 | | The Daily Reckoning | Tuesday, May 15, 2012 |
- The New American Justice: Punishment for the innocent...rewards for the guilty,
- Another look at the “meat and meat by-products” of the financial markets,
- Plus, Bill Bonner on mainstream support for a Japan-like slump, and the continuing exodus of wealthy Americans...
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[Erratum: In yesterday’s edition of The Daily Reckoning, we mistakenly implied that Ina Drew, the newly “retired” CIO of JP Morgan who was responsible for producing $2 billion of trading losses, is male. In fact, Ina is a “she,” not a “he.” Notwithstanding our error, she remains just as incompetent a trader today as “he” was yesterday. Sorry for the confusion.]
|  | | | | The "Corzine-Dimon Syndrome" | | |  | | Eric Fry | On its best days, the American judicial process is a blindfolded Lady Justice — prosecuting the truly guilty and exonerating the truly innocent. On its worst days, it is a Water Wiggle — whirling around unpredictably, without any apparent connection to guilt, innocence, Constitutionality or the proportionality of alleged crimes to one another.
On good days, guilty parties go to prison; innocent parties do not. On very good days, innocent parties do not even have to go to the trouble of hiring a lawyer and showing up in court. Law enforcement agencies correctly decide to spare them the burden (and potential agony) of proving their innocence before a judge or jury.
On bad days, the exact opposite occurs. Innocent parties go to prison, while guilty parties do not. On very bad days, guilty parties do not even have to go to the trouble of hiring a lawyer and showing up in court. Law enforcement agencies incorrectly decide to withhold charges and spare guilty parties the burden (and potential agony) of defending their guilt before a judge or jury.
Once you string enough bad days together, you get a Water Wiggle — a “system” of law enforcement that investigates and prosecutes alleged crimes capriciously, unfairly and disproportionately. You get a system, for example, that:
1) Prosecutes Hall of Fame pitcher, Roger Clemens, for injecting performance-enhancing drugs into his own body, but does not prosecute a single investment banking executive for fraudulently injecting mortgage-backed securities into the US financial system.
2) Tasers-to-death a Mexican national for sneaking into the US to find work, but provides billion-dollar bailouts to finance company executives whose extreme incompetence causes thousands of individuals to lose their jobs. (Bring us your tired, huddled masses so that we can beat them to death).
3) Threatens to shut down porn film studios for failure to comply with “condom laws,” but turns a blind eye to Wall Street’s serial financial rape of the US taxpayer.
4) Fires a 5-year employee of Wells Fargo for shoplifting when she was a teenager, but does not bother to prosecute M.F. Global’s former CEO, Jon Corzine, for allowing (or causing) $1.6 billion of client funds to disappear from the firm he controlled. | In other words, once you string enough bad days together, you get a “system” that punishes minor crimes and rewards major crimes...consistently. You get a system that punishes entrepreneurial initiative by rewarding cronyism.
To reward incompetent finance company CEOs with billion-dollar bailouts, for example, is to punish the employees and shareholders of the prudently operated finance companies that compete with the firms receiving bailouts.
To refrain from investigating and/or indicting Jon Corzine for “disappearing” $1.6 billion of client funds is to punish both the 38,000 M.F. Global customers who are still missing the money they did not deserve to lose and the 1,000 employees who lost paychecks they did not deserve to lose.
To continuously intervene on behalf of politically connected incompetence and sociopathy is to invite the kinds of corruption, recklessness, cronyism and criminal negligence that ruins innocent lives and destroys entire economies.
The US is sprinting down this very path...as last week’s “surprising” $2 billion loss at J.P. Morgan Chase illustrates. Morgan’s egomaniacal CEO, Jamie Dimon, described the furor over the trading loss as a “tempest in a teapot.”
Maybe so, but based on subsequent disclosures about the reckless trading that produced this loss, Dimon looks like a teapot in a tempest — clueless and overwhelmed.
The only surprise about this announcement was that the loss wasn’t $4 billion...or $40 billion. But let’s give it some time. Morgan’s expert traders might still get there.
There’s a direct connection, Dear Reader, between the trading losses at JP Morgan and the conspicuous non-prosecution of Jon Corzine. In fact, there’s a term for this connection. It’s called “moral hazard.”
