JP Morgan Chase's Premature Evacuation

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Feb 03, 2009
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As most banks see the brown stuff hitting the fan, they must be really jealous that JP Morgan Chase (JPM, Financial) seem so clean.

JPM's CEO Jamie Dimon was one of the few bank chiefs willing to stick his head above the parapets this week at Davos, saying things like:“We gave them (customers) weapons of mass destruction to borrow too much,” and that bankers did “some really stupid things” over the past few years in their approach to lending and borrowing.

Mind you, he also says: “To policymakers, I say where were they? … They approved all these banks. Now they're beating up on everyone, saying look at all these mistakes, and we're going to come and fix it.”

And that “JPMorgan would be fine if we stopped talking about the damn nationalisation of banks. We've got plenty of capital.”

I’m sure this makes some other bankers a bit sick, as JPMorgan use their strength to load-up on new business by advertising the strength of their capital base, as I pointed out the other day.

They were also a bank that managed to turn in a Q4 profit of over $700 million. That may have been a 76% drop, due to writing off a bunch of bad loans, but was still a profit.

And Mr. Dimon went on to say that JP Morgan had lent $150 billion in the last quarter, including $50 billion in the interbank market.

This shows that JPMorgan has managed to miss much of the real storm of this crisis, although "plenty of capital" is based upon the bank’s $81 billion in tangible capital and $136 billion in Tier 1 Capital.

According to some reports, if the unemployment rate approaches or goes over 8.5% in the USA, then that's rubbish as, using the bank’s September numbers as a guide, JPM would face an additional $10 billion in losses for each 0.5% rise in the unemployment rate above 8%.

As U.S. unemployment rose from 6.2% in September to 7.2% now, this is a real possibility.

Equally, unlike RBS, HBOS, Citi and other banks, does anyone ask why their capital is so strong?

Maybe it’s a little to do with Credit Default Swaps (CDS), a market that JPMorgan invented back in 1997.

In fact, if you click on the links in this entry I posted last year, you’ll find a lot of the history and issues with CDS.

CDS were responsible for the market drying up for liquidity in September 2008 after Lehman Brothers collapse.

For example, according to a report by Barclays Capital last year, the failure of a dealer with $2 trillion in CDS contracts outstanding could lead to losses of between $36 billion and $47 billion for counterparties in those trades. That’s the core of the issues we face today in the capital markets, as no-one knows their total exposures through CDS.

And there were big concerns about CDS when JPM took over Bear Stearns a year ago. Here’s an excerpt from Risk Magazine at the time of the takeover:

JP Morgan's proposed acquisition of Bear Stearns could thrust the bank's already formidable footprint in the credit default swaps (CDS) market through the $10 trillion barrier, raising questions over the prudence of such large concentrations within a single firm.

JP Morgan already has $7.9 trillion of CDS contracts outstanding, more than twice that of Citi, the second largest player in the market, with $3 trillion outstanding. Bear Stearns holds a share somewhere below this, and although it was unable to confirm the exact size of its CDS business, analysts estimate it has as much as $2.5 trillion in swaps outstanding.”

So I wonder something.

Is JPM’s capital base and strong position the result of managing its CDS position to the point of minimal risk, post the acquisition of Bear Stearns.

It may well be the case that JPM made some premature evacuation from all areas of over-exposure and over-leverage post this acquisition, and this might have given them the confidence others do not have in the markets post-Lehman.

This confidence would stem from having a very well-ordered and well-managed CDS book, backed by clear understanding of their leverage and capital positions.

Equally, JPM may be making a mint from the trading of CDS, as they are one of the biggest players in this market. For example, JPM also estimate that investors who are getting out of other exposures will buy up to $200 billion in CDS, selling around half of those in index protection, as they rebalance their books.

The commissions on such sales and structuring is good business for those who understand these products and, according to Seeking Alpha, JPM held $87 trillion of derivatives in total at the end of September 2008, compared to Bank of America's $38 trillion. Nearly all of these are in the OTC Derivatives markets, so they do understand these products.

The fact that they may have unravelled their own positions on CDS contracts, hedged and balanced them, whilst making strong commission for this market might explain why they are giving away their CDS pricing system today, as it no longer gives them any value:

"JPMorgan is making its pricing engine for credit default swaps (CDS) available to the International Swaps and Derivatives Association (ISDA) as an open source platform in a bid to improve transparency in the market." Hedge Funds Review, 31st January 2009

Maybe JPM just understand CDS better than everyone else, because they invented them, and this is why they are managing to turn a profit when others are not? After all, every loser on a CDS contract pays a winner and JPM appear to be winners.

Equally, why is it that JPMorgan made no losses from the Bernie Madoff affair, when most European banks only bought into Madoff on the strength of JPMorgan's backing?

From the New York Times last Thursday:

"JPMorgan Chase says that its potential losses related to Bernard L. Madoff, the man accused of engineering an immense global Ponzi scheme, are “pretty close to zero.” But what some angry European investors want to know is when the bank cut its exposure to Mr. Madoff — and why.

"As early as 2006, the bank had started offering investors a way to leverage their bets on the future performance of two hedge funds that invested with Mr. Madoff. To protect itself from the resulting risk, the bank put $250 million of its own money into those funds

"But the bank suddenly began pulling its millions out of those funds in early autumn, months before Mr. Madoff was arrested.".

Seems to me that this looks like similar behaviour to the way JPM behave with CDS and other market instruments they control and operate ... and maybe that's why their capital base is so strong whilst others are so weak.

Just a thought.

Meanwhile, Mr. Dimon, the cat with the cream, did make one extremely useful comment at Davos:

I haven't yet seen people get all the right people in a room, close the damn door and come out with a solution.”

I agree with that one.

Let’s get ready to rumble.

Chris Skinner
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