financial firm will face complete instant annihilation ???
[valuable external view of Puplava and his JPMorgan opinions
Puplava manages $200 Million, sat for interview with Task
JPMorgan owns 20x the derivative pyramid versus LTCM's
institutions are offloading risk, while JPM takes on that risk]
By Aaron L. Task
Senior Writer
10/11/2002 03:00 PM EDT
A Potential Pothole on Rally Road
The stock market rallied big Thursday and was soaring again midday Friday. A continuation of the technical factors that contributed to Thursday's gains, along with a Lehman Brothers upgrade of IBM and relief that General Electric's results weren't worse were fueling big gains for major averages Friday afternoon. Everything may suddenly appear "okey-dokey" but a large number of market participants remain worried about the potential for some upheaval in the financial system.
"I will venture there is an outside chance that in the very near future, during a momentous market upheaval, a major financial participant will face complete and instant annihilation," Fari Hamzei of Hamzei Analytics in Los Angeles commented recently.
For some time now, J.P. Morgan has been the name most often cited as a potential trouble spot. In an interview Thursday, Hamzei said J.P. Morgan is on his short list of financial firms about whose "annihilation" he is concerned. Admittedly, that's a dramatic description for what others contend may be a forced sale or, at the very least, more pain for J.P. Morgan's stock and bondholders. Specifically, concerns remain about the bank's exposure to derivatives, financial instruments that derive their value from other securities and are designed to offset risk -- although history suggests they often have the opposite effect.
As reported previously, J.P. Morgan is far and away the largest dealer of derivatives -- involved in $25.9 trillion, or 51%, of the $50.8 trillion notional value of contracts involving U.S. commercial banks and trust companies at the end of the second quarter, according to the Office of the Comptroller of the Currency. Given its dominance, J.P. Morgan is an obvious bogeyman for those concerned about derivatives in general.
A midweek downgrade by Moody's put those concerns back on the front burner. A J.P. Morgan spokesman said the bank doesn't comment on rating actions. But in a conference call after its profit warning last month, Dina Dublon, J.P. Morgan's head of finance, said a Standard & Poor's downgrade at the time would have but a "small impact" on J.P. Morgan's derivatives business. In cutting $42 billion of J.P. Morgan's long-term debt to A-1 from Aa3 and its bank subsidiary debt to Aa3 from Aa2, Moody's ratings are now in line with S&P's.
The spokesman said he was not aware of any customers seeking alternatives to J.P. Morgan's derivatives desk, or leaving altogether, as has been reported elsewhere. Indeed, with assets of $741 billion and shareholder equity exceeding $40 billion at the end of the second quarter, there appears to be no imminent threat to the firm's financial wherewithal. Moody's said Wednesday that J.P. Morgan's liquidity "remains strong," and its risk-weighted capital ratios are good. After declining over 56% year to date previously, J.P. Morgan's shares rose 3.2% Thursday and were up another 7.7% Friday afternoon.
Still, many on Wall Street fret that time, and the markets, are not on J.P. Morgan's side.
Stressed Out
Hamzei, who runs a quantitative analytics firm, is mainly focused on issues such as on-balance volume. That measure of whether a stock is under accumulation or distribution shows "money has exited [J.P. Morgan's] stock at a horrendous rate," he said.
But he also cited the "extreme levels at which the global debt and equity securities and derivatives are currently trading," which have been and presumably continue to put stress on J.P. Morgan's proprietary trading and derivatives portfolios.
Prior to Thursday's advance, yields on investment-grade corporate bonds were at their widest spread to Treasuries in a decade, while the S&P Speculative Grade Index, which mirrors the trend in spreads between high-yield bonds and Treasuries, hit an all-time high of 1573.9 on Thursday. S&P's Investment Grade Credit Index also hit a record high on Thursday. Corporate default rates are up markedly this year and Fitch Investors reported 40% of junk bonds issued from 1997 to 1999 are now in default. RealMoneyPro.com's Brian Reynolds observed that corporate spreads were "narrowing significantly" Friday morning, which would be welcome news for the corporate bond market and J.P. Morgan in particular if it continues.
In previous times of such financial market stress, "somebody's derivatives book gets out of whack," Hamzei said, recalling Victor Niederhoffer's hedge fund in 1997 and Long Term Capital Management in 1998, among others. Because J.P. Morgan was intimately involved as a lender to Enron, Global Crossing, WorldCom, Tyco, Kmart and a host of other bankrupt or teetering telecoms, investors' faith in its risk management strategies has eroded.
Concerns abound that, among others, the firm's financial models are not functioning properly in the current environment of 40-year-low interest rates and extensive year-to-date declines in major equity proxies for a third-straight year. Former employees say the current leadership, which is largely the old Chemical Bank team, is ill-prepared to handle such extreme market events.
Thus, the firm's repeated declarations, which a spokesman reiterated Friday, that its derivatives exposure is far less than the notional value of contracts it's engaged in and that the bulk are with highly rated counterparties, are increasingly failing to mollify its critics.
"Everyone knows J.P. Morgan Chase is in deep trouble," commented Jim Puplava, president of Puplava Financial Services, a Poway, Calif.-based firm with about $200 million under management. "It is a bank in all the wrong places and it is hemorrhaging from multiple sides of its businesses." Puplava, whose firm has no positions in J.P. Morgan, compared derivatives to an insurance policy, and derivative dealers as providers of such policies.
Describing today's financial markets as a "100-year storm" or a "major earthquake," the money manager suggested "the problem we have today [is that] risk has been concentrated on one particular insurer: J.P. Morgan."
Because much of J.P. Morgan's derivatives book are "highly specialized and customized contracts," Puplava suggested it's difficult to assess the true value of the portfolio. It is "highly illiquid and vulnerable to panic selling in the event of a crisis," he argued, recalling that when credit spreads widened in 1998, Long Term Capital Management's risk multiplied as it found itself unable to offload losing positions.
As word got out they were in trouble, traders began to press Long Term's positions, which exacerbated its troubles. The cycle continued, culminating with a run on the hedge fund and a bailout by its lenders, as brokered by the Federal Reserve.
"If Long Term Capital's $1.25 trillion derivatives book almost took down Wall Street, what do you do with a firm with $26 trillion?" Puplava wondered. "The problem in this derivative market is that everyone is trying to offload risk" rather than taking on more.
In broad terms, Puplava expressed concern that because of its lowered credit ratings, J.P. Morgan is facing increased borrowing costs, as well as the potential diminishment of revenue from its derivatives business. The combination could put further pressure on the bank's profitability, causing further downgrades and more problems with its derivatives business, and so on and so on.
Having said that, the money manager admitted having no specific knowledge of J.P. Morgan's derivatives book or alleged problems therein. "The only ones who know are J.P. Morgan and the Feds," he said, criticizing Alan Greenspan for consistently speaking out against more disclosure and regulation of bank derivatives positions. "But if they were doing something right, why have profits declined persistently? Any time there's trouble, J.P. Morgan is always on the scene. Let's hope J.P. Morgan's board is asking question Enron's should have been."
Whether or not J.P. Morgan has to pay the ultimate price for its derivative activities remains to be seen. But Wall Street is watching very closely.
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