JP Morgan and systemic risk

For some time, financial observers have been discussing the large positions in bond-index derivatives amassed by a trader known as the London Whale, now revealed to be Bruno Iksil working for JP Morgan Chase.
On Thursday we learned that JP Morgan has lost over $2 billion in the space of two weeks as a result of the trades. On Friday the stock price fell by 9.3%, wiping out $14.4 billion of the company’s value.

How do you lose so much money so quickly? The short answer is, leverage. Although details are not known, one likely scenario
([1], [2]) involves derivatives constructed from the riskier components of some European corporate bonds. Using derivatives, you can buy or sell securities or pieces of securities that you do not yourself own, involving a potential promise to deliver more money than you even have. If the market moves against you, you’ll have to deliver substantial real cash to unload your commitment, and this process appears to be what produced the sudden losses. The Whale’s notional exposure in one index was speculated to have been $100 billion in April.

The total notional exposure of all of JP Morgan’s trades has been estimated to be $79 trillion. That’s “trillion”, with a “T”, from a company with an equity value of $140 billion, and falling quickly.

Paul Krugman suggests that in the case of the trades by the London Whale, JP Morgan “was just engaging in financial tricks of little or no social value”. One could argue that the role of leveraged bets through derivatives is to allow those who really know what the value of the underlying security should be to help guide the market to that correct valuation. But if you’re making your bet with somebody else’s money, where the deal is you get the upside and somebody else gets the downside, those leveraged bets aren’t so likely to be in the public’s interest.

In any case, we would want to weigh any potential social benefits of such trades against their possible social costs. Is JP Morgan “too big to fail”? I think so. A recent paper by Stanford Professor Darrell Duffie highlights an unresolved weakness in the U.S. financial system centered on the tri-party repo market. This is a key mechanism whereby institutions with funds to lend overnight, such as money market funds, provide funds to those with short-term borrowing needs, namely dealer banks who are prepared to pledge securities as collateral for a one-day loan. Each day something like $100 billion in such short-term lending is intermediated by two clearing banks (JP Morgan Chase and Bank of New York Mellon). Dealer banks deposit securities as collateral with the clearing bank in exchange for a one-day loan, which funds the clearing bank in turn receives later that day from the ultimate lender.



Source: Duffie (2012).
tri_party_repo.gif



Duffie believes the system is inherently unstable, as dealer banks depend crucially on the ability and willingness of the clearing banks to provide short-term financing each new day:

A dealer whose solvency or liquidity come into question may be unable to find cash
lenders that are willing to roll over a sufficient quantity of its repos. In that case,
concerns over a dealer’s liquidity might be self-fulfilling. The dealer could fail, or its
securities might need to be liquidated in a fire sale, or both….

A fire sale of a dealer’s securities caused by the dealer’s inability to roll over its repo
financing on a given day could temporarily depress the prices of some of the affected
classes of securities, particularly those securities that lack transparency or whose credit-
worthiness depends on the stability of the financial sector. This could have spillover
effects to other dealers and more broadly.

Between the unwinding of the previous day’s repos and the roll into the next day’s repos,
money market funds and other cash investors claims are in the form of demand deposits
at the clearing bank. In extreme scenarios and in the absence of sufficient transparency,
cash investors could become concerned that a clearing bank could be destabilized by
its intra-day secured-lending exposure to a dealer. A run of these intra-day demand
deposits could indeed destabilize the balance sheet of a clearing bank in the worst case.

Here is Duffie’s recommendation for how to make the tri-party clearing system more stable:

Given the systemic importance of tri-party clearing agents, and given their high fixed
costs and additional economies of scale, tri-party repo clearing services for U.S. dealers and cash investors should probably operate through a dedicated regulated utility.
Although this would likely increase operating costs for market participants, it would
enable investment in more advanced clearing technology and financial expertise, allowing greater resilience of the tri-party repo market in the face of financial shocks such as
the default of a major dealer. The moral hazard associated with lending of last resort
to a dedicated utility is much reduced relative to the case of a financial institution with
a wide scope of risk-taking activities.

