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JP Morgan, Lehman and Nightmares
Posted by: Lance on Sunday, October 05, 2008

I am often asked about individual bank stocks, especially JP Morgan. Generally my answer is that Bank of America, JP Morgan and a few others look to be likely survivors, but how profitable they will be I am really unsure.

JP Morgan is a special discussion, because I point out a rather astonishing fact, they have a notional exposure to around 90 trillion in derivative contracts, or did last March (pdf.) 58 trillion of it swaps of some sort. Probably credit default swaps (CDS) are the majority. Which means...what? I don't know, and frankly if anybody really does they aren't telling me. In essence I am left telling people that I have to treat that as a "black box." Not exactly confidence raising. Personally there are better ways to make money than hoping a company with 90 trillion in derivatives exposure has a handle on it in my book, but then again, I am admitting that I have no idea what I am talking about, and cannot find anyone else who does either.

Warren Buffet often speaks of defining a circle of competency when investing and staying inside it. It doesn't matter how big the circle is, just knowing when you are inside it. Well, 90 trillion in derivatives exposure is outside of my circle of competency to assess.

The nightmare is what if it is outside of JP Morgans circle? I suspect it is, and the massive exposure of two other banks as well (Citibank and Bank of America have approx. 38 trillion apiece.)

What makes me wonder about it today? Personally I have always felt that there was a good chance that JP Morgan was who was being saved when the Fed brokered the acquisition of Bear Stearns. Bear goes under and JP Morgan would have to come up with huge payments on CDS contracts. Also, I suspect that Bear was a counterparty for a large number of derivatives, which if Bear was insolvent might not have all been paid up. Or maybe not. Then I see this over at Barry Ritholtz's:
"Lehman Brothers Holdings Inc.'s main lender and clearing agent, JPMorgan Chase & Co., caused the liquidity crisis that led to Lehman's collapse, creditors said.

JPMorgan had more than $17 billion of Lehman's cash and securities three days before the investment bank filed the biggest bankruptcy in history on Sept. 15, the creditors committee said in a filing Oct. 2 in bankruptcy court in Manhattan. Denying Lehman access to the assets on Sept. 12, the bank ``froze'' Lehman's account, the creditors claimed.

JPMorgan, the biggest U.S. bank by deposits, financed Lehman's brokerage operations with daily advances, while money market funds and other short-term lenders provided overnight loans, according to bankruptcy court documents. When JPMorgan shut Lehman off from funds, Lehman ``suffered an immediate liquidity crisis that could have been averted by any number of events, none of which transpired,'' according to the filing.

The creditors asked the judge in charge of the case to let them interview a witness and request relevant documents from JPMorgan and to pursue possible legal claims. U.S. Bankruptcy Judge James M. Peck is scheduled to hold a hearing Oct. 16 on that request, the creditors said."
Hmmm, so Lehman may have been torpedoed by JP Morgan? Hardnosed but not weird, until this little tidbit in the update:
Ron Kirby notes: "I wrote about a very strange occurrence – the reporting of J.P. Morgan “transferring” 138 billion dollars to Lehman, after Lehman had already filed for Chapter 11 bankruptcy early last Monday morning...It is highly likely [or a certainty on my planet] that J.P. Morgan was INSOLVENT and was “BAILED OUT” last Monday, September 15, to the tune of 138 billion dollars. This would explain why the Fed and Treasury dictated that Lehman fail – to disguise or otherwise obfuscate the recapitalization of or illicit transfer of 138 billion to A MUCH SICKER, TEETERING ENTITY, J.P. Morgan Chase."
The link is filled with some rather out there speculation (and I have no intention of confirming or discrediting it) but this is a very odd transaction. Immediately after sending Lehman 138 billion they received 138 billion from the Federal Reserve. What were they off loading? Meanwhile they allegedly cut off Lehman.

Back to Bear. Was allowing JPM to take over Bear and the Fed guaranteeing most of their debt a back door method of recapitalizing a banking behemoth? Are the acquisitions that JPM has been making under very favorable terms a sign of strength or weakness? Gifts from the Federal Reserve to recapitalize them? How much trouble is in that book of derivatives?

