JP Morgan Fiasco Means Higher Interest Rates Ahead
Tuesday, May 15, 2012 at 9:34AM Contributed by Chriss Street. Specialist in corporate reorganizations and turnarounds, former Chairman of two NYSE listed companies. His latest book, The Third Way, describes how to achieve management excellence and financial reward by moving organizations from Conflict and Confrontation to Leadership and Cooperation. Chriss lives in Newport Beach, CA.
If there was an Academy of Motion Picture Arts and Sciences Award for the best acting performance by a CEO, Jamie Dimon of J.P. Morgan Bank would surely win the Oscar for his dismissal of a $2 billion off-shore derivative loss as “a complete tempest in a teapot.” Dimon tried to use all his theatrical skills to distract the American public from discovering that the U.S. Federal Reserve’s policy of loaning money to banks at zero-interest-rates has made derivative trading wildly profitable, but made lending to American businesses less profitable. As fallout from the J.P. Morgan fiasco exposes the bloated derivative activities of major banks, the Federal Reserve will be forced to terminate the zero interest rate policy and let rates rise to retard bank speculative actions. Higher interest rates will stimulate banks to make more commercial and industrial loans, resulting in higher U.S. economic growth.
Achilles Macris, J.P. Morgan’s CIO in their London office, began using the bank’s access to cheap capital from the Fed to amass a huge over-the-counter derivative gamble that high yield and sovereign debt interest rates would fall, after MF Global suffered a $1.2 billion loss on similar bets and was forced to file for bankruptcy last October 30th. Morgan’s gamble became very profitable after December 21 when the European Central Bank (ECB) began making $640 billion of three year loans at 1% interest, referred to as “Long Term Refinancing Operations” (LTROs), available to the banks of Portugal, Ireland, Italy, Greece and Spain (PIIGS). By the end of December, J.P. Morgan’s total derivative exposure was $70.2 trillion on just $1.8 trillion of bank assets, according to the U. S. Controller of the Currency. Morgan is reported to have continued heavy derivative buying in January and February. Its profits soared again when the ECB announced LTRO2 as another $714 billion in three year low-interest loans to PIIGS banks.
The stock of J.P. Morgan vaulted from $29 per share in December to $45 a share in March as rumors swirled that Achilles Macris and his London team of 6 had already made $2-3 billion as high yield and sovereign debt interest rates continued to fall. A jubilant Jamie Dimon announced that J.P. Morgan would increase its dividend and buy back $15 billion of its stock.
Everything seemed rainbows and unicorns for J.P. Morgan until two weeks ago, when France and Greece elected hardcore leftist candidates who want to abandon austerity spending cuts and increase social welfare spending. Interest rates on the PIIGS sovereign debt shot back up and J.P. Morgan appears to have suffered a $4-5 billion loss. It also appears the bank has been unable to limit its losses to $2 billion by selling out of their enormous derivative positions.
Jamie Dimon tried to dismiss the losses by promising heads will roll, but Congressional hearings will soon illuminate to American taxpayers that the Fed has provided the capital that has allowed America’s three largest banks to engage in $173 trillion in leveraged derivative speculation:
|
Derivative Positions & Assets (in trillions of $) |
|||
|
Bank |
JP Morgan Chase |
Citibank |
Bank of America |
|
Derivative Position |
$70.152 |
$52.102 |
$50.102 |
|
Total Assets |
$1.811 |
$1.288 |
$1.452 |
|
Leverage Ratio |
38.5 |
40.3 |
33.4 |
The derivative exposure of these three banks alone exceeds 11 times the American economy and 2.7 times the economies of all the nations on earth. On December 30th, the derivatives leverage ratio of these three banks stood at 37 times. Menacingly, this leverage ratio exceeds the average leverage ratio of 32 times assets for Lehman Brothers, Bear Stearns and Merrill Lynch, shortly before the shock of their collapse instigated the start of the Great Recession in 2008.
After five years of miserable unemployment and virtually no growth, it seems clear the Federal Reserve’s $2 trillion increase in bank lending at zero interest rates has been better at expanding the international derivatives markets than expanding the American economy. The Federal Reserve owns much of the blame for this phenomenon. By keeping interest rates so low, banks were unable to make a rate of return above their cost of capital on traditional lending.
Kansas City Federal Reserve Bank President Thomas Hoenig in a recent interview warned that an extended period of ultra-low interest rates invites speculative behavior: “When you have zero rates that go on indefinitely, you are inviting future problems.” The recent J.P. Morgan derivatives fiasco has demonstrated that the Fed’s zero interest rate policy has encouraged risky financial speculation that is highly dangerous and potentially destructive. It’s time for the Fed to let interest rates rise, so banks can get back to the business of financing America’s real-economy.
