians resent paying significantly more to Madrid than they received in services, essentially subsidizing other regions. They blame Madrid for their problems. Catalonian officials have been determined to take control of their own purse strings, a right enjoyed by the nationalistic Basques region. On September 11, an estimated 1.5 million protested in support of “Catalonia, a new European state” in the streets of Barcelona.


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There has been some concern that Spain’s military may be forced to respond to Catalonia’s move to independence. This further complicates an already complex economic, social, political and historical backdrop. Spain on Friday afternoon announced the results of an “independent audit” of the country’s 14 largest banks.


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As expected, the government reported a $76bn (euro 62bn) short-fall in bank capital. While the EU would like to believe these stress tests are a “major step” in restoring confidence, few analysts believe the results accurately reflect the size of the rapidly expanding hole in Spain’s banking system. It takes a major leap of faith to believe that half of the banks tested are today adequately capitalized. And from the UK Telegraph: “The audit was based on an assumption that the economy would shrink 0.3% in 2012, but this already looks outdated as conditions quickly deteriorate.”


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And while we’re on the subject of economic deterioration and incredulous assumptions, Spain Thursday released its 2013 budget. The Rajoy government plans to use spending cuts, tax increases and $3.9bn of pension reserves to reduce its budget deficit to the agreed upon 4.5% for 2013 (in the face of an expected 30% increase in debt service costs). This budget assumes economic contraction of 0.5% next year, when some forecasts now call for deepening recession and GDP contraction of at least 3%. Tuesday, Spain reported that its deficit for the first eight months of 2012 had already increased to 4.77% of GDP (vs. year ago 3.81%), with spending rising 8.9% and receipts declining 4.6%. It’s all Greek to me.


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And while Spain’s budget and “stress test results have limited credibility, it hasn’t much mattered. Some go so far as to recommend holding Spanish debt on the view that it’s good to own what governments are about to buy (holds true, as well, for U.S. Treasuries and MBS). It’s now a matter of ironing out the timing and details of an ESM bailout and, presumably, ECB purchases in the secondary market. And, to this point, it is a case where the more rapidly things deteriorate the more confident market operators become in the imminent arrival of the liquidity onslaught.


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Here’s where things get more interesting. The original plan calling for Spain to tap the ESM for funds to recapitalize its banks has hit road blocks. Earlier in the week, ministers from Germany, the Netherlands and Finland (the Northern AAAs) argued against direct bank recapitalization, while also stating their view that problem bank assets must remain the responsibility of the sovereign.


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Besides, there is supposed to be a European-wide bank regulator in place before recapitalization fundings are considered. The whole scope of a single bank supervisor has become a source of heated debate, with Germany strongly opposed to the idea of the ECB attempting to supervise all 6,000 European banks.



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And it is worth noting that the Bundesbank’s Jens Weidmann was out in force again this week, in one instance speaking in support of the Northern AAAs: “In order to keep liability and control in balance, only risks that have arisen after common supervision is established can be taken under joint liability.


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The legacy burdens on bank balance sheets have to be underwritten by the countries under whose supervision they have arisen. Mutualization of risks can’t be the primary purpose of a banking union.” Spain has made a disastrous mess of their banking system – and market hopes that they were about to offload some of this risk to the EU/ESM is at this point little more than wishful thinking.


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Europe remains an unfolding disaster, although the region’s bonds and stocks remain speculating vehicles of choice under the assumptions that Draghi is about to lend hundreds of billions of support and, at the end of the day, the Germans will backstop the European debt markets. As for the Draghi Plan, I’ll presume many on the governing council hope that the ECB is never called upon to use its bazooka.


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Indeed, the true capacity of the Draghi Plan is much in doubt. The Bundesbank is adamantly opposed to the OMT, while questions remain as to its legality. And in Germany, it appears there is mounting political opposition to the ECB and other transfer mechanisms.


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I know, when faltering markets place the barrel of a gun to Ms. Merkel and others’ heads, mouths open and market-friendly utterances pop out. Yet, once again, we’re witnessing how it is incredibly difficult to go from talk to actual bailout program implementation. Meanwhile, the politics seem to only get more difficult by the week – if that’s even possible. Right now, markets are focused on the inevitability of a Spain bailout and the unleashing of the vaunted ESM and OMT programs. I’m not sure whether it will be weeks or months, but I do expect we’re heading in a direction where the markets will turn attention to sinking Italian and French economies and worry that these bailout programs are not going to be up to the task.