Most parents understand the term. They understand that the best way to raise a socially dysfunctional brat is to give him a candy bar every time he whines for something, and to give him a $20 bill every time he bullies a classmate. And yet, incredibly, the Federal Reserve, Treasury and Congress are doing exactly that. They are creating a generation of “spoiled brat” bankers.
Just three years after the depths of the 2008-9 Credit Crisis, Wall Street’s power brokers remain as remorseless as ever, as self- entitled as ever and, therefore, as fearless as ever. That’s not a good thing.
Three years after a crisis that nearly toppled the US financial sector, JP Morgan is playing the same old games...as if nothing had changed. The official chitchat from Washington and Wall Street about “risk” and “regulation” has changed quite a bit since 2008, but Wall Street’s behavior is just as deplorable and dangerous as ever.
As the chart above shows, the “gross market value” and “gross credit exposure” of global OTC interest rate derivatives has jumped to its highest levels since 2008. If you don’t understand what these data points mean, don’t feel bad, Jamie Dimon doesn’t seem to get it either. (But if you’d like to understand what these data points mean, check out this report from the Bank for International Settlements).
The only thing you really need to know about the global derivatives market is that risk exposures are increasing, not decreasing. JP Morgan’s balance sheet tells the tale. According to Morgan’s latest quarterly report, the firm was a net seller of credit protection — to the tune of about $206 billion, up from $116 billion as of Dec. 31. In other words, it nearly doubled its risk exposure. Morgan calls this speculation “hedging.” Unfortunately, it is hedging without a hedge, which is the same thing as speculating.
The newly “retired” Chief Investment Officer of JP Morgan, Ina Drew, was supposed to be hedging other exposures at the firm. But hedging is not supposed to produce billion-dollar losses. That’s why it’s called “hedging.”
“[Ina Drew’s] position over the years has always been around hedging,” explains Dina Dublon, a former JPMorgan CFO who worked with Drew for 22 years, “but hedging for profit as opposed to hedging just to counter losses.”
Ah yes...“hedging for profit”...also known as “speculating.”
“The sheer size of this trade,” says Barry Ritholtz, editor of the Big Picture and recurring speaker at the annual Agora Financial Investment Symposium in Vancouver, “makes it far more accurate to describe this as speculation than hedging. The loss was the tell. A true hedge would have been offset by the underlying position that was being hedged — so any loss should have been insignificant. Even a minor correlation error should not lead to a $2 billion hit.
“If we are going to define this trade as a hedge, then there is no other conclusion to reach except that everything at a huge bank is a hedge. And once you define everything as a hedge, well then, nothing is a hedge.”
In other words, Dear Reader, nothing has changed since 2008. Absolutely nothing. The only reason Dimon is around to lose $2 billion of the shareholder’s capital in 2012 is because the federal government (i.e., we taxpayers) bailed him out in 2008.
Therefore, Dimon understands the rules of this rigged game very well. He knows he can conduct mega-billion-dollar speculations because he knows that JP Morgan could never bankrupt itself, no matter how recklessly it conducts its business. The US central planners would not allow it. Morgan could build bonfires with $100 bills in front of all its branches every night, and it still would not be able to burn through the federal government’s commitment to keeping it alive.
Jamie Dimon, along with the rest of the coddled Wall Street predators, knows he is just as free to jeopardize the US financial system as he was in 2008. He and his counterparts at Goldman and elsewhere are just as free to place their monstrous heads-I-win- tails-you-lose bets with non-consenting US taxpayers as they were in 2008. No one will stop them.
Vibrant economies and civilized societies rely on law and order. And law and order relies on a foundation of fairness — a basic understanding that bad things are bad and good things are good. But when the powers of government begin to affirm that bad things are okay and good things are irrelevant, all hell breaks loose.
If America is to regain her former glory, she must first regain the integrity to prosecute criminality, no matter how many politicians know the criminals on a first-name basis...and she must regain the courage to let incompetent capitalists fail so that competent capitalists can arise to take their place.
If America is to regain her former glory, she must regain the integrity to prosecute guys like Jon Corzine and the courage to let guys like Jamie Dimon fail.
