Sunday, May 27, 2012

On the supposedly massive JPM trading loss


My teaching term at UCLA Anderson is coming to a close. I am actually already missing my students, though I still intend to give them a hard final.  However, on my first weekend off from teaching, I am finally able to steal time to re-devote to my favorite past-time--blogging about the macro financial events of the world.  For my first blog since March of this year, I am going to do something that I have not done before.  I am running an edited version of an article from a good friend and a colleague of mine at Research Affiliates, Chris Brightman.  I have discovered that most of the really smart things that I can come up with have often been said more eloquently by others.  If, on occasions, you find what I say to be insightful, more often than not, it is because I am ignorant of what other wiser men have already said.  Though, the stupid things I say, I suspect, are probably original.

Anyways, I hope you enjoy the following untitled article from Chris.

***********************************************************

You cannot help but to have noticed the media coverage of the "scandal" about JPM's trading loss. Rather than take the media's word for it that this story is meaningful in financial terms, I decided to actually look at the facts. I thought you might find my quick analysis informative.

JPM runs a $2.3 trillion balance sheet. In micro, this balance sheet is far to complex for me to analyze; that's the job for their risk management staff. In macro, its rather simple. They have about $200 billion in equity capital and $2,100 billion in debt (deposits, fed funds, repos, long-term debt) that they invest. Of this $2.3 trillion in assets $1,900 billion is invested in in loans and securities and $400 billion sits in cash.

The credit, interest rate, and currency risk characteristics of the approximately $2 trillion in interest bearing assets that arise from JPM's various financial businesses will inevitably differ from the risk characteristics of the approximately $2 trillion in interest bearing liabilities that funds those assets. Managing those mismatches is called asset/liability management (ALM). For JPM, ALM is managed by a group called the office of the CIO, let's call it the CIO. The CIO is managing a portfolio of credit, interest rate, and currency derivatives to hedge the risks of its approximately $2 trillion balance sheet. According to media reports, the size of this CIO portfolio is $400 billion (about equal JPM's cash position and double its equity).

In May, JPM reported a $2 billion loss on its CIO portfolio. Wow; $2 billion sounds like a shocking amount of money to lose! Let's grab the pitch forks and demand a regulatory witch hunt!

But wait, how big is this $2 billion loss for JPM? Factually, its 0.5% of its cash and/or 1% of its equity. In context, this trading loss now seems tiny.

As a tax payer backing this too big to fail bank, should I worry about this hit to capital? Well, JPM makes profits of about $5 billion a quarter. So this quarter it will probably report a profit of only $3 billion. Some of these profits it returns to shareholders as dividends and some as buybacks. The rest is retained to fund growth. At the same time it announced the $2 billion loss it also announced it would suspend stock buybacks (presumably in the amount of about $2 billion). Hmm, the loss is only a modest and temporary reduction of this year's distributions to JPM's shareholders. I'm feeling less concerned as a tax payer.

How should I feel as shareholder? How did financial markets react to this news? After trading on Friday May 11, JPM announced the $2 billion trading loss. JPM closed Friday May 11 at $40 and then closed Monday May 14 at $36; a 10% stock price decline in a single day! Mr Market decided that a $2 billion trading loss reduced the value of JPM by $16 billion, from $160 billion to $144 billion. 

Let's put this single day market value loss of $16 billion into a longer time frame. At March 31, JPM traded at $45 per share and had a market value of $180 billion. Then, it was traded at 0.9 times its book value and at 9 times its earnings. Today, JPM trades at $33 and has a market value of $130 billion. It trades at 0.7 times its book value and at 7 times its earnings. Over the past two months, Mr Market has reduced the value of JPM by $50 billion. That $2 billion trading loss now seems truly insignificant. 

Before we interpret Mr Market's deteriorating assessment of JPM (27% stock price decline in two months), let's see what happened to its most direct peer, BAC. Over past two months, BAC's stock price dropped from $9.6 to $7.1, a loss of 26%. Hmm... JPM and BAC declined by the same amount over the past two months. Maybe Mr. Market has nothing special to tell us about JPM and its $2 billion trading loss. Is anything else going on that we might wish to consider? Maybe bank stocks are declining because of the increasing risk of implosion of the Euro. Maybe?