I have already pointed out the problems in Europe, problems which the failure of AIG would have exacerbated due to their massive involvement in the CDS market. Is it possible that JPM was also heavily exposed to a failure by AIG? With 90 Trillion in nominal exposure it is hard to imagine they were not. With that much exposure who could possibly be more of a candidate for the "too big to fail" label. Could the Fed be manipulating these events to save them without causing the kind of panic that Bear and the later victims have caused?

I don't know, which is the real tragedy. Nobody knows what the exposure of anybody is, so we are all left guessing. The Federal Reserve, our government, the financial institutions themselves are all busy obscuring rather than bringing things to light. In order to avoid panic by showing us all how deep the problems are, they are busy spreading suspicion, distrust and panic by keeping everybody, including financial institutions they have to deal with, in the dark. The hope of generous terms from the government keeps banks from admitting what their books really look like, or to try and sell in an orderly manner what they have. Who needs to expose your books to potential lenders when the Federal Reserve will take a used car as collateral and at a lower rate.

How bad off are these institutions? We have no idea. We are left with our imagination and our nightmares.
 
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Previous Comments to this Post 

Comments
90 trillion?! Wouldn’t that be more than the entire planet’s annual gross product? I’m not sure that number is believable.
 
Written By: Grimshaw
URL: http://
Grimshaw, that’s 90 trillion in Zimbabawe currency
 
Written By: kyleN
URL: http://impudent.blognation.us/blog
If we come out of this without a Great Depression, it is probably too much to ask that our rulers put into place the right kind of reforms to make it unlikely to happen again.

I am sure they will not, because one of the biggest problems in this whole mess I have yet to hear one pundit or politician to even bring up.

That problem I am referring to is the failure to enforce anti-trust law in the last thirty year which led to the creation of gargantuan financial houses, filled with debt created by leveraged buyouts of their smaller competitors.

It is absolutely obscene that AIG was able to use leverage to buy up so many insurance assets, so that it’s failure drags everyone down with it. It is appalling that Morgan-Chase was allowed to snap up so many regional banks and thus replacing community minded lending with one size fits all failure.

It seems that every generation must learn the lessons of Adam Smith all over again.
 
Written By: kyleN
URL: http://impudent.blognation.us/blog
Wouldn’t that be more than the entire planet’s annual gross product?
It sure would be. More than double. The global derivatives market is truly immense. Realize that in theory much of this exposure cancels each other out. The net exposure, as opposed to the notional exposure, should be the key.

Unfortunately there is as of yet no exchange or clearinghouse which trades CDS contracts, so who knows if they all net out properly, who can actually pay up, etc.

As I said, this is a black box. It may all be fine, or it could be truly scary. Click on the link to the pdf. The data is all there, though that number takes scrolling down quite a bit to find.
 
Written By: Lance
URL: http://riskandreturn.net
"The Federal Reserve, our government, the financial institutions themselves are all busy obscuring rather than bringing things to light. In order to avoid panic by showing us all how deep the problems are, they are busy spreading suspicion, distrust and panic by keeping everybody, including financial institutions they have to deal with, in the dark."

Hence the real reason for the worsening financial crisis worldwide as evidenced by the moonshot in LIBOR, EUIBOR and TED spread percentages. Looks like a vote of "no confidence" for the Fed, Congress and banks worldwide as they continue to putz around and make the problems exponentially worse.
 
Written By: Unscripted Thoughts
URL: http://
About 12% of my retirement funds were in Lehman Brothers premium bonds; I am retired, so that savings is my life blood. Lehman established a 2.5 billion fund to pay bonuses to the managment and my information is that the money will be paid. Lehman, having filed for banrupcy, makes these bonds almost wothless with the possibility that all of the money invested is lost. Buying stock or bonds has risk, but to see those that caused the bankrupcy to receive bonuses makes by blood curl.
 
Written By: AMR
URL: http://
but to see those that caused the bankrupcy to receive bonuses makes by blood curl.


I am right there with you buddy. In fact, there should be clawback provisions to account for people getting huge bonuses based on profits that later evaporated. I think it is time for shareholders to become a lot more active.
 