More below...
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OIL: My Shocking New Target Price Is Shockingly Accurate
I’m raising my target price for oil — significantly. Here are my new projections. And get ready: The speed at which this could unfold is dramatic. The event is now just seven weeks away. And oil at this level is set to have significant effects worldwide — many of which the world is not prepared for.
Yet the most significant effect of all — for you, anyway — will be the extraordinary amount of money this situation is likely to create. The new way to play oil — there’s never been a more compelling move. Full Story.
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| | The Daily Reckoning Presents | “Net Sober”...Revisited
By Eric Fry | | | The accidental $2 billion loss JP Morgan disclosed last week was an accident-waiting-to-happen, as we remarked one month ago here in The Daily Reckoning. In a column entitled, “Net Sober,” we presented the chart below and noted that JP Morgan’s derivatives exposure is “larger than the entire world’s GDP...[Morgan’s] notional value of derivatives as of March 31, 2009 stood at 39.0 times its total assets and 959 times its tangible equity... Enormous, opaque and illiquid risk exposure is rarely a good thing.”
In case you missed the story the first time around, we’re providing a second chance. The following words originally appeared in the April 17, 2012 edition of The Daily Reckoning...
Derivatives are the “meat and meat by-products” of the financial markets. They look, smell and taste just like regular securities, but almost no one understands why we need them in the first place. After all, what’s wrong with actual meat? Or to re-phrase the question: Is Spam really an advancement over ham?
More importantly, can we trust the derivatives markets? Or might they be toxic? Might they subject the financial markets to devastating side effects?
No one really knows...and since lab rats refuse to eat them, we must assess the risks of derivatives by relying on suppositions, theories and conjecture. Therefore, as a public service, your California editor will offer a few suppositions, theories and conjectures about the rapidly expanding derivatives markets.
The worldwide marketplace of financial derivatives is enormous. No one disputes that fact. But the potential destructive impact of these arcane, opaque securities is very much in dispute.
The apologists for financial derivatives usually say something like, “Sure, the derivatives markets are huge on a gross basis, but relatively small on a net basis.” According to this logic, a bank that purchased $1 trillion worth of Spanish interest rate swaps from one-party, but also sold $1 trillion worth of Spanish interest rate swaps to another party, has zero “net exposure.”
Mathematically, that statement is correct. Realistically, it is a delusion. If the financial markets should hit a pothole or two, that “zero net exposure” has the potential to behave a lot more like the $2 trillion of gross exposure. How could that happen? Very simple. One or more of the parties to these enormous transactions would have to renege on its obligations, thereby triggering a domino effect. Very simple...and not difficult to imagine.
In fact, we’ve already seen the trailer for this horror film. The bankruptcy of Lehman Brothers in 2008 was not only the demise of a prestigious investment bank, it was also the demise of a major counterparty to numerous derivatives contracts. Without Lehman, billions of dollars’ worth of “zero net exposure” suddenly became billions of dollars of plain, old exposure — i.e., unhedged risk.
But that’s when the US Treasury stepped into the path of the falling dominoes with trillions of dollars of newly printed cash and government guarantees. As a result, the dominoes did not merely stop falling, but Wall Street banks were also able to take their fallen dominoes to the Fed and trade them for cash. Pretty nifty, no?
But what happens next time? Will the US government’s power of credit and collusion be sufficient to prevent a disaster in the derivatives markets?
No one knows — least of all the folks who are sitting atop this big, steaming pile of risk exposure. Here’s a bit of background...
In the derivatives markets, the term, “net exposure,” conveys a sense of certainty and reliability — a sense of finely calibrated balance. In fact, “net exposure” more closely resembles the image of two drunks leaning against one another. The net balance between the two drunks is the only pertinent risk factor, the apologists argue. As long as the two drunks are leaning towards one another, the two of them can toss back as many tequila shots as they wish. On a “net basis,” they behave as if they are completely sober.
But what if one of the drunks should keel over backwards, instead of merely leaning toward his fellow drunk? “That won’t happen,” comes the practiced response from the derivatives industry. “That won’t happen. Don’t worry about it. The four largest banks operating in the derivatives markets maintain very manageable levels of net exposure.”