JPMorgan Loss Could Be Next 'Shock' Event

September 28, 2012

by: Chart Prophet




The JP Morgan (JPM) trading blunder could result in a $100 billion loss, a contagion of its massive portfolio, and even the wipeout of its entire asset base. Even worse, these extremely risky and potentially-illegal actions on behalf of the CIO office and the "London Whale" could be the unexpected "shock" that breaks the market, derails the Fed's huge monetary stimulus, and sends us back into a global recession.
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The JP Morgan Shock
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The entire world has forgotten about or ignored what could be the upcoming "shock" that puts the global financial system in severe jeopardy. To make matters much, much worse - I don't think anyone even has a clue as to what is really happening. Investors, economists, financial powerhouses, top business executives, politicians, lawmakers, consumers, students, governments, and even central banks are completely confused. None of them are expecting what I will describe below.
 
 
 
 
There is one event that may ultimately solve the mystery of the global economy. This event would not only plunge the economy back into a deep recession and lose investors hundreds of billions of dollars, but it could bring about the collapse of some of the world's largest financial institutions and even render central bank stimulus and QE completely ineffective and futile.
 
 
 
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This event is by no means a guarantee; its probability is even likely under 5 percent. But this event has all the necessary ingredients to culminate into a major panic. Together with slowing global economies and an extremely unstable financial system, this could be the next Lehman Brothers.
 
 
 
 
This event is JP Morgan's huge trading mistake. The massive losses that were racked up starting in April and May 2012 are by no means over. What has been represented by JP Morgan as a trading mistake and "hedging" strategy with an initial estimated loss of $2 billion, was really a leveraged and speculative bet that could soon infect JP Morgan's entire portfolio and result in losses of $100 billion.
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The Global Economy and Huge Underlying Risks
 
 
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Most investors already know about the very weak economic growth, European financial crisis, Chinese slowdown, Middle East tensions, and dangerous Fed actions. All are huge threats and may drag the global economy into a double-dip recession. But most investors don't know if the fears are overblown; they don't know if central banks will be successful in boosting the economy; and they don't know the real risks out there. Most investors are either overly-optimistic, over-confident that they will be able to pull their money out quickly, following the crowd, or simply taking way too much risk unnecessarily. After a 115% + rally, and only 7% away from the all-time stock market highs, it's just not worth staying invested right now.
 
 
 
 
This was my warning to my friends on September 25, 2012:

Take your money out of stocks and gold NOW!!!

$SPY $GLD $AAPL $FB $GOOG $MCD $CAT $JPM

Way too much risk, stock market is only 7% away from the all-time highs (and the economy is nowhere near where it was), Apple has failed to stay above $700 and will potentially never make new highs ever again, Google might have just put in a top, Facebook continues to fail, China is slowing down tremendously and could enter recession, Europe has a financial crisis that is still unresolved, global growth and manufacturing is slowing (already at recession levels), massive debt could lead to financial collapse, the US Dollar is getting stronger, commodity prices are falling after over-speculation, oil prices failed to stay above $100 and signal a deflationary recession, and the Fed's actions have given investors too much confidence when they might not work at all.......Just not enough reward at all for the massive risk that you'd be taking.
 
All of the above reasons are absolutely enough to crush this market, but guess what? It could get even worse.
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JP Morgan Loss
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JP Morgan announced that its Chief Investment Office made a terrible trading error and lost $2 billion. The company said that the loss was due to a failed "hedging" and "protection" strategy and blamed it on trader Bruno Iksil, the "London Whale". At first, the company tried to deny or downplay these very negative rumors in order to prevent any panic. But by May 2012, losses of $2 billion were reported and the stock had lost a third of its value in two months, from early April to early June. On an emergency conference call, JP Morgan CEO Jamie Dimon announced that the strategy was "flawed, complex, poorly reviewed, poorly executed, and poorly monitored."
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Jamie Dimon was called to testify in front of the Senate, and investigations were initiated by the Federal Reserve, the SEC, and the FBI. In July, the total loss was updated to $5.8 billion and the firm announced that they could total $9 billion under worst-case scenarios. But the problems have still not been solved! JP Morgan is still not out of the trade, and all of the investigations and testimonies have still not uncovered exactly what the trades were, how they resulted in such massive losses, and why such severe mistakes were not caught by top management.
 
