The mainstream media is abuzz with stories about JPMorgan's $2 Billion in trading losses in just the past six weeks. Here some typical coverage: JPMorgan Hit by ‘Egregious’ Trading Loss of $2 Billion. The culprit? It was derivatives.
Ah yes, those pesky derivatives. Ich habe es Ihnen gesagt (way back in 2006.)
I won't re-hash the details of the JP Morgan debacle that have come to light, because they have already been spelled out by many journalists. The best analysis that I've found thusfar came from the editors of Zero Hedge, in this piece: The "World's Largest Prop Trading Desk" Just Went Bust. The facts are all there. There is also some good commentary at Fierce Finance: JPMorgan "hedges" look like prop bets.
What are the implications of this mayhem? They are all bad, especially for Mortgage Backed Securities (MBS), Credit Default Swaps (CDSes) and other collateralized debt obligation (CDO) derivatives. The band of fools in JPMorgan's Chief Investment Office (CIO) were buying up CDOs at the same time wiser heads in the banking world were avoiding them like proverbial hot potatoes. It is noteworthy that most of these derivatives were purchased after the 2008 credit crisis. In the greedy eyes of the JP Morgan derivatives trading staff, buying this paper after it had taken a 20% haircut appeared to be a bargain. To compound their problems, not only they take on CDS contracts, but they created additional hedges around those derivatives. This is like taking a bet on a bet. What idiots. There is lots of conjecture about what was really going on in Morgan's CIO. Was it all a hedge on inflation that went awry, because deflation lingered longer than expected? It may be weeks before the cognoscenti speak and we learn the full story. But one thing is certain: There is a fine line between hedging and proprietary ("prop") trading, and the CIO appears to have crossed the line. And their hedges were big enough that they shifted the landscape of the entire CDS market. (They have hundreds of billions of dollars in derivative contracts in play at any given time. The counterparty risk is huge.)
The world of derivatives is a wilderness of mirrors. There are far more reflections (or vehicles) than there are real assets. There are synthetic CDOs--these are collateralized debt obligations (CDO) that are based on credit default swaps (CDSs) rather than physical debt securities. There are passive CDOs, and managed CDOs. (Those CDOs were what caused the huge writedowns of both Citigroup and Merrill Lynch.) There are Structured Investment Vehicles (SIVs), Super SIVs, and SIV-lites, all created by packaging multiple CDOs. SIVs are vehicles that allow banks to borrow short and lend long. There are variable interest entities (VIEs)--one of the favorites of the now-defunct Enron Corporation. Then there are Qualified SPEs (Special Purpose Entities or QSPEs) and Special Purpose Vehicles (SPVs) which are entirely new corporate entities--usually set up offshore--just for the purpose of handling SIVs and various CDOs. Ask presidential candidate Mitt Romney to explain these, since he is an expert. But then, he might not want to talk about it. So instead, read Moorad Choudhry's book "Structured Credit Products: Credit Derivatives and Synthetic Securitisation."
There is nothing quite like buying into a falling market. On Wall Street, they call that "catching a falling knife." Many of the Credit Default Swaps that the JPMorgan CIO was trading were investment grade corporate bonds. But some, no doubt, were tied to real estate--the notorious residential mortgage backed securities (RMBSes). With so many foreclosures now hitting the market, the bottom for residential real estate in the United States is still nowhere in sight. And RMBSes are the main "assets" underlying most of those CDOs. In this amorphous era of the Fed's Zero Interest Rate Policy (ZIRP), the practice of borrowing short and lending long can't go on for much longer. At some point, interest rates will rise, and there will be blood in the streets. We must also consider that JP Morgan isn't the only trading firm holding this stinky paper. There are probably lots of others that pursued similar hedging strategies. But because of its size, JPMorgan got all the recent publicity. I suspect that the full extent of the losses--especially those by other banking and hedge firms--have not yet been reported.
The bottom line, predictably, is that it is the American Taxpayers who are the ultimate guarantors for the losses caused by their folly. In the millennial era, the banksters consistently bet big, knowing that if they lose, then there will always be another bailout. They have a the certain knowledge that they have the Federal government in their back pocket. (The lack of a criminal indictment of MF Global Chairman Jon Corzine was clear evidence of that.) The "Too Big to Fail" mantra is now so engrained that the bankers feel invulnerable. This is one reason that the derivatives casino has grown tremendously. Of course they are willing to gamble when it is a "heads I win, and tails you lose" proposition! Banks that have their losses guaranteed by the government (and ultimately, by our tax dollars) shouldn’t be sitting at a casino table, slurping down liquor. But in effect, that is just where they are.
What will be the end result of JPMorgan's huge losses in derivatives? Just a wait a few months. We likely hear post facto that there was a quiet bailout, measured in billions. The Mother of All Bailouts (MOAB) is alive and well.