Why JPM has the Market Panicked-OR-All you ever wanted to know about derivatives

MoneyCentral ^

[BlackJack]

You’ve got to understand how important the derivatives business is to J.P. Morgan Chase today -- accounting for 15% to 40% of revenue. That’s not insignificant at a bank that issued a huge earnings warning on Sept. 18, saying that third-quarter earnings would be substantially below those for the second quarter of 2002. Anything that would threaten that revenue stream would be a big deal.

To understand what might threaten that revenue, you’ve got to understand something called counterparty risk. When a derivative is created, somebody winds up holding the risk; it’s the other party in the transaction that helped someone shed the risk. Counterparties themselves don’t hold onto all of the risk. They use more derivatives, in fact, to pass it on to other parties. Part of the science of designing a derivatives portfolio lies in putting together the pieces of the portfolio so that all the risks -- those the bank has assumed and those it has laid off on other counterparties -- net out to something close to zero under most market conditions. That leaves the bank with no risk, as far as the mathematical models can tell, and just the fees earned in passing paper around.

Now, the company that is trying to lay off risk through a derivative certainly doesn’t want to pay a fee and take on the potential risk that the counterparty won’t have the cash to pay off on the derivative. Rather than just trusting that the counterparty has built its portfolio correctly and laid off its own risk, the derivative customer looks for a counterparty with a solid credit rating. It’s therefore critical to J.P. Morgan’s revenue that its derivatives-facilitating unit retain a top-notch credit rating. Otherwise, derivatives customers will go elsewhere with their deals.

Before the earnings warning, the J.P. Morgan Chase Bank unit had a credit rating of AA-, well above the rating of most investment banks and most of the corporate customers who do business in the derivatives market.

But after the earnings warning, Standard & Poor’s cut the long-term counterparty credit rating at the unit to A+, down one grade, and the short-term rating to A1 from A1+. And Standard & Poor’s has the company on credit watch with a negative outlook for further possible credit rating downgrades.

The disaster scenario

From this, I think you can construct the disaster scenario that so scares some on Wall Street. The downgrades are enough to encourage some of J.P. Morgan’s customers to take their business elsewhere. That -- plus the other big problems at the bank that are part of the general carnage among investment banks and its portfolio of bad telecommunications loans -- takes another bite out of earnings. Which leads to a further credit rating downgrade. Which leads to more earnings declines. Which leads to more credit rating downgrades. At some point in this process, J.P. Morgan finds that it has more at risk in the derivatives market -- the bank’s actual value at risk runs in the tens of billions, according to some estimates -- than cash and … something bad happens. Whether it’s an outright failure or simply a near-failure that requires a Federal Reserve-led buyout, the event would certainly send shock waves through the financial markets

[BlackJack]

Read the whole article. It explains derivatives. This is mainstream media info on JPM.

[mjp]

Another article on this subject here

[Vince Ferrer]

There was one theory from JPM bears about the stock price. They said if their stock went below $20, all kinds of catastrophies would happen, and gold would skyrocket. It has been below $20 for about two weeks now, and the world didn't end. When is all of this bad stuff supposed to happen?

[Anti-Bubba182]

DONATE TODAY!!!. SUPPORT FREE REPUBLIC

Donate Here By Secure Server

Or mail checks to
FreeRepublic , LLC
PO BOX 9771
FRESNO, CA 93794

or you can use

PayPal at Jimrob@psnw.com
STOP BY AND BUMP THE FUNDRAISER THREAD

[tubebender]

I read in Barrons yesterday and heard someone today calling for replacement of CEO Anderson (i think that's his name) I don't see how that can help at this late date.

[Fractal Trader]

The problem here is similar to the Enron-style shell game, only in this case we are a bit more informed as to the financial aspects of the situation.

Basically, a company which engages as an intermediary in trading activity has to have a sterling credit rating or else traders will begin to doubt whether the intermediary (counter-party is the correct term when dealing with derivatives) will be able to enforce the terms of the contract when it comes due.

While JP Morgan has more financial strength than Enron, continued balance sheet weakness will drive traders away from it to other, more reliable, counterparties. Its major competitor is Morgan Stanley, which is also forecasting earning difficulties.

A worst-case scenario would be for all major players to lose their balance sheet luster, and the market for derivatives could dry up completely, which is what happened in the commodity markets after the 1970s. An alternative scenario would be for new counterparties or counterparty markets to develop to take away the lucrative business from these major banks. Either way, the derivatives market bears watching and the major counterparty players such as Morgan and Chase could well see a cascading collapse as traders flee them for safer options (forgive the pun).

[WOSG]

look at the energy markets for this effect.

[TheLion]

In the early 90's the media had the insurance companies on the run as the next savings and loan debacle. I see a little resemblance here. It was almost a self fullfilling prophecy. The author of this article doesn't have enough information to drawing conclusions about derivatives. I see this all the time on this website...derivatives in the trillions. First we need to understand what they really are and what the risks really are. This article sheds little light on either. One thing is for certain and that is the markets could sink JPM without anything to do with derivatives........is that the self fullfilling prophecy. I for one would like to learn more about derivatives and not just use them in debate to warn of the imminent collapse of global financial markets.

[BlackJack]

Tokyo, Oct. 9 (Bloomberg) -- Mizuho Holdings Inc. and UFJ Holdings Inc. led drops in Japanese bank shares on speculation their loans to problem borrowers may put them first in line to be seized by the government.

