Greedy Capitalists, Venal Politicians, and Voters

 Have Some More Money

J P Morgan, the biggest bank in the US, has lost a couple of billion dollars on a bad trade.  What's the odd billion amongst friends, eh?  Oh, no.  Gasp!  Horror.  Something must be wrong within the innards of what President Obama has described as "one of our better run banks". 

A phalanx of police and federal officials has descended upon the once-shining-knight, now tarnished JP Morgan to investigate what happened.  No doubt it will add to the swelling chorus for more regulation, controls, rules, and compliance that failed the last time in 2008 and have failed in their object ever since. 

The truth appears much, much more simple, yet sinister.
  But we can guarantee the root of the problems, the original cause, will not be addressed.  The reason?  The root of the cause gets far, far too close to the regime of US government itself.  It seems that Reagan's dictum still holds true: government is not the solution to the problem, it is the problem.

Chriss W. Street has written the background piece which explains what appears to have happened in one of the "better run banks".  Granted, it is early days yet, but his diagnosis has a ring of truth about it. 

After five years of miserable unemployment and virtually no growth, it seems clear the Federal Reserve’s $2 trillion increase in bank lending at zero interest rates has been better at expanding the international derivatives markets than expanding the American economy. The Federal Reserve owns much of the blame for this phenomenon. By keeping interest rates so low, banks were unable to make a rate of return above their cost of capital on traditional lending.

In an effort to stimulate the economy, the Fed has created out of thin air billions upon billions of dollars at near to zero cost to the wholesale borrowers.  The inane and naive idea was that these lovely banks would borrow the money from the Fed at little or no cost.  They in turn would rush out into the US heartland and on-lend that money to businesses and consumers at a low, but reasonable cost.  The end result?  Business would expand, employment would pick up, economic recovery would be underway.  The Fed has been following the classic Keynsian playbook.  When the pump is dry, to get re-started it needs to be primed with water, allowing it to turn over, which in turn creates the pump's suction will actually start to pump "real" water.  Then away it goes.  Hey presto--an economic recovery bursts forth. 

But banks have a duty to generate a return for shareholders. This classic Keynsian play forgets one little detail.  Those that borrow billions from the Fed's free money spigot are human beings.  They are animal spirits, with, strangely enough, an overwhelming desire to maximise returns and profits for their owners. That's what they are paid to do, and they get paid well when they are successful.  So, instead of taking the Fed's "free" money and thinking let's invest in mainstreet Ohio businesses or rust-belt Detroit battlers--which is a long, risky, low-return, granular strategy--where can we get the biggest bang for the billions of bucks the Fed has just created?  We owe it to our shareholders and to our bonuses to find an answer to that question.  JP Morgan asked the question, and got an answer.

The answer was in the form of a "big macro picture".  The world was stabilising after the global credit crunch of 2008.  Gummints were back in control.  They had removed most of the risks.  All would be well going forward.  (Doubtless the billions of new dollars floating around in the JP Morgan vaults gave strong supportive testimony to this "big picture".)  So, interest rates were going to fall.  Particularly in Europe where the Euro was stabilising due to the sterling work of Merkel and Sarkozy and the European Central Bank.  We can make quick money off this.  Quick money beats slow, risky money every time.

Achilles Macris, J.P. Morgan’s CIO in their London office, began using the bank’s access to cheap capital from the Fed to amass a huge over-the-counter derivative gamble that high yield and sovereign debt interest rates would fall, after MF Global suffered a $1.2 billion loss on similar bets and was forced to file for bankruptcy last October 30th. Morgan’s gamble became very profitable after December 21 when the European Central Bank (ECB) began making $640 billion of three year loans at 1% interest, referred to as “Long Term Refinancing Operations” (LTROs), available to the banks of Portugal, Ireland, Italy, Greece and Spain (PIIGS). By the end of December, J.P. Morgan’s total derivative exposure was $70.2 trillion on just $1.8 trillion of bank assets, according to the U. S. Controller of the Currency.

Morgan is reported to have continued heavy derivative buying in January and February. Its profits soared again when the ECB announced LTRO2 as another $714 billion in three year low-interest loans to PIIGS banks.