 
 
It appears that the losses are still increasing and that JP Morgan is hiding a lot of important information. It is absolutely possible that a number of traders, risk managers, and even Jamie Dimon himself have engaged in illegal activities, misrepresented the real situation, and even lied to the public.
 
 
 
What's Really Happening?
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  • The Trades


 
JP Morgan's full list of positions is still unknown (because it could affect their ability to sell out of losing trades), but a few very important bets have been revealed. So far, it appears that the big losses were the result of two trades (though others are likely still to be uncovered).



Trade #1 was a smart hedge betting against the global economy, by having bearish positions on junk bonds (JNK) - one of the riskiest asset classes most sensitive to the condition of the economy. This position was a very good hedge because JP Morgan needs to protect itself from a potential economic downturn. If the economy deteriorated and stocks fell, JP Morgan would at least make up some losses by profiting from these bearish bets.



Trade #2 is where the real trouble stems from. Instead of hedging through bearish positions, Trade #2 actually bets on continued economic strength. Trade #2 was a bet that investment-grade bonds will not default - that strong corporations will continue to be financially stable and be able to pay off all of their obligations.


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JP Morgan's bet was that credit markets would strengthen. To make matters even worse, Trade #2 was based on the position that 2012 should be protected but that 2013-2017 would be safe (buying CDS protection for 2012, selling CDS protection out to 2017). In other words, JP Morgan was now betting that investment grade bonds would not default from 2013 to 2017.
Moreover, Trade #2 was much bigger than Trade #1.



  • How They Lost
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The trades are highly dependent on the state of the economy. If conditions improved, JP Morgan would lose on its short position in junk bonds (because junk bonds would continue to gain) but would profit from its long position in investment-grade bonds (because these bonds would gain as well). And since Trade #2 was bigger than Trade #1, the gains on Trade #2 would offset the losses on Trade #1. Therefore, if the economy improved, JP Morgan would make a profit.



On the other hand, if economic conditions declined, JP Morgan would profit from its short position in junk bonds (which would be hard hit by a slowdown) but would lose on its long positions in investment-grade bonds (which would now be at greater risk of default). Because Trade #2 was much bigger than Trade #1, deteriorating economic conditions would result in a large loss.




JP Morgan's trades were a terrible "hedge" because they were much more geared for an improvement in economic conditions than for a deterioration. Therefore, when world financial markets fell into a slight panic over Europe's financial crisis and slowing global growth, JP Morgan lost billions of dollars on their trades. And it's not over.
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Why They're Lying




There is a good chance that legal actions will soon follow. Not only did the Chief Investment Office make very serious trading errors and failed to oversee the trouble that was going on, but there is a fair possibility that a number of individuals in top-level management positions knew what was happening and failed to act. In fact, the CIO (Ina Drew), Chief Risk Officer (Irvin Goldman), and others have already been forced to resign. In my opinion, JP Morgan and a number of individual in high-level management have engaged in market manipulation, public misrepresentation, and conflicts of interest.



  • "Hedge." First, calling these botched trades a "hedge" is hugely misleading and even a lie; these trades were not "protection," but an outright bullish and speculative bet on a European resolution and strength of the credit markets. JP Morgan made a massive bet on improving economic conditions instead of rightfully protecting itself from the threats of a recession.

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And I'm not the only one who thinks so:
Monday, May 21, 1:35 PM JPMorgan's CIO losses can't be described "in any way as a hedge," says hedge fund giant Michael Platt, whose BlueCrest capital was on the other side of the trade. "It's a trading loss. They deliberately put the positions on." "They're not out of those positions," he says and will face further losses if Europe continues to deteriorate.

Source: Seeking Alpha, Market Currents
 

  • Hiding Losses. Second, it appears that JP Morgan attempted to hide these losses from the public by either denying or minimizing early reports. Finally, when losses grew too large to hide, the company reported a $2 billion loss. Then, after investors had some time to digest the $2 billion loss reported in May, JP Morgan updated the loss to $5.8 billion in July.


