JPM Derivatives Monster Crashes

Zeal Intelligence ^ | 7/26/02 | Adam Hamilton

[Torie]

Derivatives.

[tcostell]

I'm sorry I don't mean to be dense, but this is a little too cryptic for me. Can you elaborate a little?

[bvw]

Well, let's see if things unwind nicely or shatter.

[isthisnickcool]

Thanks! Voodoo.

Sounds like this stuff should be more closely regulated than it is.

[tcostell]

Again, I'm sorry. Are you saying that if they don't "shatter" then it is proof of their corruption, but if they do then they were honest?

[bvw]

Was there a lot of pride in that division? Who did they hire?

[junta]

For a counterpoint see Doug Noland's analysis at prudentbear.com. While they are wise to straddle and probably effective in doing so they are beginning to straddle an ever widening crevasse as some of kinkier deals look less comforting to S&P.

[Torie]

Derivatives are useful risk hedging tools. The problem though is then when they are leveraged. Hedged positions require maintenance to stay hedged as prices move. The problem is that when there are big price moves, the market can become illiquid, and preclude keeping the hedge in neutral. At that point, one is exposed to risk, and with leverage, that can become quite expensive.

Derivatives are also used to try to exploit small perceived inefficiencies in the market, with the exploitation made more "profitable" with high leverage. Sometimes though, such "inefficiencies" are not really so, but rather rational pricing differentials that reflect rare events. When those rare events pop up, the thousands of small profit trades can be wiped out and then some in a matter of hours. That is what happened to Long Term Capital Management. They thought they were exploiting inefficiencies in the bond market, and then things took a big dump when the Asian contagion hit, and the music stopped.

[Washington-Husky]

Just curious, do you feel JPM's dividend is safe? (Their stock, at these levels, with that high a dividend (currently yielding around 6 percent) makes a compelling investment idea...)

IMWTK

[arete]

Without fail they are all among the most fanatically honest and respectable people in the industry

So which part of the team was helping Enron cook the books?

Richard W.

[tcostell]

Saying that JPMorgan helped Enron defraud it's investors is rather like saying that the gun dealer is responsible for murder. JPMorgan sold Enron special credit risk management products, but did so under the assumption that the transactions and their inherent risk would be adequately reported by Enron's management to their board and investors. It was never JPMorgan's job to guarantee that Enron's management was operating ethically with regard to their investors, nor should it have been.

But please don’t let the absence of facts get in the way of a good lynching.

[tcostell]

I haven't really looked at the stock or the fundamentals of the company. but I'm confident that it is no worse of a stock because of their derivatives position.

Regards.

[Torie]

No, actually they were marketed as an off balance sheet device. Without that, the product would have no purpose. Granted, it took lax auditors to make the product "work" close the sale. The problem is the JPM and Citicorp knew that their product was the functional equivalent of debt, that it was not on Enron's balance sheet, and that of a few other companies that bought the accounting gimmick product, and that therefore investors were being misled, by design. Thus the banks have huge legal exposure, as recognized by the markets.

[blam]

"So, I moved anything that I could that was short term and uninsured out. So were other people. I could hear them doing it."

I shuffled some cash out of the bank myself.

[tcostell]

These markets only seem secretive from the outside. Anyone who has worked on the trading floor of a major sell side institution knows that there are no secrets in the finance world. All the references to "da Boyz" and to the secret controlling "fat cats" dominating markets and controlling stock prices are just paranoid nonsense.

The industry is so competitive, that it's impossible to keep anything secret form your competitors, and if anything is illegal, they wouldn't wait 2 seconds before running to the authorities. The big scandals you hear about in the US finance industry, are cases of poor internal controls, not illegal activity.

More and more on FR I see posters who are throwing out the last 50 years of economics, or writing up obvious hatchet jobs in order to instill fear, and promote themselves (or gold speculation) as the last hope for civilization as we know it. I take offense to that. I have a great affection for the people on this site, and I hate to see them so obviously manipulated.

This article was an obvious attempted hatchet job. It’s so full of slant an innuendo, that it sounds like it was produced by the socialist party. And I don’t, think it promotes a view of JPMorgan or the US finance industry that is at all realistic.

Now if you don’t believe me, that’s fine. I have nothing to sell to you, and wouldn’t want to anyway. All I suggest is that you all think carefully about the motives of the authors of some of these articles.

[Washington-Husky]

Did you remove money from that bank as an expression of protest or disgust with their practices... or are you suggesting that Citibank could eventually declare "bank holiday" and not be able to pay its depositors? (...or, all of the above??)

[tcostell]

As you are clearly aware, all OTC derived products are "off balance sheet" transactions regardless of their similarity to debt. And I agree there will probably be someone trying to make the claim that the banks had liabilty, but US law is stuffed to the rafters with previous cases on the subject. I personally don't think they have much of an argument.

I could be wrong, but I feel pretty confident about it.

[arete]

But please don’t let the absence of facts get in the way of a good lynching.

I believe that you seem to overlooking the facts here. JPM knew exactly what the purpose of the arrangements were. Enron needed revenue to explain high profits. JPM knew the Enron was going to report the money as revenue when it really wasn't. Any empty claims that JPM makes about how they just drove the getaway car, are laughable. They knew what Enron was doing and they helped facilitate and eagerly participated in it. I hope that the class action lawyers pick their bones clean.

Richard W.

[Torie]

No, the economic substance of this will dominate, and there is a catchall in GAAP that if following technicalities does not reflect economic substance, than the latter must be dispositive. The prospect of big bucks for all caused a whole lot of greedy folks too cute by half. They might have got away with it if the roof had not fallen in. But it did, and they won't, and I disagree with your assessment of the magnitude of the legal liability. I think it is mega. I think some of these bank folks might be headed to jail in fact, but if not that, liable for a massive civil fraud.