The $2 Billion Loss By JP Morgan Is Just A Preview Of The Coming Collapse Of The Derivatives Market

The Economic Collapse Blog ^ | 05/12/2012 | Michael Snyder

[SeekAndFind]

When news broke of a 2 billion dollar trading loss by JP Morgan, much of the financial world was absolutely stunned. But the truth is that this is just the beginning. This is just a very small preview of what is going to happen when we see the collapse of the worldwide derivatives market. When most Americans think of Wall Street, they think of a bunch of stuffy bankers trading stocks and bonds. But over the past couple of decades it has evolved into much more than that. Today, Wall Street is the biggest casino in the entire world. When the "too big to fail" banks make good bets, they can make a lot of money. When they make bad bets, they can lose a lot of money, and that is exactly what just happened to JP Morgan. Their Chief Investment Office made a series of trades which turned out horribly, and it resulted in a loss of over 2 billion dollars over the past 40 days. But 2 billion dollars is small potatoes compared to the vast size of the global derivatives market. It has been estimated that the the notional value of all the derivatives in the world is somewhere between 600 trillion dollars and 1.5 quadrillion dollars. Nobody really knows the real amount, but when this derivatives bubble finally bursts there is not going to be nearly enough money on the entire planet to fix things.

Sadly, a lot of mainstream news reports are not even using the word "derivatives" when they discuss what just happened at JP Morgan. This morning I listened carefully as one reporter described the 2 billion dollar loss as simply a "bad bet".

And perhaps that is easier for the American people to understand. JP Morgan made a series of really bad bets and during a conference call last night CEO Jamie Dimon admitted that the strategy was "flawed, complex, poorly reviewed, poorly executed and poorly monitored".

The funny thing is that JP Morgan is considered to be much more "risk averse" than most other major Wall Street financial institutions are.

So if this kind of stuff is happening at JP Morgan, then what in the world is going on at some of these other places?

That is a really good question.

For those interested in the technical details of the 2 billion dollar loss, an article posted on CNBC described exactly how this loss happened....

The failed hedge likely involved a bet on the flattening of a credit derivative curve, part of the CDX family of investment grade credit indices, said two sources with knowledge of the industry, but not directly involved in the matter. JPMorgan was then caught by sharp moves at the long end of the bet, they said. The CDX index gives traders exposure to credit risk across a range of assets, and gets its value from a basket of individual credit derivatives.

In essence, JP Morgan made a series of bets which turned out very, very badly. This loss was so huge that it even caused members of Congress to take note. The following is from a statement that U.S. Senator Carl Levin issued a few hours after this news first broke....

"The enormous loss JPMorgan announced today is just the latest evidence that what banks call 'hedges' are often risky bets that so-called 'too big to fail' banks have no business making."

Unfortunately, the losses from this trade may not be over yet. In fact, if things go very, very badly the losses could end up being much larger as a recent Zero Hedge article detailed....

Simple: because it knew with 100% certainty that if things turn out very, very badly, that the taxpayer, via the Fed, would come to its rescue. Luckily, things turned out only 80% bad. Although it is not over yet: if credit spreads soar, assuming at $200 million DV01, and a 100 bps move, JPM could suffer a $20 billion loss when all is said and done. But hey: at least "net" is not "gross" and we know, just know, that the SEC will get involved and make sure something like this never happens again.

And yes, the SEC has announced an "investigation" into this 2 billion dollar loss. But we all know that the SEC is basically useless. In recent years SEC employees have become known more for watching pornography in their Washington D.C. offices than for regulating Wall Street.

But what has become abundantly clear is that Wall Street is completely incapable of policing itself. This point was underscored in a recent commentary by Henry Blodget of Business Insider....

Wall Street can't be trusted to manage—or even correctly assess—its own risks.

This is in part because, time and again, Wall Street has demonstrated that it doesn't even KNOW what risks it is taking.

In short, Wall Street bankers are just a bunch of kids playing with dynamite.

There are two reasons for this, neither of which boil down to "stupidity."

• The first reason is that the gambling instruments the banks now use are mind-bogglingly complicated. Warren Buffett once described derivatives as "weapons of mass destruction." And those weapons have gotten a lot more complex in the past few years.

• The second reason is that Wall Street's incentive structure is fundamentally flawed: Bankers get all of the upside for winning bets, and someone else—the government or shareholders—covers the downside.

The second reason is particularly insidious. The worst thing that can happen to a trader who blows a huge bet and demolishes his firm—literally the worst thing—is that he will get fired. Then he will immediately go get a job at a hedge fund and make more than he was making before he blew up the firm.

We never learned one of the basic lessons that we should have learned from the financial crisis of 2008.

Wall Street bankers take huge risks because the risk/reward ratio is all messed up.

If the bankers make huge bets and they win, then they win big.

If the bankers make huge bets and they lose, then the federal government uses taxpayer money to clean up the mess.

Under those kind of conditions, why not bet the farm?

Sadly, most Americans do not even know what derivatives are.

Most Americans have no idea that we are rapidly approaching a horrific derivatives crisis that is going to make 2008 look like a Sunday picnic.