From the facts, I can find no good reason for the media to continue writing about the trading loss at JPM. An informed financial media would cover the announcement and note that the financial impact of the loss is immaterial. The actual coverage is rather different. 

by Chris Brightman

***************************************************************

A Ph.D. student who works with me, Phillip Wool, made the following insightful observation:


"...I find that there's something laughably inconsistent in the press's response to this debacle. Although I completely disagree with the lawmakers on this one, at least they've got a rational motive to scream about JP Morgan's losses: they've been desperately searching for a narrative to support tighter regulation on banks, which was under pretty heavy pressure from lobbyists, from what I'd read. The financial journalists are more disappointing, and I can only chalk their apparent disdain for Jamie Dimon up to a petty sense of schadenfreude. To be consistent--if, as they claim, they're really concerned with I-banks taking "undue" risks in the first place--they'd have to react just as angrily when a bet was seen to have payed off. But of course, when that happens, they [write a story making the CEO a super hero]"


30 comments:

Chris O said...

Professor Hsu,
While we students might still be basking in the afterglow of your final lecture, we also have a void knowing that there is no more Finance Class.

However, we also feel that absence makes the heart grow fonder. By giving us a diabolical final, it might corrupt the sentiments we have for you...

Anonymous said...

Thanks for the excellent summary of the JPM trade.

Anonymous said...

You completely miss the point about why this is newsworthy. If a trading firm wants to make bad bets and lose their money, I could care less.

However, they should not be allowed to do this while taxpayer money and FDIC funds will bail them out if their losses are too big.

jason c hsu said...

I don't think I agree that institutions, which are potentially too big to fail, cannot take risk. I think we have to put "size" of the risk into context. Is 2B+ large relative to JPM's balance sheet and what it earns? Was the loss a one standard deviation outcome or a three standard deviation outcome given the bet in place? We need to answer those questions if we really want a sensible debate about whether JPM was engaged in "unreasonable risk taking" to the detriment of society.

Here is something else to think about. Public pensions and corporate pensions are all implicitly guaranteed by the government and therefore by the taxpayers. Why do we allow them to invest 60%+ in equities, which can lead to enormous risk relative to the liability of those plans? The expected size of the bailout for pension funds will dwarf anything we have seen on the banking side.

Navid Sohrabi said...

I do not think it is fair or correct to compare a pension fund's equity exposure to JPM's CDS HY trade. Their risk profiles are not similar or symmetrical. Also, pensions and their investments are highly regulated to prevent massive blow ups (their effectiveness is another discussion), which is why they are afforded some government protection.

Banks who have a direct line to taxpayer money should not take part in trading speculation because of the moral hazard. Banks like JPM know they can put the losses to the government and get bailed out. For a short period after a crisis, everyone says the right things and that they will not do it again, etc, etc. But without regulation, they will eventually take bigger and bigger risks which at one point will lead to another government bailout. It practically happens every decade (S&L in the 80s, LTCM/Asia/Russia in the 90s, financial crisis in 2008). To think banks are above human nature is a mistake.

The point of the JPM trade isn't the magnitude of the loss (which we do not know exactly as of yet despite what Dimon says, and that uncertainty is why the stock took a larger beating than a $2bb loss would imply). The JPM trade is a sign that the pre-2008 view of risk at banks is coming back. Less than 4 years after that debacle with the economy nowhere near healed, the banks are taking risks that can account for material losses. This is a sign that the risks will only get bigger which would be fine if JPM was a hedge fund. It is not, however, and it is very troubling when they/we know they have a perpetual put option to the taxpayer.

I do not know how the regulation should be structured or what exactly the regulatory definition of a material loss is but restrictive regulation is needed as long they have indirect/direct access to public funds.

jason c hsu said...

Navid, I disagree here on both points.

1. Pension funds are explicitly guaranteed by the U.S. government; through the PBGC for corporate pensions and implicitly for the state pensions. The true liability-defeasing pension portfolio is one that only holds bonds to match the future retirement payments. However, pension funds take on very significant risk by buying more than 60% of the portfolio in equities. They do this to legally avoid fully funding the pension. The average pension fund in the U.S. today is probably 20% underwater because their risky returns have not come close to their targeted returns. That amounts to more than 3T of liabilities that taxpayers must foot for the public sector pensions! The corporate pension underfunding is another 500B.

Firms and states are unwilling to make the proper pension contribution but instead take on large investment risk hoping to fill the underfunding gap. If things turn out well, they win and save themselves trillions of dollars. If their risky equity bets continue to underperform expectation, then taxpayers are on the hook for trillions of dollars. This is no different and, in many ways, far worse than banks, which are too big to fail, taking risk on their balance sheets.