Cross-posted from Chriss Street's blog www.chrissstreetandcompany.com
Reader Comments (14)
The Fed didn't increase bank lending by $2T, it increased excess reserves by $2T. Those reserves are still there. It was an asset swap in which the Fed bought long-duration financial assets (Treasuries) and sold short-duration financial assets (reserves) in order to lower long-term interest rates. It had no effect whatsoever on M2, as the NY Fed said a year ago in a research paper. That's because M2 leads M0, and not the other way around. The money multiplier is a myth.
I recommend you read some of their papers. Central banking doesn't work the way you think it does.
The beauty of derivatives is that their duration is considered by the securities industry to be one = equal to money market instruments, because the derivatives supposedly settle up in cash. every day or every third day. Therefore, for accounting purposes the "notional" value returns to zero. This is why you will not be able to discern the scale of derivatives on a bank 10Q or a quarterly investment account statement.
I was the Treasurer of Orange County, California. In 2007, on an $800 million portion of an $8 billion pension account, I discovered that PIMCO had $22.3 billion in European interest rate swaps. A close inspection of the account demonstrated that PIMCO's trades were directional rather than hedges. I had to go through a knock down battle to shrink derivative exposure to $2 billion. When the crash hit in 2008, Orange Countywas the only public pension plan in California that did not have big derivative exposure. As a result, OC was in the top 1% of public pension plans for 1,3 and 5 years in 2009 and 2010.
Current Fed policy has made bank spread lending to businesses an unprofitable activity. This is about to change.
Thanks for getting back to me.
Do you think it's accurate to say the Fed "advanced" cash? To me that sounds more like a loan, whereas QE and Operation Twist were asset swaps. As far as I know there was no repurchase agreement. I suppose since they will be taking the reserves back again at some point, that might be considered an advance.
I'm also a little uncomfortable that the broadest measure of money the Fed appears to track (in public, anyway) is M2. They got rid of M3 back in the 90's, I believe, because it was "too expensive" to gather the data. How something can be too expensive for an organization which has literally an infinite amount of money isn't clear to me.
Another concern I have is that credit always flows to where the demand is, assuming any exists (this is one of the problems in the US, as you point out: a lack of credit-worthy borrowers). In the last year or so the demand has come from China, and countries trading with China (Canada, Australia and Brazil in particular). I don't think it's all that far-fetched to say that perhaps M2 didn't move as a result of QE because the money flowed out of the country and blew up money supplies elsewhere, but I'm a very amateur economist and this is all just speculation.
Here's the thing, tho. That demand has now dried up. The bubbles in Canada, Australia and China look to have very thoroughly burst now, and Europe is on track to disaster. I have a suspicion that some sort of announcement is coming at the G-8 meeting this weekend, which was moved at the last minute from Chicago (where Obama's buddy Rahm is mayor, of course) to Camp David. Obama has never held a summit at Camp David before. In my mind that's a pretty strong signal. So what could the announcement be? Given that Merkel said a couple weeks ago that Germany is willing to undergo higher inflation, and given the overwhelmingly anti-austerity result of the regional election on Sunday, I wonder if they're not going to announce a devaluation of the Euro (which would obviously involve spending lots and lots of money, perhaps through the European Investment Bank). In that case people would quickly realize that almost all other currencies are also too strong versus the dollar (or that the dollar is too weak -- see commodity prices), and they'd all adjust very quickly downwards. Mark Carney of the Bank of Canada has been warning about inflation for several years, and recently said that he might have to use "monetary policy" in the event of extraordinary circumstances threatening the financial stability of the country. Well, you can't get much more extraordinary than right now.
What are your thoughts on that? If there is a devaluation of other currencies against the USD then wouldn't that mean deflation in the US and inflation everywhere else? This makes sense to me because Treasury has been making noises about issuing floating-rate bonds recently, and I don't see why they'd do that if they expected interest rates to go up. My vague notion is that they're going to allow ZIRP to continue in the US temporarily while the rest of the world inflates and exports to the US, which could use the massive inflow of capital fleeing emerging nations, Canada, Australia etc. to fund programs to get money into Main St. A New Deal 2.0, if you like. This seems to me to be the only way to deal with the problem without catastrophic deflation and a EZ breakup, which no-one wants despite the politicians' saber rattling.
Very interesting info about Orange County. Good call! Have you written more about that?
P.S. Do you think you could persuade Mr Richter to put a log scale on the y axis of the "DEBTOR NATION" chart? It's a bit ridiculous as it stands :)
The Fed took collateral no one wanted and gave cash = sounds like an advance to me.
