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?
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]"