According to the Comptroller of the Currency, the "too big to fail" banks have exposure to derivatives that is absolutely mind blowing. Just check out the following numbers from an official U.S. government report....

JPMorgan Chase - $70.1 Trillion

Citibank - $52.1 Trillion

Bank of America - $50.1 Trillion

Goldman Sachs - $44.2 Trillion

So a 2 billion dollar loss for JP Morgan is nothing compared to their total exposure of over 70 trillion dollars.

Overall, the 9 largest U.S. banks have a total of more than 200 trillion dollars of exposure to derivatives. That is approximately 3 times the size of the entire global economy.

It is hard for the average person on the street to begin to comprehend how immense this derivatives bubble is.

So let's not make too much out of this 2 billion dollar loss by JP Morgan.

This is just chicken feed.

This is just a preview of coming attractions.

Soon enough the real problems with derivatives will begin, and when that happens it will shake the entire global financial system to the core.

[freekitty]

Money laundering

[Sequoyah101]

In my simple mind and humble opinion:

The derivatives market should collapse.

We will all suffer though for the sins and profit of the few.

Derivatives produce nothing. The market has all become about gambling and not about value So much business has become about smoke and mirrors and much much less about adding value through manufacturing or invention or technology applications.

When a 38 year old can amass 3.8 billion after leaving a failed Enron by simply trading paper and taking a risk doing that... nothing is gained by anyone but him. Sure, he may have made people money along the way. I’ll bet though that most of the time he was on both sides of the trade and profited either way.

NO VALUE WAS PRODUCED. This is the business equivalent of spilling your seed on the ground.

[Texas Songwriter]

You eventually have another AIG event. One which cannot be staunched. Then AIG makes a claim against its counterparts and then that counterpart against its counterpart....and on and on. If it cannot be stopped everything unwinds. It is true that JPM may or may not be the counterparty to other demand of performance but if they are and cannot satisfy the counterparty claim they are screwed, their investors are screwed and the payor of last resort (the taxpayer) under the careful direction of Obama, Geitner, and the ben bernanke will print towards infinity....and with that the Republic will have failed. Right now it is a slow-motion trainwreck. If that accellerates with a dozen JPM-like events, at some point there are not enough fingers to put in the dike.

[wiggen]

Many of those derivatives offset each other. I agree the notational value is too large but absolute exposure is far lower.
Another point in the article about the SEC (and FINRA,unmentioned) sleeping. They were no doubt. Without question. Now they have the sharp knives out and will attempt to blow up the smallest infraction. They are measuring success there now by fines and jail terms and not a lack of scandal.

[wiggen]

A million in the business is insignificant. Something along the lines of a percentage of a firms capital or an absolute number like 50mm. You get a bad day in the market with a billion dollar position and you can lose million just on lower valuations. Unrealized as it were.

[Soul of the South]

It was George W. Bush who decided to bail the Wall Street banks out in 2008 instead of forcing them into bankruptcy. Instead of bailing out the banks and their executives, the government should have bailed out the depositors up to the FDIC limit. Let the shareholders, executive, and shareholders take it on the chin. The New York banking cabal would have evaporated and the conservative regional banks such as BB&T would have survived and rebuilt the system. We wouldn’t have the trillion dollar deficits or the trillions of dollars of money printing that is destroying the currency and the economy.

Yes Bush abdicated to his Secretary of the Treasury Paulson (former Goldman Sachs Chairman) and Ben Bernanke (Bush’s appointment to Fed Chairman). The Republicans in the House tried to stop this massive payoff to irresponsible special interests but were brought to heel by Bush and McCain. Bush rewarded the irresponsible and by passing TARP set the stage for Obama’s irresponsible deficit spending spree. Not that Bush hadn’t doubled the national debt himself during his 8 years. He never could find that veto pen when it came to spending bills.

Paul O’Neill, Bush’s first Secretary of the Treasury tried to institute budgetary reforms and rein in some of the irresponsible behavior of the banking community. O’Neill was sacked for his efforts. John Snow (a railroad man) who followed O’Neill was eased out to make room for Goldman Sachs Chairman Henry Paulson. Thanks to Bush the fox was literally running the henhouse when the 2008 financial crisis occurred and Bush failed to take away the keys during the moment of crisis. It is sad, given a choice between the citizens who elected him and the crony capitalists of Wall Street, Bush chose to bail out the financiers and hand the check to Main Street.

[Toddsterpatriot]

You eventually have another AIG event.

Firing every trader who ever loses $1 million will not prevent an AIG event.

[Toddsterpatriot]

Instead of bailing out the banks and their executives, the government should have bailed out the depositors up to the FDIC limit.

Brilliant idea! Instead of $700 billion for TARP and getting the bank portion entirely paid back, we could have spent $700 billion, with nothing paid back, and a crushing depression. Brilliant!

Let the shareholders, executive, and shareholders take it on the chin.

Yeah, because those groups didn't already take it on the chin, you want the rest of the country to take it over the head, with a brick.