Your California editor is not convinced. He suspects these levels of net exposure are only manageable...until they aren’t. Furthermore, these exposures are growing rapidly. Since 2000, the notional value of US derivatives outstanding has multiplied ten times faster than world GDP. At last count, American banks had conjured more than $200 trillion of financial derivatives into existence, according to the Options Clearing Corporation — a staggering sum that is equal to roughly three times world GDP!
Even scarier, this mind-blowingly enormous pile of risk is highly concentrated inside the finance industry. A mere four banks hold 94% of all derivatives contracts outstanding. JP Morgan’s exposure, alone, is larger than the entire world’s GDP...while the gross exposures of Bank of America, Citigroup and Goldman Sachs do not trail very far behind.
The story becomes even more frightening when you take a closer look at what these “little derivatives are made of.” Snakes and snails and puppy dog tails would be an improvement.
“In its 2011 annual report,” reports James Grant, editor of Grant’s Interest Rate Observer, “J.P. Morgan Chase & Co. discloses that the great bulk of the bank’s [derivatives]...are classified as ‘level 2’ assets, i.e., they are valued, in part, by analogy.”
JP Morgan’s derivatives book is not unique. A whopping 97% of all derivatives trade “over-the-counter” where illiquidity and opacity are the norm. In other words, they do not trade on a public exchange where buyers and sellers continuously exchange cash for securities, thereby establishing real-world, real-time values for the securities they trade.
Let’s summarize:
1. Gross US derivatives exposure is more than three times world GDP. 2. Four banks hold nearly all of this risk. (And by the way, each of these four banks received billions of dollars from the Federal Reserve and Treasury four years ago to ensure their survival). 3. Almost none of these securities trade on a transparent, public exchange. Therefore, they are valued, as Jim Grant says, “by analogy.” | What could possibly go wrong?
To begin answering that question, let’s take a closer peek at JP Morgan’s exposure — specifically, the calculation of its “Derivative Receivables” relative to its tangible equity capital (TEC).
“Derivative Receivables” represents the money other folks owe to J.P. Morgan, based on the current pricing of the derivatives on JP Morgan’s books. These are Morgan’s “winning bets” in other words. But as every gambler knows, a winning bet is not automatically a moneymaker. You must also collect the bet from the loser. Thus, the “Receivables” line item on the balance sheet represents uncollected bets.
So, what would happen if a couple of the losers didn’t pay...just like Lehman Bros. didn’t pay its bets a few years ago? Would that be a problem? In a word: yes.
Obviously, the size of the problem would depend upon the size of the reneged bet or bets. So just for kicks, let’s imagine that almost everyone made good on their bets with J.P. Morgan. Let’s say that 19 out of 20 repaid their bets, while only one out of 20 refused to answer his phone.
If something like that occurred, Morgan would be short roughly $90 billion — a shortfall that would completely wipe out Morgan’s tangible equity capital. In other words, just one deadbeat gambler out of 20 could imperil the bank’s very existence. Morgan would be insolvent...at least until the Treasury and the Fed flew in their “financial medevac” choppers to airdrop billions of dollars onto the disaster scene.
We aren’t saying a disaster is likely to strike. We are merely saying that it is not unimaginable.
And here’s the really crazy thing; there aren’t even 20 gamblers in the derivatives markets to diversify the risks, there are only four that matter — all four of whom are also “the House.” In other words, because only four big banks hold 94% of the derivatives, they all owe money to each other in virtually incalculable ways.
Yes, they can each count the actual receivables and payables, but they still cannot quantify the “what ifs” they could ensue if one piece of this multi-trillion daisy-chain breaks down. “The high concentration of derivatives among the top four players,” warns Reggie Middleton of the Boombustblog, “strongly suggest that they may be subject to extreme levels of counterparty risk towards each other. JPM is the largest player in derivative markets accounting for approximately 40% of total notional value of derivatives in US. JPM’s notional value of derivatives as of March 31, 2009 stood at 39.0 times its total assets and 959 times its tangible equity.”
These spectacularly large data points concern us. Enormous, opaque and illiquid risk exposure is rarely a good thing.
