Last week I posted a short piece complaining that the press coverage of the Whale Trade was low-balling the eventual and/or possible loss. The press has been slowly catching up to reality, and now figures from 3 to 7 billion in losses are tossed around instead of the original 2 billion estimate.
Then yesterday, the consistently excellent FT Alphaville provided an interesting summary of a Morgan Stanley research report on the situation at JPMorgan. Apart from the stated guesstimate of 5 billion in immediate losses, one chart in particular seemed to leap off the page.
Here we see the state of JPMorgan’s credit derivatives book as compared to its peers. On the top, we see the other big banks being net insurance protection buyers, hedging prudently against losses in their holdings of loans and bonds. And down at the bottom we can see how JPMorgan took a look at the risk of losses on their loan book, and decided to double down in a quite hazardous manner by being net sellers of credit insurance, i.e. making a big bet that their loans won’t go bad. And the sharp dip between the last quarter of 2011 and the first quarter of this year? That is the so-called ‘risk-mitigation’ unit of JPM finally deciding to go … all-in.
So just how dangerous is this 150 billion dollar CDS bet really? After all, JPM have 189 billion in shareholder equity. They are big boys. And they have been selling insurance on a very safe index of US corporates, and part of it allegedly on Super Senior tranches (read ‘Super Safe’).
How could it possibly go wrong?
Let me then tell you a long-forgotten story, now the stuff of faint memory. Long, long ago in a land
far far away, there was a huge company called AIG. It was the strongest company in the land, with 1 trillion in assets, a strong cash-flow and a whopping 95.8 billion in shareholder equity. Over the course of a couple of years, they wrote credit insurance (CDS) on Super Senior tranches of super safe collateralized debt obligations diversified by sector and region, you know, the kind of thing that they would never actually have to pay insurance on. Because there would have to be massive 15-20% defaults before the Super Senior tranches of those CDOs faced losses. The AIG executives were laughing all the way to the bank, calling the sale of these CDS as “gold” and “free money”. They loved the program so much they sold CDS insurance on 64.1 billion in value of these multi-sector CDOs. Nothing could go wrong, and even if it did, even a large loss on 64.1 billion in notional value was barely a dent in their almost 100 bn dollar shareholder equity.
Nonetheless things began to go badly for poor AIG. The housing crash caused even the Super Senior tranches of CDOs to take losses and AIG lost 31.1 billion on the insurance they had sold. That 31 billion was naturally not enough to sink the great AIG. But it did make AIG’s creditors and counterparties nervous. And those nervous creditors started to pull their lending, in the so-called repo market, and in the commercial paper market. And the nervous counterparties demanded more and more in collateral on their deals. All of a sudden AIG found itself unable to fund its holdings of financial assets, and needed cash to pay off creditors and to pay off counterparties. So it had to sell its precious assets off. But, poor unlucky AIG, just as it needed to cash out its assets, it found that the value of those assets was falling as the whole market started sliding downwards. And as they did so, AIG found its shareholder equity (the difference between the value of its assets and its liabilities) suddenly vanishing into thin air as well. Oh dear…
Do not worry, though, dear reader, for AIG had a good friend called Uncle Sam, who saved the company and all its traders’ bonuses. However, Uncle Sam had to send a mysterious creature called the “Main Street Economy” into a deep and neverending depression, but that’s another story that need not concern us here.
The moral of the story is that a net 150 billion dollar Bullish CDS position, more than twice the amount that did the great and mighty AIG in, is dangerous even for the greater and mightier JPMorgan.
We might try to console ourselves that JPMorgan has written insurance only on an index of quite strong US corporates. It would take an unthinkable calamity for them to take serious losses on this index, because it would involve 10-20% defaults amongst some of the strongest US companies, the likes of
CIT Group, Fannie Mae, Freddie Mac and Washington Mutual … … well, uh, mostly really strong companies, you know.
And that level of defaults would only occur if something inconceivable happened, for instance, the dissolution of a major currency union, causing the banks within that union to off-load their massive holdings of US corporate debt as they scamper for cash.
You know, the kind of thing that isn’t at all right around the corner…
Why is all this important? Apart from the obvious, it is important, first, because Jamie Dimon seems to have made a decision to let the bank sit on top of a potentially catastrophic loss in the hopes that … catastrophe doesn’t strike …, rather than take a slightly painful 10 billion dollar loss in the current quarter. That is to say, press reports suggest that JPMorgan has stopped unwinding the bullish CDS position, and is not hedging it extensively in any other way, due to the high cost. This means they are just sitting on this risky position for the time-being. And that is a socially irresponsible thing to do.
Second, even as Jamie Dimon does this, regulators seem content to let him not only do nothing to mitigate the underlying risk, but also continue to pay out the usual shareholder dividend, where instead they should be forcing him to strengthen the bank’s capital buffer. Again, a deeply irresponsible move on the part of regulators who seem to serve the banks, bankers and shareholders, more than they serve the tax-payer.
(P.S. A caveat of sorts is in order. The chart above oversimplifies JPMorgan’s net CDS position somewhat. If, for instance, they have bought CDS on so-called ‘mezzanine’ tranches that are more volatile on the whole than the CDS that they have sold, then, in some scenarios where defaults occur, the winnings on the insurance they bought might cover to some extent the losses on the insurance they sold. So a small credit crunch might not endanger JPMs solvency. It would take a major crisis.)