Written By: Lance
URL: http://asecondhandconjecture.com
“The total notional value of derivatives held by the U.S. commercial banks [is] … $180 trillion.” (From the OCC’s quarterly report.) From a chart in this report, 80% are interest rate contracts and 9% are credit derivatives (almost all CDS), i.e. $16 trillion are CDS. The first 5 largest commercial banks hold 97% of all contracts. J P Morgan has $8 trillion notional CDS. Bank of America has $3 trillion and Citi has $3 trillion.

The key word is “notional.” An interest rate swap (80% of derivatives) is an agreement between two institutions where one pays a fixed rate of interest and the other a floating rate of interest, both on the same notional amount. However, no principal payment is exchanged. It’s as if both institutions make each other loans of the same amount differing only in the kind and magnitude of interest payments. The $180 trillion doesn’t exist. Only the interest on $180 trillion exists. At 5% interest that would be $9 trillion.

The CDS is a different kind of exchange. It’s an insurance contract where one side pays periodic payments while the other side pays losses if they occur.

In both cases, one doesn’t know the net exposure from the notional amounts. Many institutions enter into contracts and offsetting contracts. This means they have little next exposure. However, it does mean that they depend on each other to stay solvent. It’s an equilibrium of tremendous forces which if a large component is removed leads to a chain reaction. Table 6 says that J P Morgan’s derivate contracts are worth about $243 billion (longs) and about $236 billion (shorts) for a net exposure of $7 billion. Obviously if a large fraction of the $250 figures is obliterated the exposure would shoot up considerably.

In any case, I believe Lance is essentially correct. Bear Stearns wasn’t bailed-out but wiped-out. It was the counter parties of Bear that were bailed-out.

I’d like to know the history of this vast “trust” between institutions. Back in the 1990s when I looked at the interest rate swap business, it was common knowledge that one needed a triple-A credit rating to be competitive in the business. Thus, commercial banks dominated but how did they enter swaps with the low-rated investment banks? What made them take this risk? Does anyone have a good link?






 
Written By: Jason Pappas
URL: http://libertyandculture.blogspot.com/
Hence the real reason for the worsening financial crisis worldwide as evidenced by the moonshot in LIBOR, EUIBOR and TED spread percentages.
Exactly. We need more transparency, not less. We need for the Feds to go into triage mode with these guys. Close down the weak and let the stronger survive, but above all the markets need to know as much as possible. Forget heading off panic, the horse is out of the barn. The markets need reasons not to panic, which means actionable information.
 
Written By: Lance
URL: http://asecondhandconjecture.com
Jason,

Thanks for wading through the data. As I said, outside of my circle, and I think anybody else’s.

You are correct about the net exposure in theory, and about counterparty risk. My question is who and what are they exposed to? I suspect a sizable chunk may be people who are very unlikely to pay up, or even more likely, those parties are exposed to people who will not pay up for the contracts written to lay off the risk of paying JP Morgan (or whoever) and so on and so on. The chains of counterparty risk go on a long, long way.
Thus, commercial banks dominated but how did they enter swaps with the low-rated investment banks? What made them take this risk? Does anyone have a good link?
I don’t have a good link, but with the use of swaps exploding not doing business with non AAA credit was difficult. Heck, hedge funds and others were heavy in the business. Also, who had a AAA credit rating? AIG did, and they put no reserves up. People relied on their rating without ever looking at what would happen in the case of lots of defaults.
 
Written By: Lance
URL: http://asecondhandconjecture.com
I don’t have a good link, but with the use of swaps exploding not doing business with non AAA credit was difficult.
I suspect competitive pressure lead to increase risk. But how did they rationalize this risk internally? Did they believe they had collateral they could seize? Did they only consider a few defaults that are isolated to a single institution while assuming no systemic risk?
Heck, hedge funds and others were heavy in the business.
True but hedge funds are buying from the banks with credit given to them by the banks. Most fixed-income hedge funds remember the liquidity crisis in 1998 and liquidated to prepare for the current crisis. They knew they exist at the grace of their creditors. No one lends to the hedge funds with “trust” of their credit worthiness.