Getting rid of M3 was a canard. The Fed has plenty of resources, but did not wanted to keep its activities more opaque. Lombard Street and a couple of other economists work dilligently to recreate M3. It would be much more illuminating if the Fed shared their knowledge on this issue.
I believe QE2 was the equivalent of a finacial attack on China to create big inflation as punishment for buying huge amounts of T Bonds to push U.S. competitiveness down and Chinese competitiveness up. One of the unintended consequences was vicious inflation in the Middle East that launch the "Arab Spring".
Credit does not flow to demand, credit flows to its highest return given the rules. Money center banks would finance Columbian drug lords if it was legal and the rates were high. There just isn't any margin, given the current bank rules, to make the bank's 175 basis point spread to justify a big increase in commercila and industrial loans. Given the current rules, banks could make many multiples of "small spreads" on providing liquidity to the derivitives market. One of the reason JPM was going to make $18 billion is that they were the deepest pocket counter-party for prim dealers. The problem with small margins leveraged up is black swans.
America is still in deflation. There is no worker wage power. This has flipped the terms of trade and made America much more competitive. Manufacturing in-sourcing is returning with a vengence. We also are on the verge of energy independence through natural gas, It will takle $2 trillion to build out this infrastructure to distribute NG and export LNG. This is what the banks need to start funding.
Obama is a game show host, who had is day in the sun. Nobody takes him very serious anymore. Devaluing the euro will just make Germany more competitive. The euro is one size fits none. Europe is in balance with no net trade deficit or surplus. Germany has 3% unemployment and much of the rest of Europe has 20% unemployment. The euro can only last if the Germans are willing to fund social welfare for all of Europe. Generosity has not been a big foreign policy of Germany in the past.
The U.S. dollar has cemented its sole reserve currency status for the next 2 decades. America is moving from a service based economy with high debt growth, to a production based economy driving productivity and wage growth.
Agreed. But I guess the thinking was that the lifetime of the govt (in which I include the Fed) is sufficiently long that they really can wait until people want houses again, even if it takes 30 years. And as the currency issuer their balance sheet isn't really very relevant. What's relevant is inflation.
"Getting rid of M3 was a canard. The Fed has plenty of resources, but did not wanted to keep its activities more opaque. Lombard Street and a couple of other economists work dilligently to recreate M3. It would be much more illuminating if the Fed shared their knowledge on this issue."
That's what I suspect too. The Greenspan era seems quite different to me than the Bernanke era. The former canned M3 possibly to hide the true extent of credit growth because his extremist laissez-faire ideology told him everything would be fine, whereas the latter is pushing for more transparency. Whether he's being genuine is another question, but I have no real reason to doubt him as of yet.
"I believe QE2 was the equivalent of a finacial attack on China to create big inflation as punishment for buying huge amounts of T Bonds to push U.S. competitiveness down and Chinese competitiveness up. One of the unintended consequences was vicious inflation in the Middle East that launch the 'Arab Spring'."
Yes, I've thought about that myself. On the other hand, the Chinese did benefit from the increased value of their reserve assets. I'm not entirely convinced the Arab Spring was an unintended consequence. I have no real opinion either way, but I do know enough about statecraft to know that it's not beyond the realms of possibility. The Chinese-driven property bubbles in the Western world was probably unintentional, though.
"Credit does not flow to demand, credit flows to its highest return given the rules."
The highest returns exist where demand is strongest :)
"There just isn't any margin, given the current bank rules, to make the bank's 175 basis point spread to justify a big increase in commercila and industrial loans."
I'm not sure this fits with what I've been reading in various Fed confidence reports. My impression was that companies have plenty of liquidity, just nothing to spend it on due to a lack of demand.
"The problem with small margins leveraged up is black swans."
I don't believe in black swans. Shit happens. The problem is the models they use (especially VaR) are complete bunk, because they're based on faulty mathematics. Have you come across the work of Steve Keen? He has an excellent series of lectures on credit and behavioral economics on YouTube. He's developed several mathematical proofs (by contradiction) showing that the very foundations of neoclassical economics are dead wrong. Asset prices follow a power-law distribution, not a normal distribution. Even Fama and French admitted in 2004 that CAPM is based on ludicrous assumptions, but that doesn't seem to have stopped people using it to make enormous bets with other people's money. And they didn't give back their pretend Nobel, as far as I'm aware.
"Obama is a game show host, who had is day in the sun. Nobody takes him very serious anymore."
I think people are underestimating him. I'm anticipating a flurry of pre-election revelations. What better way to put your opponents on the back foot than to appear ineffectual while actually working on a plan to, for example, save the world's financial system? Just a hunch, but Obama doesn't seem like the kind of guy to sit around and let "this sucker go down". Nor does Geithner.
"Devaluing the euro will just make Germany more competitive. The euro is one size fits none."