If nothing else, this week’s news should remind us that more needs to be done to ensure financial stability and that the incentives of private participants align with the public’s best interests.

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25 thoughts on “JP Morgan and systemic risk

  1. dwb

    i think that its positively ridiculous that JP Morgan thought these trades were less risky than (for example) lending to American homeowners.
    I am deeply familiar with industry risk models and the fact that they had to restate them says a lot. poorly documented, poorly executed, and they got the risk math wrong. And by way their Daily VaR (which is supposed to be a 99% worst loss) was 186MM, 1/10 of what they actually lost. I’ve read that as they lost money they tried to “fix” the trade, which is why the notional got so large. Yep, large illiquid trades are hard to fix when your ba!!s are in a vice. same old story.
    How about: lets not be doing this with taxpayer subsidized excess deposits (and because they are TBTF their borrowing costs are lower, the rating agencies say so). You want to run a hedge fund i have no problem with that, don’t do it on the taxpayer dime.
    The only way to reduce the significant moral hazard here is if the trader, Dimon, head of risk, head of market risk, on down get fired and *banned from the industry*, and every last dime they have is clawed back. And where were the Fed quants who reviewed this? It’s really totally ignorantly absurd in this age that they signed off on the risk.

  2. 2slugbaits

    dwb where were the Fed quants who reviewed this?
    Did they review this? My (admittedly feeble) understanding is that the regulatory rules were still being developed (read: “watered down”) almost 2 years after Dodd-Frank. According to the NYT a lot of this hinges on JP Morgan’s special pleading that JP Morgan should be allowed take advantage of what they argued was a Volcker Rule loophole. According the NYT:
    “The loophole is known as portfolio hedging, a strategy that essentially allows banks to view an investment portfolio as a whole and take actions to offset the risks of the entire portfolio. That contrasts with the traditional definition of hedging, which matches an individual security or trading position with an inversely related investment — so when one goes up, the other goes down.”
    This sounds a lot like the old tricks that got us into the big mess four years ago. The legality of what JP Morgan did is very much in doubt. The spirit of Dodd-Frank pretty clearly argues against portfolio hedging, but the FED, Treasury and Comptroller of the Currency seemed to wink at what JP Morgan was doing, while the SEC and Commodity Futures Trading Commission thought it was illegal. Roll the cameras for a good old fashioned perp walking. If there’s any justice in this world Jamie Dimon’s high-end tailor will be fitting him to a stylish orange jumpsuit.

  3. dwb

    Did they review this? My (admittedly feeble) understanding is that the regulatory rules were still being developed (read: “watered down”) almost 2 years after Dodd-Frank
    I cant say, but even under longstanding existing rules, new products and models are supposed to be reviewed and validated, (most recently for example, see OCC 2011-12). It’s a good question.

  4. Lyle

    I have just read Slapped by the Invisible Hand, and the author defines the failure to roll repo’s as an old fashioned bank run, just done by other banks rather than depositors.

  5. Chris

    What about the government’s withdrawing deposit insurance from any bank that engages in proprietary trading? If such banks were deprived of most of their depositors I suspect they would cease their reckless speculations very rapidly.

  6. Johannes

    Thats quite bad, as JPM is financing Obama’s campaign. Hope there are a few dimes left for the next round of “hope” and “change”.
    Contributions to Obama’s campaign:
    1. University of California,
    2. Goldman Sachs,
    3. Harvard University,
    4. Microsoft,
    5. Google,
    6. Citigroup,
    7. JPMorgan Chase & Co.,
    and 8. Time Warner.
    JP Morgan “was just engaging in financial tricks of little or no social value” as Krugman tells us, which is quite trivial, as the social side of the game is really out of sight.
    No, JPM is not TBTF, if there is a real will to execute a gang.
    But my bet is : our media will forget the $2 billion quite soon …