  • Misrepresenting Financial Results. Third, it is possible that JP Morgan attempted to hide the losses and manipulate investors by retroactively updating financial results, after it misrepresented them more positively. On July 13, 2012, it announced that it had a $4.4 billion loss in the second quarter and a "recalculation" of first quarter results that resulted in a $1.4 billion loss. To me, it looks like JP Morgan pushed off announcing the losses until after first quarter results were announced, and then tried to quietly tuck some of those losses into Q1 only afterwards - when investors weren't paying much attention. To me, it looks like JP Morgan has been trying to cover up its mistakes.





  • Conflicts of Interest. Fifth, there are major conflicts of interest at JP Morgan. Not only is CEO Jamie Dimon a board member of the Federal Reserve Bank of NY (why is a top bank CEO so heavily influential on a government institution?), but the biggest campaign donor to many members on the Senate's banking committee - JP Morgan Chase. (Huffington Post, JP Morgan Chase and The Senate Banking Committee Are Best Friends).



  • Pointing The Blame. Finally, even though JP Morgan has placed the blame on the "London Whale" and the Chief Investment Office, it is CEO Jamie Dimon who deserves a lot of the blame as well. It is the role of the CEO to oversee what goes on and even to sign off on financial documents that they are accurate (Sarbanes-Oxley). Dimon told lawmakers that the loss was an "isolated incident," but it is more likely that there is much more brewing under the surface.



Why It Could Get Much Worse



The $5.8 billion loss that has officially been announced is by no means the final count. Not only have we seen the loss rise from $2 billion to $4 billion to $5.8 billion, but JP Morgan still hasn't exited from its positions. There are a number of reasons why this loss could quickly spiral out of control.



  • Still Not Out of Bets. The official announced losses are "only" $5.8 billion, but JP Morgan still hasn't exited from all of its risky positions. In fact, even though JP Morgan's losses have been estimated to be as much as $9 billion under worst case scenarios, this is according to JP Morgan's own internal report. Why should we believe what JP Morgan tells us? Obviously they underestimate their own losses.





Moreover, the company is holding positions in derivatives with a face value of $100 billion. Not only are these positions betting on the health of corporate debt and relying on improved economic conditions, but these positions are very illiquid. JP Morgan holds a major chunk of this market, and it's had a very hard time unloading its bets.



Unwinding these bets could put JP Morgan at tremendously high risk:


J.P. Morgan's decision to move slowly in unwinding the positions highlights a painful dilemma for the company and Chief Executive James Dimon: The bank can move slowly and risk being bled by small but regular losses over time, or it can attempt to close out the trades sooner but face potentially larger losses. Moving slowly also holds risks if the market turns sharply against the bank in the near term.

Source: WSJ: JP Morgan Struggles To Unwind Huge Bets


  • Sold Protection Maturing in 2017. Perhaps the dumbest move for JP Morgan was its failure to protect itself from a recession or economic slowdown. Instead of buying protection, JP Morgan actually sold protection. Though it bought protection for 2012, it sold protection for 2013-2017 - definitely not a position that would save it if a recession took hold. If economic conditions deteriorate, JP Morgan is in a tremendously dangerous position; it not only failed to protect itself for the next few years, but it even made bullish bets by selling that protection. If it can't unload its positions soon, an economic slowdown could wipe out its entire portfolio as the 2013-2017 protection soars in value and blows up in JP Morgan's face (the positions lost JP Morgan a minimum of 24% in just over a week - WSJ, ibid).


  • Regulators Still Haven't Figured It Out. Regulators such as the OCC and SEC have attempted to find out exactly what has happened and how much risk is still out there, but they have likely been looking at "the same models that the bank itself was using (WSJ, ibid.)." It seems that the regulators themselves still have a lot to find out, and the $9 billion max-loss estimated by JP Morgan itself is not likely accurate.


  • Way More Than $10 Billion At Risk. While Jamie Dimon insists that Iksil (The London Whale) made a risky $10 billion bet in an illiquid debt index, and that this is an "isolated incident," there may be much more at risk than the measly $10 billion.



In fact, the CIO's job was to "invest the difference between the $1.1 trillion in deposits the bank has on hand from its customers and the $750 billion the bank has lent out to corporate borrowers (Bloomberg, Exactly Whose Money Did The London Whale Lose?)." That leaves $350 billion that was under the direction of CIO Ina Drew, who has since been forced to resign. Dimon claims that the bad trade was limited to the $10 billion bet by the London Whale, but a number of factors point to this mess potentially affecting way more than just $10 billion.