The plan was working.  Now at this point, we need to dismiss as utterly fabricated the notion that a few rogue traders were at fault.  There is no way that such a huge exposure would be kept hidden from executives.  The bank's internal regulations, risk management, reporting and controls would make that impossible.  We have no doubt that the senior executives would be up to this to their eyeballs.  They were booking the profit of the strategy to their accounts daily--as all the investment banks do. Their behaviour at the time lends weight to this:

The stock of J.P. Morgan vaulted from $29 per share in December to $45 a share in March as rumors swirled that Achilles Macris and his London team of 6 had already made $2-3 billion as high yield and sovereign debt interest rates continued to fall. A jubilant Jamie Dimon announced that J.P. Morgan would increase its dividend and buy back $15 billion of its stock.

But the problem with "big macro picture" strategies is that they always oversimplify reality.  In the oversimplification, risk becomes far more concentrated.  So, when a few uppity Greek voters began to make it clear they thought their government had taken austerity a step too far, suddenly risk returned to the debt markets in Europe.  Interest rates began to rise. 

Everything seemed rainbows and unicorns for J.P. Morgan until two weeks ago, when France and Greece elected hardcore leftist candidates who want to abandon austerity spending cuts and increase social welfare spending. Interest rates on the PIIGS sovereign debt shot back up and J.P. Morgan appears to have suffered a $4-5 billion loss. It also appears the bank has been unable to limit its losses to $2 billion by selling out of their enormous derivative positions.

The Fed provided the easy money capital for US investment banks once again to speculate at will.  Worse, the provision of this easy money confirmed the "big macro picture" which they developed as quick a money making strategy. 

Jamie Dimon tried to dismiss the losses by promising heads will roll, but Congressional hearings will soon illuminate to American taxpayers that the Fed has provided the capital that has allowed America’s three largest banks to engage in $173 trillion in leveraged derivative speculation:

JP Morgan Chase Bank
Derivative Position $70,1517,56,000,000
Total Assets $1,811,678,000,000
Leverage Ratio 38.5

Citibank National Bank
Derivative Position $52,102,260,000,000
Total Assets $1,288,658,000,000
Leverage Ratio 40.3

Bank of America
Derivative Position $50,102,260,000,000
Total Assets $1,451,890,000,000
Leverage Ratio 33.4

Of course the Fed's "free money" was itself leveraged up many, many times over to create gargantuan derivative positions.

The derivative exposure of these three banks alone exceeds 11 times the American economy and 2.7 times the economies of all the nations on earth. On December 30th, the derivatives leverage ratio of these three banks stood at 37 times. Menacingly, this leverage ratio exceeds the average leverage ratio of 32 times assets for Lehman Brothers, Bear Stearns and Merrill Lynch, shortly before the shock of their collapse instigated the start of the Great Recession in 2008.  (Emphasis, ours)

Have these investment banks not learnt, we hear you ask?  Nonsense.  Of course they have learnt very well the lessons of 2008 and 2009.  They have learnt that in the end the bigger you are, the more you become sacrosanct to the state--too big to fail.  The Treasury and the Fed will always come to the party and bail you out--that's the real lesson, and they have learned it all too well.  Meanwhile the Fed happily continues to throw money at them, pouring gasoline on the smouldering fire of animal spirits.

Kansas City Federal Reserve Bank President Thomas Hoenig in a recent interview warned that an extended period of ultra-low interest rates invites speculative behavior: “When you have zero rates that go on indefinitely, you are inviting future problems.” The recent J.P. Morgan derivatives fiasco has demonstrated that the Fed’s zero interest rate policy has encouraged risky financial speculation that is highly dangerous and potentially destructive.

The fundamental, systemic problem here is not the investment banks.  It is those governments which give them billions upon billions of cheap, easy, electronic money, zero cost money to play with with the ultimate protection of a government bailout.  All in a vain, completely discredited Keynsian attempt to get the economy moving again. 


Reagan was right: virtually without exception the gummint is the problem, or at best, it makes the problem far, far worse. 

(Postscript: some will point out that big investment banks were allowed to fail in 2008,9 and their shareholders and bondholders took not just a haircut, but a scalping.  True.  Then the government lost its nerve and recommenced the big bailout.  President Obama ran up 6 trillion dollars of debt, and the Fed exploded its liabilities in an historic manner to accomplish it.  The result?  The big investment banks that survived are even more of an oligopoly than before, risk is more concentrated, and the systemic problem has worsened.)