Not if they announce Eurobonds at the same time.
"The euro can only last if the Germans are willing to fund social welfare for all of Europe."
I don't agree. Yes, there need to be transfer payments, just as there need to be transfer payments from NY to TN. But the Greek export sector is actually a lot bigger than most people think. They need to get their shit together, but I think a (temporarily?) devalued Euro plus joint-and-several liability would go a long way to making them competitive again. Likewise Spain, Ireland, Italy, France. I've traveled in most of Europe and they're not the slack-jawed layabouts everyone seems to like to make them out to be. Europe was once the most powerful continent on the planet for a reason. They still have what it takes, which is why I've been buying Euro stocks this week. There's too much gloom.
"Generosity has not been a big foreign policy of Germany in the past."
Well, except towards East Germans. That was a special case, I admit, but individual Germans are very generous, at least according to this site:
"Although Germany is a leader in foreign trade, it has never been generous with foreign aid. West German official developmental assistance between 1976 and 1989 ranged between 0.40 and 0.47 percent of German GDP, well below the 0.70 standard proposed by the United Nations (UN). German aid sank to 0.36 percent of GDP in 1993 as the costs of unification reinforced the reluctance of the German government to grant assistance. But German private contributions to international causes, especially for humanitarian purposes, are consistently high. During 1992 those contributions matched the level of official assistance." - http://www.mongabay.com/history/germany/germany-foreign_aid_.html
"The U.S. dollar has cemented its sole reserve currency status for the next 2 decades. America is moving from a service based economy with high debt growth, to a production based economy driving productivity and wage growth."
I agree. I've never not agreed with that, actually. I've always considered America to be the strongest country on Earth and likewise its currency. Where does everyone flee to when trouble's a-brewin'? I'm saddened that so many Americans are anti-America, anti-government, anti-capitalism, pretty much anti-everything -- but I guess that's what prolonged high unemployment does to a society. I think Americans will soon realize that they really do live in the best country in the world, and that should be amazing for morale and productivity. I'm very bullish on America and I can't wait to see her regain her full glory.
Concerning the debtor nation chart: I need to update it to include fiscal 2012, when gross national debt will be over $16 trillion. So it will look even more ridiculous. But I won’t put a log scale on it. You’re right, it looks ridiculous ... because the way our debt is growing IS ridiculous (and sad). A log scale would diminish the true tragedy of what they’re doing in Washington. It’s a bipartisan act of irresponsibility and vote buying, and the graph shows it in a simple way. Just wait till you see the $16+ trillion version. Or the graph for fiscal 2013....
I could adjust it for inflation, and that would shrink it down a lot. But then I’d have to show a graph of what the Bay Bridge cost in 1933 ($77 million) and what HALF of it costs today ($7.2 billion), and that would look even sadder. For more on the Bay Bridge, check out http://www.testosteronepit.com/home/2011/7/25/our-chinese-bay-bridge.html
I agree with Chriss: I don’t think that the euro will be devalued anytime soon in an overnight way. It wouldn’t help Greece and other weaker Eurozone members (they would still have to compete with Germany in the same monetary union). It would help German exporters who export outside the Eurozone, but it would wreak havoc with the German economy, which imports almost all of its raw materials, and lots of finished products and components. And it would be political suicide for anyone who has anything to do with it in Germany (and other countries by the way).
No worries! I very much enjoy your blog, especially the Euro stuff. Nicely done.
"A log scale would diminish the true tragedy of what they’re doing in Washington"
Actually, it would show exactly the same data, but it would be more technically accurate from a scientific point of view. When you have a large range on the x axis (e.g. from 1960-2011) and an exponentially growing time series, it's standard to use a log scale. People who know how to read plots will still appreciate the import of what it says, and they'll know you know how to do plots properly :). As it is, the linear scale and the "portrait" orientation of the plot made me think on first glance that you were deliberately trying to make the situation look worse. But I'm coming at this from a technical perspective; I understand most of your readers don't have a firm position on how plots should be done ;)
http://www.fool.com/foolfaq/foolfaqcharts.htm
By the way, I did post a reply to Chriss, which said it was awaiting moderation, but I've not seen it appear yet. Should I repost it? (I wrote it in a text editor so I still have a copy.)
I noticed you added Recaptcha. Is blog spam getting bad again? It seemed to me like it dropped off there for a while (or maybe the blogs I read just got better at filtering it).
Maureasy - yes, interesting table.
Yes, the whole "notional vs gross" thing ZeroHedge has been going on about for ages now.
I'm sure you're right about Greece/Goldman. Back when the Greek thing first started it was reported that Goldman "helped" Italy with their budget too. I've not heard anything about that since. You'd think it would be an interesting story for a reporter to dig into, but nada.