That said, we would quickly add that we have no axe to grind with J.P. Morgan...or any of the other big banks. Maybe they are great banks in every way, maybe they aren’t. We have no idea. We are all about hating the sins, not the sinners. And we are concerned about the sizeable risks that linger just beneath the surface of the world’s financial markets.
Any fool can see that the four big derivatives banks should be dialing back their exposures before the next credit crisis, rather than necessitating the next mega-bailout. But Fed Chairman Bernanke is no fool. He’s got enough education and advanced degrees to understand that two drunks leaning against one another are actually “net sober.”
We aren’t that smart...and probably never will be.
Regards,
Eric J. Fry,
for The Daily Reckoning
| | | | | Dozens of Congressmen have used “inside information” to make a fortune on stocks... |
But did you know that there’s another way Congressmen pile up personal wealth while they’re in office?
Senator John Kerry did this recently and took home at least $92,723.
But what’s really surprising is that you and I can use this “trick” as well.
Learn about the full story here .
| | | | | | Bill Bonner | | What Happens When the World Economy "Goes Japan" | | |  | | Bill Bonner | The Dow sinking.
Gold sinking.
Oil sinking.
Copper sinking.
Yields sinking.
We struggled with this, Dear Reader. We meditated. We prayed. We drank heavily.
And finally...we overcame the rank desire to say: “We told you so!”
As you know, Martin Wolf, of The Financial Times, is the voice of The Economics Establishment. All that is great and good in the field — which isn’t very much — is given voice by Wolf. Then, it is acceptable for policymakers, Treasury ministers, and central bankers, not to mention the people you talk to at cocktail parties.
And lo! Here cometh the neo-Keynesian economist. What saith he?
He says the world is drifting towards Japan.
Of course, that was the message 10 years ago from a certain feral economist who will not be mentioned. He maintained that Japan was a leader, not a follower...and that the US would follow in Japan’s footsteps...with about a 10-year lag.
He even wrote a book on the subject, with Addison Wiggin: Financial Reckoning Day.
Where he got these ideas, we don’t recall. What we do recall is that almost everyone laughed at him. “Japan?” they said. “The US is nothing like Japan. We have a dynamic, robust economy. We have Lehman Bros., Bear Stearns and Countrywide ‘low doc’ mortgages. We have Alan Greenspan. And George W. Bush. We have ‘mission accomplished’ in Iraq. We have Silicon Valley, Bernie Madoff and a housing boom. Japan has none of those things. Ha. Ha.”
But now, the last laugh is on the other foot!
Japan’s market topped out in 1990. The US market topped out — in real terms — in 2000. Thereafter, Japan saw on-again, off-again recession...sinking prices, generally...and slumpy conditions. The US economy staged a limp recovery in the ’02-’03 period...then gave investors a bubble head-fake. Now, it’s back to the slump...
..and now, both Europe and America are looking more Japan-like every day.
Martin Wolf explains:
On May 10, 2012, the yield on the German 10-year bund was 1.44 per cent, on the US 10-year Treasury was 1.85 per cent and on the UK 10- year gilt was 1.9 per cent.
These are extraordinary numbers. They are particularly striking in the cases of the US and UK, which unlike Germany, run very large fiscal deficits and are experiencing very rapid increases in public sector indebtedness.
This combination of falling government bond rates with very rapid rises in public sector indebtedness reminds us, of course, of the experience of Japan since 1990.
At the end of 1990, when its “bubble economy” went pop, the Japanese government’s 10-year bond was yielding 6.7 per cent. As the economy subsequently declined, deflation took hold and fiscal deficits and public debt exploded. But yields on 10-year Japanese government bonds (JGBs) fell to close to 2 per cent in 1997 and then, with sizeable fluctuations, to troughs of 0.8 per cent in 1998, 0.4 per cent in 2003 and, recently, to 0.9 per cent. In short, the worse the Japanese government’s present and prospective debt position has become, the lower the interest rates on JGBs has also become.
Similarly, in July 2007, just before the beginning of the crisis and consequent explosion in fiscal deficits and debt, the US 10-year Treasury yielded 5.1 per cent. Now, almost five years later, the bonds of this alleged fiscal basket case yield less than 2 per cent. Again, in the UK, another supposed basket case, with huge fiscal deficits and a slipping austerity programme, yields have fallen from 5.5 per cent in July 2007 to below 2 per cent. | What does it mean?