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First, we've already heard that JP Morgan's position in risky, illiquid debt derivatives has had a face value of $100 billion; Iksil's position may have been $10 billion, but somehow JP Morgan attained a $100 billion risk exposure. Second, even if just a $10 billion position was taken, if it is highly-leveraged it could wipe out much of the value of JP Morgan's other assets.



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Haven't we learned the lessons of the giant financial collapses of Lehman Brothers, Bear Stearns, Merrill Lynch, AIG, MF Global, and others? Haven't we already seen how leveraged, "isolated" bets can bring down entire corporations?



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Even if JP Morgan's bet was limited to $10 billion (which it likely wasn't, because we've already heard of the $100 billion in risky positions), its leveraged losses could infect the entire $350 billion CIO portfolio. It is completely possible that the contagion will spread, the $6 billion in losses will continue to grow, the $100 billion in risky positions will collapse, and JP Morgan's $350 billion CIO portfolio will be severely affected.



  • Depositors' Money At Risk? It is not even a stretch to say that depositors' money is at risk (Bloomberg). If the botched position is still uncovered, it could potentially infect the rest of the CIO's portfolio - and even wipe out JP Morgan's entire capital base.


"Essentially, JP Morgan has been operating a hedge fund with federal insured deposits within a bank," said Mark Williams, a professor of finance at Boston University, who also served as a Federal Reserve bank examiner.

Source: NYT DealBook, JPMorgan Trading Loss May Reach $9 Billion
 

  • Could Derail Fed's Monetary Policy. If JP Morgan's losses really do begin to escalate, they affect much more than just JP Morgan. As one of the largest "too big to fail" banks, JP Morgan has benefited tremendously from the added liquidity that the Fed has brought to the markets. The Fed's mission was to increase lending, improve banks' balance sheets, and give "easy money" to these institutions in order to boost the economy. There is no doubt that the Fed's stimulus has bolstered companies like JP Morgan , Bank of America (BAC), AIG (AIG), Wells Fargo (WFC), Goldman Sachs (GS), Citigroup (C), and many financials (XLF). But if JP Morgan goes down, the repercussions will be much greater than in 2008. The economy is not ready to deal with another huge shock. This time, the contagion would be much greater, and the government will not have the capacity to protect failing firms. A collapse of a too-big-to-fail bank would destroy confidence and undermine the Fed's monetary policy.




How You Could Have Seen This Coming



Though it is impossible to predict events exactly, sometimes there are enough clues that point to good or bad news that may soon come. Sometimes there are rumors, improving or deteriorating financials, upcoming catalysts, and a number of hints which signal that momentum is shifting.



Sometimes these are positive developments, pointing to an explosive surge in the company's stock, and sometimes these are negative developments, pointing to an upcoming crash. In the case of JP Morgan, there were reasons to watch out.




1. Hedge Funds Take Other Side. In early 2012, hedge funds such as Saba Capital and Blue Mountain Capital made billions by taking the opposite side of the trade when they noticed that JP Morgan was affecting the market and making aggressive bets. Anyone who paid attention could have noticed that something was going on.



2. Jamie Dimon Against Higher Capital Requirements. In June 2011, Dimon became a "Wall Street Hero" when he boldly questioned Bernanke about whether too much bank regulation - especially the higher capital requirements - would affect the economy and prevent a full recovery.


"Now we're told there are going to be even higher capital requirements, and we know there are 300 rules coming, has anyone bothered to study the cumulative effect of these things? And do you have a fear-like I do-that when we look back and look at them all, that they will be the reason that it took so long for our banks, our credit, our businesses, and most importantly, our job creation, to start going again? Is this holding us back at this point?"

Source: CNBC, Jamie Dimon Becomes Wall Street s Hero Figure
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Bernanke didn't have much to say other than that they are doing everything they can to "develop a system that is coherent and that is consistent with banks performing their vital social function in terms of extending credit."