  7. Ricardo

    JDH wrote:
    Is JP Morgan “too big to fail”? I think so.
    Professor,
    I have been very interested in this fiasco at JP Morgan Chase so I was very excited when I saw that you had a post on it. My excitement quickly turned to dispair when I read the phrase above. Professor, if a company is “too big to fail” it is too big to exist.
    The problem at JP Morgan is very obvious. Jamie Dimon needed to continue making huge profits and he put pressure on his people to turn the deal. Both Dimon and his people “knew” they were “too big to fail” in the eyes of our resident mercantilists, so they took greater risks. They didn’t take these risks because of a lack of regulation. They took these risks because of a lack of responsibility.
    Regulation is meaningless if it is not enforced, or if the regulations themselves create moral hazard. As our central planners have increased their regulation they have done both, changed enforcable rules to unenforcable guideline, and then facilitated bailouts rather than dissolutions of failures. In this case we had moral hazard fed by both meaningless regulation and the implied promise of a bailout.
    “Too big to fail” actually means not quite big enough not to bailout. But after the bailout, after the losses grow bigger and after the risks are still pushed off on others – after the next failure comes when the failure is too big to save, that is when we all pay the price.

  8. tj

    Menzie,
    The business model you describe, in which banks rely on short term financing for cash flow, is exactly the failed business model that brought all the investment banks under the fed umbrella. They became insolvent while at the same time the money market froze.
    Every transaction needs to be transparent and derivatives need to be limited to the face value of the underlying security. Easy fix, if our elected leaders could create policy without the ‘help’ of special interests.

  9. AS

    Why don’t we just bring-back Glass-Steagall and forget the Volker rule? What harm to the economy if any is caused by Glass-Steagall ?

  10. AndrewR

    Until this mess Dimon was lionized as one of the world’s greatest bankers. If you bought the stock when he became CEO (12/31/05) and sold the Friday before this scandal hit, your total return, including dividends, would have been +3% per annum. That’s less than the annualized total return generated by USBancorp, Wells Fargo and Berkshire, financial institutions that take a lot less risk. This begs the question: why was Dimon considered so great?
    What is truly mystifying is the fact that Dimon let the bank’s main risk management arm become a profit center. Any banker with common sense would have seen the profits coming out of the Chief Investment Office and scaled it back enormously. Only hubris can explain something so stupid.

  11. Steven Kopits

    Achuthan at ECRI sticks to his guns, calls for US recession mid-summer.
    http://www.businesscycle.com/
    This is actually turning into something of an interesting contrast in perspectives. Jim has linked recessions to fixed assets–residential and business investment, automobiles. As he has pointed out, these sectors remain pretty depressed–there’s not much more compression to be had–particularly in housing. So to the extent a recession is linked to fixed assets, the US should be largely recession-resistant at this point, and ECRI should be proved wrong. (Jim – Don’t hesitate to correct me if I have mischaracterized your line of argumentation.)
    On the other hand, if ECRI proves right, then what is the means of propagation? Would a recession be even more compressed into fixed asset sectors? Or is a recession possible without consideration of those sectors?
    Taken on their own, recent oil prices should be enough to put down the US economy, with the nearest comparable period being mid-1980 to mid-1981, which also ended in a recession.
    In any event, if ECRI is right, or even close to right, the Obama administration could find itself in deep, deep trouble come November.

  12. Raph

    Who made the money on the other side of the trade? Overall what are the costs to the public of such trading activities?

  13. acerimusdux

    I wince a bit at the term “notional exposure”, when the bulk (about $64.8T) of the $73.3T in “notional amounts” of derivatives on JPM’s 10-Q as of 3/31/2012 was still in interest rate and foreign exchange contracts, where the “notional amount” is just a number used in a calculation, not reflective of any underlying exposure or risk.

    That said, for credit default swaps, which are the problem here, notional amounts do represent the underlying amount of insurance sold. There, JPM reports $3.16T in insurance sold, and $2.95T in protection purchase on the same underlying instruments, for just under $210B in “net protection sold”.

    You see part of the problem with credit default swaps when you see that when these are carried on the books at fair market value, this amounts to $6.6B in receivables and $6.7B in payables. In other words, the amount at risk is quite a bit greater than the market values.

