From Matt Taibbi of Rolling Stone
"Either way, the incident underscored the basic problem. If J.P. Morgan Chase  wants to act like a crazed cowboy hedge fund and make wild exacta bets on the derivatives market, they should be welcome to do so. But they shouldn’t get to do it with cheap cash from the Fed’s discount window, and they shouldn’t get to do it with money from the federally-insured bank accounts of teachers, firemen  and other such real people. It’s a simple concept: you either get to be a bank, or you get to be a casino. But you can’t be both. If we don’t have rules to  enforce that concept, we ought to get some."

Hamilton explains why this type of Casino betting creates systematic risk.

"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 ommitment, 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."

FT speculates on what happened:
"It’s an OTC market!!!
The hedge funds got angry.
They developed a theory that one trader was behind all of this. One trader,  at one bank. One trader, at the CIO, at JP Morgan.
The hedge funds got more angry.
It dawned on the hedge funds that they had no one to complain to.
The hedge funds and banks had lobbied long and hard to keep this over-the-counter market in credit derivatives unregulated.
Thus it is unregulated, and they had no one to tell, officially, about what  they suspected — that a single player had cornered, and distorted the market by  putting on huge trades.
But the hedge funds were very, very angry that their trades were unprofitable while believing it was one bank’s fault.

 They complained… to… journalists.


Now for something to go wrong
Our guess is that at some point, either the risk of the trades was spotted for real (see above, re: journalists) and/or, as previously mentioned, the CIO stopped managing the hedge ratio on the curve trades. Stop managing the ratio, and the trade will turn into an outright long or short position on credit."

10 years ago, I spent a brief stint as a sell side stock analyst for a start-up Investment Bank-Lightyear Capital Inc. I told the President of Canadian Western Bank (CWB), Larry Pollock, that I didn't understand the large Canadian Banks businesses. I explained that their 40 to 60 pages of financial statements do little to reveal the inherent risks they are taking and that you
can't even tell the duration of the bank based on their financial statements.

Canadian banks avoided the mistakes of their American counterparts in the latter part of last decade. However, today Larry Berman on his weekly show on BNN (the very last comments), claimed the Canadian Banks were starting to pursue some of the same poor lending practices as the Americans but got lucky the bubble burst when it did before they got too deep;-had it come two  years later; the consequences in Canada would have been similar. 

10 years ago, it was Big Six’s bad loans to Argentina that were in the headlines and my coverage initiation (January 4, 2002) of CWB reflected  that:

 “Edmonton based Canadian  Western Bank (CWB:TSE) is quietly becoming an impressive western Canadian based commercial bank. While the larger Canadian banks are experiencing difficulty with their foreign loans, including those in the US and Argentina, CWB’s laser-like focus on western Canadian commercial banking continues to represent an attractive investment
opportunity.”

So as I write this (10:18 AM local Calgary time) Francis, one of the commenters at BNN is saying the problem with the Banking system is that you don’t know what you are investing in -  exactly.


These thoughts are mirrored by comments made by Hussman this week:

 “When I was a professor at the University of Michigan, I used to tell my MBA students that the best way to avoid seeing the word "debacle" next to their name in the Wall Street Journal was to avoid situations involving a  "leveraged mismatch with a lack of transparency." Those features are at the  heart of nearly every major financial crisis: a) leverage - taking positions with large amounts of borrowed money, which magnifies the impact of errors; b) mismatch - long and short positions in risky securities that don't closely offset, and; c) lack of transparency - organizational structures or accounting rules that prevent positions from being monitored and marked-to-market. A fourth feature, d) a sudden absence of liquidity - is often the event that triggers a debacle, but the root of the problem is almost always a highly leveraged, mismatched, opaque position that was there in the first place.”


I am happy to see that at least one head was cut off at JP Morgan, but absent regulatory changes it will not be enough.

The following quote is attributed to Albert Einstein:

 Insanity: doing the same thing over and over again and expecting  different results.

Jamie Dimon beat his chest about how well JP Morgan navigated the subprime crisis and how they didn’t need TARP. He has consistently argued against regulating the OTC derivative market and financial regulations more generally. Today he announced a $2 Billion trading loss that “might” grow to $3  Billion next month. Lacking shame, he refuses to resign, lacking balls, the board
refuses to fire him.  

I  think I just threw up in my mouth.

Thursday’s With Mishkin Part 1

Recently, former Fed Governor Fredric Mishkin, one of the Economists interviewed in ‘Inside Job’, came to give a talk at the University of Calgary. I had the opportunity to speak with him privately for fifteen minutes before his lecture and found him energetic and engaging. His talk comes out of two papers he has written since the start of the Great Recession.

Mishkin cites nine basic principles of monetary policy that he believes remain valid after the crisis:

1. Inflation is Always and  Everywhere a Monetary Phenomenon
2. Price Stability Has Important Benefits.
3. There is No Long-Run  Tradeoff Between Unemployment and Inflation.
4. Expectations Play a Crucial Role in the Macro Economy.
5. The Taylor Principle is Necessary for Price Stability.
6. The Time-Inconsistency  Problem is Relevant to Monetary Policy.
7. Central Bank Independence Improves Macroeconomic Performance.
8. Credible Commitment to a Nominal Anchor Promotes Price and Output Stability.
9. Financial Frictions Play and Important Role in the Business Cycle.

 “None of the lessons from the financial crisis in any way undermines or invalidates the nine basic principles of the science of monetary  policy developed before the crisis.”

Where then did the Fed go wrong? He offers five lessons learned.
1. Developments in the financial sector have a far greater impact on economic activity than we earlier realized.
2. The macro economy is highly nonlinear.
3. The zero lower bound is more problematic than we realized.
4. The cost of cleaning up after financial crises is very high.
5.  Price and output stability do not ensure financial stability.

Lesson 1
 Developments in the financial sector have a far greater impact on economic activity than we earlier realized.

 “The global financial crisis of 2007-2009 therefore demonstrated that financial frictions should be front and center in macroeconomic analysis: they no longer could be ignored in the macro-econometric that models that central banks use for forecasting and policy analysis, as we saw was the case  before the crisis. As a result, there is a resurgence of interest in the
interaction of finance and macroeconomics.”

Too bad the OTC market remains unregulated and the money center banks are even too bigger to fail than before the crisis. Mishkin did take a shot at Jamie Dimon for claiming the size of JP Morgan Chase put them at a competitive disadvantage.