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Wall Street considered Jamie Dimon a hero, but Dimon's rejection of higher capital requirements should have been a warning. Higher capital requirements are a smart and likely effective way of reducing banks' risk-taking. By increasing capital requirements, the banks would be forced to hold more reserves on hand in order to protect them in case of a sudden downturn or financial distress.


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This is exactly what we need! Without higher capital requirements, banks are just leveraging their money even more - taking way more risk than they can afford.



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Jamie Dimon was basically saying: "Please allow us to bet or loan $1000 when we only really have $100." In other words, Dimon wanted an expansion of banks' financial power without having to increase the safety. By decreasing capital requirements, banks would be able to decrease the amount of money they used as collateral - the "money multiplier" would allow banks to essentially create money out of nowhere and increase lending and investments - which helps banks make more profits and would hopefully help boost the economic recovery. However, if anything goes wrong, the billions (or trillions) of dollars of new loans and investments could collapse in value. And if all of these new loans and investments have been made on "margin" through leverage and monetary expansion, there isn't enough capital to cover the losses - their entire business could be wiped out.




If we actually paid attention to what Jamie Dimon said that day, we could have seen that he wanted more leeway and more power for the banks. Perhaps banks needed more power in order to help the economy, but decreasing the capital requirements and giving banks more room for leverage is exactly what leads to huge financial catastrophes like Lehman Brothers. It was obvious that Dimon was paving the way for increased risk-taking by the banks. And that mindset is what ultimately led to this JP Morgan fiasco.



Dimon's actions in June 2011 foreshadowed this trading loss:


The enormous loss JPMorgan announced today is just the latest evidence that what banks call "hedges" are often risky bets that so-called "too big to fail" banks have no business making.
-Senator Carl Levin, Michigan (D)

Source: NYT DealBook. SEC Opens Investigation Into JPMorgan s $2 Billion Loss
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3. Eight Technical Failures.

Perhaps the most obvious sign that JP Morgan was about to drop, was the consistent technical failure in the charts. Every time JP Morgan's stock approached $45 or $46, it failed. Looking back all the way to 2007, the $45-$46 level was like a brick wall that completely blocked the stock every time. This could be one of the easiest bets a short-seller could ever make. If you just looked at the 5-year chart of JPM in April 2012, you'd notice that we were approaching major resistance overhead. Every single time we rose to this level, we fell; and in late 2008, we fell from over $45 to almost $14.




All one had to do was see if JPM could break above and stay above $46. If it did, JPM would be a decent long position at very low risk, with a brand new support at $45. But if it failed (and it did), JPM would be a good short.




This massive resistance was so powerful, that JPM actually failed once again. Not only that, but it failed in late March - investors had over a month to notice this and short the stock! Technicals were signaling a massive warning even before the bad news reached the public.

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(Click to enlarge)

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Conclusion



All of these facts and clues are still to be determined. JP Morgan may in fact work everything out and escape with under $10 billion in losses. A lot of what I've written is opinion based on the available facts, and the probability of the collapse of a giant financial institution is still extremely low. But there are simply way too many unresolved issues still to be dealt with; there are way too many unanswered questions to be answered by Jamie Dimon and regulators.


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JP Morgan was lucky that the bad news came out right before the summer, and that the "summer doldrums" helped investors and lawmakers forget about the massive trouble that may be underway. JP Morgan and CEO Jamie Dimon have been completely silent about this for a few months now, and the stock has recovered all of its losses since the news broke out.




Technically, this looks like a "pullback" before the next plunge. The stock may have room to rise, but after such terrible news it is hard to see how it can sustain new highs. To make matters worse, JPM was included in Goldman's Hedge Fund Very Important Position list and Goldman Sachs' VIP List of 50 stocks most important to hedge funds. If JPM suffers, you can bet that most hedge funds, pension funds, and investors will suffer as well.






I repeat: QE and central bank stimulus could turn out to be a great success that saves our economy. But the risks of investing just far outweigh the potential rewards at this point.


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If you're smart, you'll avoid or short this market and miss out on a maximum 7% upside move if stocks continue to rise (and then get in at minimum risk if we exceed the 2007 highs). By doing so, you'll also save yourself from a devastating 20-50% drop in stocks if the situation deteriorates. I understand we all want to grow our wealth and make money through investing in order to improve our lifestyle, fund our retirement, support our children, and have the ability to do what we want. But at this point, staying long is just being greedy.