Mizuho, the world's biggest bank by assets, and UFJ, Japan's fourth-largest lender, both fell as much as 30,000 yen, their daily limit, to record intraday lows of 164,000. Both lenders traded 7.7 percent lower at 179,000 on the Tokyo Stock Exchange as of 1 p.m. Japan time.

Both Japanese and foreign investors are concerned about Japan's banks, which they say may have more bad loans than the official estimate of about 52 trillion yen ($422 billion). The government may need to seize the most troubled lenders to reform and revive the industry, said Richard Medley, chairman of Medley Global Advisors, a New York-based hedge fund adviser who previously worked for George Soros.

``There may have to be a nationalization of a (major) bank or two,'' Medley said. ``The most important thing that can get done now is to support Minister (for Financial Services Heizo) Takenaka in his effort to get the bank situation dealt with as rapidly as possible.''

Takenaka, who was last week named to his post, has said Japan will consider injecting public funds into banks. Finance Minister Masajuro Shiokawa has said Japan must use taxpayer money to ``rescue'' the industry.

Takenaka is scheduled to hold a monthly press briefing on the economy at 4.15 p.m. Tokyo time, in his capacity as minister for economic and fiscal policy.
__________
Looks bad for world banking. Mizuho is the worlds biggest bank.

[Rodney King]

worst-case scenario would be for all major players to lose their balance sheet luster, and the market for derivatives could dry up completely, which is what happened in the commodity markets after the 1970s. An alternative scenario would be for new counterparties or counterparty markets to develop to take away the lucrative business from these major banks. Either way, the derivatives market bears watching and the major counterparty players such as Morgan and Chase could well see a cascading collapse as traders flee them for safer options (forgive the pun).

Good post. The internet guys who keep screaming about JP Morgan are confusing the collapse of JP Morgan from a scenario similar to the above one with the notion that JP Morgan is somehow exposed to these trillions of laibilities and that a worsening financial performance by JP Morgan will mean that somehow all these outstanding derivatives contracts will cocme due with JP Morgan liable for, but unable to pay.

[TheLion]

I understand the article on the Japanese bank but how do derivatives fit in here? Were they the ones with the risk?

[MoralSense]

Right. Or else JPM would be forced to re-price its options more attractively, to offset the perceived counterparty risk. Either way, there's a market solution, and, the derivatives market being what it is, a very fast market solution.

[ameribbean expat]

a well written "article", with a broader view of how derivatives affect the equity and credit markets.
http://www.capitalstool.com/cgi-bin/ikonboard/printpage.cgi?forum=1&topic=5067

[galt-jw]

if you have any money in the stock market you want to protect, get it out and into bonds, now.

two things: pension scandal.
derivative debacle.

this will be a big dip, and you may want to hold a cash position in order to buy some great values out there.

Meanwhile, libs, dems, the Dumb and Old will be losing their ass, which, of course, they deserve, because they voted for it all these years.

[Deuce]

I for one would like to learn more about derivatives and not just use them in debate to warn of the imminent collapse of global financial markets.

The three most important things to understand about derivatives are:

1. They are one of the tools that the unproductive financial sector uses to rip off a bigger piece of the proverbial pie from the productive sector of the economy.

2. Part of the supposed profits attributed to derivatives trading comes from creative bookkeeping. Therefore, while derivatives are a zero sum game in reality, they are (have so far been) a positive sum game on the collective books.

3. While derivatives supposedly allow companies to manage risks, they actually create systemic risk. Victor Haghani, formerly of LTCM summed it up, thusly: The hurricane is not more or less likely to hit because more hurricane insurance has been written. In the financial markets this is not true. The more people write financial insurance, the more likely it is that a disaster will happen because the people who know you have sold the insurance can make it happen. So you have to monitor what other people are doing.

[TheLion]

From what I have read so far on the net, JPM must be exerting control over many of these markets. Would like to know what they know, then we might know what is going on!

[Soren]

I tried to trace the source of that $20 number. I tracked it back to the GATA site (Bill Murphy's site). After JPM broke through $20, there was a comment in his daily commentary that it was based on a rumor passed on by a reliable floor trader. Later, the number was revised to $18.50. So the source appears a bit soft to me. I have not seen any hard analysis that shows exactly why they implode at a given price. OTOH, if they were in trouble, we would probably not be reading about it in the news, for obvious reasons. Instead, you would probably have a lot of behind the scenes activity like we saw with LTCM in 98. Inevitably, some word would leak out to those who are connected and we would see downward pressure on the stock price (as we have seen). I'm not saying they have imploded or even that I believe the implosion theory; only that current events do not necessarily refute the implosion theory IMO.

[Soren]

The notional value of JPM's derivative book has been reported to be $26 trillion. I have read that it is customary to set aside reserves of 2% of notional value for unexpected losses, such as when your counterparty defaults. 2% of $26 trillion is $520 billion. JPM's net worth is in the range of $40 billion. That is the problem, IMO.

Another problem is that hedging models assume that "tail" events are independent ("tail" refers to the tail of the probability distribution, i.e. events that are highly unlikely to occur). In reality, they are not. This is what sunk LTCM. When Russia defaulted, it triggered a cascade of "tail" events. With all the dislocations occurring in the markets, interest rates and spreads, foreign situations, etc., it seems a very ripe environment for "tail" events to occur.

[Deuce]

JPM must be exerting control over many of these markets.

The financial sector in general exerts control over all of the financial markets. The banking segment of the the financial sector has unbelievable control over all facets of money. Within the banking system, the money-center banks are the most specially privileged of all. In 1913, the Federal Reserve was instituted to serve the needs of this specially privileged cartel under the masterful guise that the Fed would actually serve the public interest.