2. JPM is a listed private corporation. Its mandate from shareholders has always been to use its balance sheet to make money. Part of being an investment bank managing risk and return of its balance sheet is that risk happens and the bank can lose money. Whether it is trading, hedging, making loans, advising clients on M&A deals, there is always risk of losing money. And generally, shareholders and debt holders are on the hook for losses. And yes, since JPM is considered too large to fail, there is a positive probability that if it ever runs into existential risk, the government will step in to rescue it. Though, so far, JPM has not had to be rescued. Regardless, I do not think that JPM is somehow forbidden from taking on risk just because when extreme events occur, its losses might spillover to taxpayers. If that argument makes sense, then we shouldn't even let banks lend mortgages since a significant housing bust would cause bank failure which would trigger FDIC payout, which harms taxpayers. If somehow taxpayers are never to be harmed, then we shouldn't definitely not allow FDIC, PBGC, Fannie and Freddie to exist--these are government entities which insure against defaults of one type versus another. These defaults all end up causing the taxpayers money.

Navid Sohrabi said...

You raise good points. However, there are distinct differences.

To address the pension issue, you are absolutely correct that they are grossly overfunded and that the equity bet may not pay off. There is a problem there that needs to be addressed. The difference between that and the bank crisis is in the type of shock to the system. The pension issue will be a drawn out long term drag on the taxpayer, but it does not have the potential to sink the system in a matter of months like the financial crisis did. One is like cancer, the other like a car crash. Both need to be addressed.

In regard to your second point, those government insurances are very specific in what they insure, mainly mortgages, deposits, etc and the banks pay directly into them to have such coverage. The insurance afforded to JPM by way of “too big to fail” essentially covers any activity they partake in (not limited such as banks) and they do not directly pay into an insurance program to cover such speculation. Also, the banks lent too leniently as you said and paid the price as did the taxpayers. As a result, regulation was instated to prevent such practices going forward. The same should occur with the investment bank trading practices. Additionally, the kind of risks we are talking about happen every decade so I don’t think it is so rare that it does not need to be addressed.

I have no problem with JPM taking any risk it wants as long as the government is not going to be responsible for its mistakes, whether that mistake occurs once a decade or once a century. That is not the case however since they willingly chose to become bank holding companies and groveled at the feet of the fed asking for money in 2008. Once they accepted taxpayer money, they invited stricter regulation. Their investments and practices have to be regulated to protect public funds. They can’t have it both ways and they cannot have the potential to take risks that will put the system as a whole at risk. If they really want to, they can become hedge funds.

Anonymous said...

The problem with JP is that Dimon, protrayed by the press in a positive light, found about the trade in the newspaper. He didn't know what his risk exposures were -- so the point is what else is he or are the big banks unaware of? As for the pension issue, the PPA (specifically Boehner) effectively killed the corporate pension plan in America when he did away with smoothing, which was your get something for nothing argument. Yes, corporations and states should fund their liabilities as they are incurred, but if they had to, they wouldn't offer benefits, would they? Smoothing made a kind of sense, but the real problem is that most corporations manipulate earnings through their ROA assumptions -- not dissimilar in its stock price orientation from what Dimon did by selling corporates to cover his loss and touch up earnings -- due in large part to FASB putting off what they should have done before 157, i.e., stop corporations from using pension income based on long term assumptions to prop up earnings: stock price games that result in a loss to the shareholder.

Unknown said...

I agree - let JPM take all the risks that they want. That is between management and stockholders to hash out. If they blow up as a result of a bad hedge or trade, let them fail - the risk of failure is the best "regulation".

Lloyd Chin said...

The problem is that the $2 billion loss has morphed to $4.4 billion and now $7.5 billion before ending up at a potential $9 billion loss.

Yes, "small change" for JPM, however, losses at AIG were manageable until the weren't.

The potential for extremely large losses, a "fat tail event" cannot be properly estimated.

It's like nuclear reactors. No matter how safe you build them, the rate of failure due to unforeseen circumstances cannot be discounted to zero. Are the consequences worth it so JPM can make a few extra billion per year?

Let's also ask ourselves, what did JPM add to the world by taking on these derivative positions?

In AIG's case, they merely managed to extend the time before mortgage CDO's blew up, by effectively INSURING them. They also managed to make a select group of speculators extremely rich.

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