ContraryInvestor<>JULY Newsletter: A Dimon In The Rough
You are probably fully aware that the largest US bank, JP Morgan, had a more than noticeable derivatives loss that was announced a few weeks back. In fact, regulators seemed so taken aback that they had JP’s CEO, Jamie Dimon, appear before the Senate Banking Committee to explain. Only a week prior to the announced loss, Mr. Dimon conducted the first quarter earnings conference call for JP. As you’d guess, not a mention of a derivatives related problem. We can only infer that a) Mr. Dimon was not being completely truthful on the prior period earnings conference call, or b) Mr. Dimon, the management team and Board of Directors at JP really have no idea of the overall directional and individual position risk in JP’s derivatives book. It’s either one of the two. Fortunately, given that we have no reason to believe Mr. Dimon is untruthful, it’s probably the latter. Unfortunately, we’re not so sure that isn’t scarier than the former. Why? It just so happens JP Morgan is the largest holder of financial derivatives contracts…on planet Earth.
The wonderful world of financial derivatives is opaque at best, and completely non-transparent at worst. There is no disclosure of positions or risk posture in any company specific regulatory filings. The industry tells us non-disclosure is for competitive reasons and there is some merit to this argument. But even in light of the AIG 2008-2009 derivatives accident that precipitated the larger Wall Street bailout and now the JP Morgan loss measured in billions, regulators have simply turned a blind eye. Make no mistake about it, Goldman and Morgan Stanley would be distant memories, as would have a number of other leading US financial firms, had it not been for the Government bailout of the AIG derivatives debacle. Maybe a bit surprising, the most vocal advocate for derivatives non-disclosure was none other than Alan Greenspan over the last few decades. Of course this was just one of his many “accomplishments”.
Why should we care about all of this? We’ll be the first one to suggest that financial derivatives serve a very needed function in the greater domestic and global economy. At a very basic level as a simple example, farmers can use commodity derivatives to “hedge” or lock in price levels for their crops well in advance of actual harvest and sale. It allows them a certain degree of financial certainty from planting to harvest. Large corporate users of energy can hedge against higher energy costs over a certain period, again giving them a sense of operational cost certainty. The permutations on the theme in terms of derivatives serving a solid business purpose are almost endless. But practicality ends when derivatives are being used increasingly for speculation. It’s here where we personally believe the regulators are miles behind the financial markets. But the reason this is important to at least be aware of is magnitude of the existing derivatives complex and the clear examples of very large mistakes in recent years. In a minute, we’ll leave you with what are hopefully are two important questions of the moment for the domestic and global derivatives complex. Unfortunately, we have no answers for either question. Don’t worry, you don’t either.
One of the very few places we see any actual disclosure of derivatives numbers is in the OCC (Office of the Comptroller of the Currency) quarterly derivatives report. We thought we’d quickly run through a number of facts which we personally believe most folks are unaware. It’s also a reason that we have a very hard time investing in many financial stocks currently when we cannot see what we believe is very meaningful risk exposure on balance sheets. Let’s face it, if the CEO of the largest US bank could not see a large derivatives problem coming, then how are shareholders ever expected to anticipate such an occurrence? The OCC looks only at the US banking system in their report. Important in that the large US banks are some of the largest holders of derivatives worldwide. The second largest holders? The European banks. Feeling comforted? The chart below looks at total US banking system derivatives exposure really since the inception of the broader derivatives markets in the late 1980’s. From about $10 trillion in notional exposure, US banking system derivatives holdings have grown to over $225 trillion as of the first quarter of this year. This is exactly the magnitude we believe is so important.
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