Well, if the US and Europe are following Japan...and Japan is going nowhere...then three of the world’s large major areas are dead in the water.
And if that is the case, you can expect the entire world economy to “go Japan.”
That will mean lower commodity prices. A lower price of oil. A lower price of gold. Lower interest rates — yes, look for the yield on US 10-year notes to drop below 1%. Bad unemployment figures. Low...or negative growth...falling real estate prices.
..and probably a stock market crash.
Hold onto your hats!
And more thoughts...
Well, okay...so the Yahoo! guy ‘embellished’ his resume a little. Big deal. Really, we’re surprised to see people make such a fuss about it. After all, who can honestly say they haven’t put a little positive spin on their own achievements. We have!
But let us rush to clean up our credentials before Dear Readers make a federal case of it.
Okay...on our age. It says we were born in 1959. Must be a typo. We were really born in 1953...okay...’48.
And, it says we attended Harvard University. Well, yes...we certainly did ‘attend’ Harvard... But through some bureaucratic mix- up our name was never on the official student list and our diploma must have gotten lost in the mail.
As for the Pulitzer Prize, we wouldn’t say that we were awarded the prize, not exactly. There again, it seems to be a case of a slight mis-wording. “Pulitzer Prize-winning” describes the quality of our work...as widely recognized, at least in the office here.
And we didn’t exactly invent the Post-It note. We just invented something like it, with scotch tape and a piece of paper. Same idea.
And, okay, did we really “win” the Nobel Prize in economics? We probably shouldn’t have used the word “win.” We were nominated...well, mom thought should have been nominated. She was putting us “in the running”...or something like that.
There, we hope that clears up any misunderstandings.
*** How do you like that? A guy comes from Brazil. He makes billions helping Zuckerberg launch Facebook. And then he leaves the country. You’d think he’d be more grateful. Or at least more sentimentally attached to the land that gave him so much loot.
But no. Edouardo Saverin is pulling out of the USA. Bloomberg reports:
Eduardo Saverin, the billionaire co-founder of Facebook Inc. (FB), renounced his US citizenship before an initial public offering that values the social network at as much as $96 billion, a move that may reduce his tax bill.
Facebook plans to raise as much as $11.8 billion through the IPO, the biggest in history for an Internet company. Saverin’s stake is about 4 percent, according to the website whoownsfacebook.com. At the high end of the proposed IPO market capitalization, that would be worth about $3.84 billion. His holdings aren’t listed in Facebook’s regulatory filings.
Saverin, 30, joins a growing number of people giving up US citizenship ahead of a possible increase in tax rates for top earners. The Brazilian-born resident of Singapore is one of several people who helped Mark Zuckerberg start Facebook in a Harvard University dormitory and stand to reap billions of dollars after the world’s largest social network holds its IPO. | But the rich are doing it all over the world.
A report from London tells us that the French are moving to town. France’s new president has pledged to raise income taxes on the rich to 75%...and to boost France’s wealth tax too. Wealthy French people are buying houses in South Kensington to escape.
As for the rich in Argentina, they’ve been making tracks for many years. As soon as they get some money they buy an apartment, in Miami!
Here in Baltimore, wealthy people have been getting out of town since the top in real estate in 1927.
And now, the rich are leaving Maryland too. Governor O’Malley says “wealthy people can afford to pay a little more in taxes...”
Well, yes, they can afford it. But that doesn’t mean they will like it.
“We’re moving to Florida,” says an old friend.
“Wait for me,” says your editor...
Meanwhile, the Irish and Spaniards are leaving their homelands too. Money is the reason. But smaller amounts of it. There are few jobs in Ireland or Spain, so they’re leaving to find work.
Even the Chinese are jumping ship. No kidding. Taxes are low in China.
Regards,
Bill Bonner
for The Daily Reckoning
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Here at The Daily Reckoning, we value your questions and comments. If you would like to send us a few thoughts of your own, please address them to your managing editor at joel@dailyreckoning.com
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