    There are some appropriate uses of derivatives in managing risk, but I can’t see a good reason why banks ought to be permitted to trade in CDS markets at all. Even when they are legitimately hedging credit risk, doesn’t that just increase the likelihood they would again get reckless on the lending side?

  14. econ

    Supposedly the $2B loss is all…investigation may show more than $2B. When America goes into a huge decline in Jan 2013 (tax cuts expire, defense cuts and debt ceiling) let us hope that the last one leaving puts the light out. Dysfunction is too kind to describe the mess that the 99% will pay.

  15. time123

    JP Morgan is a very big bank and a couple of billion in the big scheme of things is peanuts for them, relatively speaking.
    By the way, lots of people are shorting right now. I expect a major short covering rally any day now. You heard it here first.

  16. acerimusdux

    My best guess is we have another drop in asset prices, maybe another 20% decline.

  17. RebelEconomist

    I don’t begin to understand what JP Morgan were doing, but I can imagine how a market-making business generates a need to hedge, that this will normally involve some degree of speculation (inevitable if you are not just reversing the position as soon as it is acquired), and that this can generate positions that are large enough for illiquidity to be a risk (it seems that the London Whale ended up in the shallows being pecked by seagulls). Certainly, those in the industry did warn of the difficulty of distinguishing market making and proprietary trading. Perhaps such cases can only be judged individually in the light of detailed questioning by informed regulators.
    JP Morgan may be too big to fail, but no bank is too big to be nationalised with shareholders written down to zero, bondholders haircut according to seniority and all senior managers fired and investigated for negligence, which is just as bad an outcome for them as if the bank failed. If the US can establish such a rigorous bank resolution regime, that should help to restrain the potential for hedging to become betting.

  18. Joseph

    W.C. Varones: Why did Obama and Congressional Democrats allow the Too Big To Fail banks to become even bigger?
    Washington Mutual acquired by JP Morgan;
    Bear Stearns acquired by JP Morgan;
    Countrywide acquired by Bank of America;
    Merrill Lynch acquired by Bank of America;
    Wachovia acquired by Wells Fargo;
    Lehman Brothers acquired by Barclays;
    $700 billion TARP bailout of the banks to prevent breakup;
    What do all of these have in common? They all occurred during the Republican Bush administration. How soon they forget.

  19. JoshK

    Banks will sometimes loose money. Lending is very risky as well. I wish someone could explain why a derrivatives loss is bad and a loan loss is good (or at least OK).
    It’s kind of silly to sit there and try to pretend that hedging is OK and risk taking is not. If a bank was truly hedged it would earn no money. Every loan would be offset with some kind of hedge that would cost about as much as the loan could make.
    Maybe it’s time to get rid of the FDIC? For hundreds of years the only form of backstop banks had was their own, self-policing (badly, but maybe not as bad as the FDIC), mutual associations. There were bank runs and panics, but we also had economic growth…

  20. Simon van Norden

    JDH:“If nothing else, this week’s news should remind us that more needs to be done to ensure financial stability and that the incentives of private participants align with the public’s best interests.”
    Hard to argue with that. But your post surprised me by highlighting a proposal to reduce the systemic risk to clearing banks caused by dealer-banks dependent on repo financing. Others have argued that repo-financing of major financial institutions (such as dealer banks) is a key source of systemic risk (and was a key element in the panic of 2008.) If so, I would have thought it an even more glaring example of “a private participant’s incentive that needs to be aligned with the public’s best interests.” Why not address the problem directly instead of just addressing the impact of the risk it generates for one part of the financial system?

  21. don

    The MF Global fiasco should have given people pause about the workings of our financial sector. (Corzine’s claims are a point of derision in foreign press accounts. Why not here? And JP Morgan was innocent of knowing that moeny it got was inappropriately taken from customer funds? Please.) Dimon on the Board of the NY Fed? How appropriate is that? The TBTF aspect of our financial sector stinks, but if anyone thinks regulation is the key, they better be prepared fro some really draconian measures, else they will accomplish little.

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