My guess is that the Fed’s intervention to protect the creditors of Long Term Capital (in 1998) sent the message that counter-parties will be protected from their folly even if the trouble institution becomes liquidated. This is what happened at Bear. I don’t know the details, however.
Also, who had a AAA credit rating? AIG did, and they put no reserves up. People relied on their rating without ever looking at what would happen in the case of lots of defaults.
True. Interesting enough, CDS spread have replaced the ratings of the rating agencies. Right now Morgan Stanley and Goldman Sachs have high CDS spreads (over 400 bp) with Citi, RBS, and UBS in the mid range (around the 300 level). Thus, the liquid market for CDS contracts gives a market consensus of credit risk of these institutions.

Many of the foreign banks achieve lower spread because of their government backing. However, the European taxpayers are going to pay for that. I wonder if our banks tried to stay competitive with foreign subsidized banks and went out on a limb given the Fed’s message from the LTC crisis in 1998. It wasn’t a bad bet for the commercials. It has shown that the integrated institutions (Citi & Solomon Brothers) withstood the shocks better than the stand-alone Glass-Steagall investment banks (Bear, Merrill, Lehman, etc.) Perhaps they just assumed our government would go "European" when the whole system was threatened. That bet paid off for J P Morgan ... for now.


 
Written By: Jason Pappas
URL: http://libertyandculture.blogspot.com/
My guess is that the Fed’s intervention to protect the creditors of Long Term Capital (in 1998) sent the message that counter-parties will be protected from their folly even if the trouble institution becomes liquidated. This is what happened at Bear. I don’t know the details, however.
Bingo, which is why I have been so upset at the way we have handled the bailouts. We are feeding speculative behavior.
I wonder if our banks tried to stay competitive with foreign subsidized banks and went out on a limb given the Fed’s message from the LTC crisis in 1998.
Definitely, especially in the case of the stand alone i-banks. That was the explicit rationale for waiving the old capital requirements for i-banks back in 2004.

Anyway, if you go back over my posts for the last month you will notice similar themes to what you are positing.
 
Written By: Lance
URL: http://asecondhandconjecture.com
Thanks. I’ll check them out. I haven’t stopped by this venue in awhile and clearly I missed some good stuff.
 
Written By: Jason Pappas
URL: http://libertyandculture.blogspot.com/
"However, it does mean that they depend on each other to stay solvent."

Seems to me like a game of hot potato where everyone gets their own potato.
 
Written By: timactual
URL: http://
So if I understand this right, J. P. Morgan had a total credit exposure to asset ratio of 411! Wow. HSBC leads that game with 721.3 (Table 4). That seems insane.
 
Written By: Joe Canadian
URL: http://
The CDS is a different kind of exchange. It’s an insurance contract wager where one side pays periodic payments while the other side pays losses if they occur.
There. Fixed that for you.

A CDS can be simply a wager in that neither party to the CDS contract has to be party to the debt instrument on which the CDS is based.

There was a very, very informative program on Credit Default Swaps on This American Life on XMPublic Radio Saturday evening. I was lucky enough to be flying through the cotton fields and lovebugs of southern GA at 18mpg while it was on.
 
Written By: Arcs
URL: http://
A CDS can be simply a wager in that neither party to the CDS contract has to be party to the debt instrument on which the CDS is based.
True, and while I expect that is not a large part of JPM’s exposure, who the heck knows?
 
Written By: Lance
URL: http://asecondhandconjecture.com
True, and while I expect that is not a large part of JPM’s exposure, who the heck knows?
Only JPM and the respective parties to the individual CDS know. Like you said — black box — and an individual black box for each CDS at that.
 
Written By: Arcs
URL: http://
Great. Let’s start more rumors about the banks. When will it end? When everything has failed? Why doesn’t the media stop spreading fear before we are in a depression. Isn’t this a type of terrorism? These accusations bring terror to my heart. We have to CALM DOWN. We have to stop gossiping like a bunch of washerwomen. We have to STOP...before everything is gone.
 
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