We wouldn’t have the trillion dollar deficits or the trillions of dollars of money printing that is destroying the currency and the economy.

We'd be wishing for a $1.5 trillion deficit.

The Republicans in the House tried to stop this massive payoff to irresponsible special interests

Yeah, but enough about Fannie, Freddie and the auto makers.

[Toddsterpatriot]

Bush chose to bail out the financiers and hand the check to Main Street.

The nasty financiers repaid the bailout. Main street still owes the banks.

[American Infidel]

You have to dissect the multi-trillion dollar figures thrown around in order to panic the ill-informed. 80% of this total exposure is in the form of plain vanilla Interest Rate Swaps.

In a vanilla Interest Rate Swap, the 2 parties involved in a transaction are only exchanging fixed interest payments for floating interest payments on an agreed-upon notional. For example: 2 parties may engage in a Swap transaction on a $100million notional amount. They are not exchanging the entire $100million. They are only exchanging interest payments on that $100 million on a monthly, quarterly, semi-annual or annual basis (whatever they agree to), so the true exposure is nowhere near the $100 million notional amount of the swap.

Additionally; If JPM does one side of a swap with Bank "A" and the other side of a swap with Bank "B", with both swaps having a notional amount of $100 million each, the net exposure is essentially "0" since the swaps offset one another. However; these transactions will be reported in the media as "$200 million in outstanding derivatives exposure".

Let's not become like our enemies on the left. They would love nothing more than to use this mark-to-market, paper loss (not a realized loss) as an excuse to let the government run wild and take control of the entire banking industry "for our own good".

Besides - is it the job of the government to ensure that investment banks don't incur trading losses? As long as the banks don't come back looking for a bailout after such a loss, this is simply a consequence of being in a business were risk is taken.

The outrage at banks being bailed out should be directed towards the government who authorizes the bailouts. You make a big bet and it goes against you? Eat the loss.

[Texas Songwriter]

I agree with you.

[A Strict Constructionist]

“The Goldman Sack”

That sounds like a good play to me. I personally would like to give them all a golden parachute without the ripcord.

[Paladin2]

I think the term comes from one of those talking head cartoons about how the economic system works.

[Soul of the South]

I would hope they paid off TARP. When the Fed prints and loans you money at less than 1% and you then loan it back to the Treasury for 3% you are making a 2% margin at zero risk. The Federal Reserve, the Treasury, and Congress colluded to give the banks the money they used to pay off TARP. Unfortunately for Main Street the game continues allowing the banks to make record profits and Main Street to pay in the form of energy and food price inflation as well as a devalued currency.

The fact they know the government and taxpayer are backstopping them allows the banks to continue gambling with derivatives far beyond the value of the assets they hold on their balance sheets.

Main Street is also continuing to pay for the Fannie and Freddie write downs. GM also continues to draw on the government account for its working capital.

[Toddsterpatriot]

When the Fed prints and loans you money at less than 1% and you then loan it back to the Treasury for 3% you are making a 2% margin at zero risk.

Sounds like a great deal! How many trillions are the banks borrowing for this arb?

As far as risk free, you obviously don't understand interest rate risk. Or yield curve risk.

[Wolfie]

Policy needs to be: if a bank is judged "two big to fail", then it is too big to be allowed to exist. Bank regulators would then order the bank to unwind and shed any derivative and options holdings, and then be ordered to split into multiple independent pieces.

Sounds like Anti-Business, Big-Government, LibTard talk to me. Yes, that's sarcasm.

[A Strict Constructionist]

These are great, thanks!.

[Soul of the South]

I very much understand interest rate risk and yield curve risk.

The article with the link I’m providing below speaks to the sweet deal the banks are getting. One particular salient quote:

“The Fed’s low-rate policy “has been a plan to buy time for the banks to take free money and invest it, and make some kind of spread, and work their way out of the hole they were in,” said Mark MacQueen, a partner and money manager in Austin, Texas, at Sage Advisory Services Ltd., which oversees $10 billion, in a telephone interview on March 6. “Banks are trying to clean up and improve the appearance of their balance sheets and buying Treasuries accomplishes this.”

http://www.bloomberg.com/news/2012-03-12/banks-buying-treasuries-at-seven-times-2011-pace-as-deposits-beat-lending.html

This is a rigged game with the big boys on Wall Street still being protected by the government and the taxpayer with the Fed keeping interest rates low. Meanwhile the average seasoned citizen who saved for 40 years gets 1% on CD’s. At current artificially depressed rates where’s the risk premium for the Main Street investor?

[Toddsterpatriot]

I very much understand interest rate risk and yield curve risk.

Not based on your belief that borrowing overnight at 0.75% to buy Treasuries is a risk free arb.

The 5 year Treasury now yields 0.73%. Exactly how far out do you want to go to hit this "risk free" sweet spot you feel is out there?

And if this is such a good trade, how much are the banks borrowing from the Fed to put this trade on? Give me some concrete numbers for once. Thanks.

[Soul of the South]

I stand corrected on Treasury rates. The spread is much narrower now than it was in 2008.