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Is JP Morgan leveraged to death on derivatives?

By maynard in MLP
Thu Oct 18, 2001 at 02:51:03 PM EST
Tags: You Know... (all tags)
You Know...

Zeal Research claims to produce "contrarian" analysis of market trends. On September 7th they published The JPM Derivatives Monster , an essay which provides a basic explanation for derivative such as puts and calls, a history of some of the derivative debacles of the 1990s (such as the spectacular implosion of Barings Investment Bank of England), and then finally uses a Office of Comptroller, U.S. Treasury, report to discern that JP Morgan, a blue chip high profile bank, has it's 41 Billion worth of assets leveraged on the derivative market 611 to 1, for a staggering $26 Trillion leveraged exposure against a total $43.9 Trillion derivatives market. That's almost 60% of the entire derivatives market. Given the high risk of these securities, does this seem wise? And considering that the US GDP is somewhere around $8 Trillion, what would a market implosion of their position imply for the overall US Economy?

I'm sure there are better heads than mine here at K5, what do you think?


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I have purchased derivative investments and...
o Won big time on average 0%
o Lost big time on average 10%
o Came out about even 6%
o Kill the rich! 83%

Votes: 30
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Related Links
o Zeal Research
o The JPM Derivatives Monster
o Also by maynard

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Is JP Morgan leveraged to death on derivatives? | 35 comments (24 topical, 11 editorial, 0 hidden)
Uhhhh... Ummmm... Errrrrr... (3.72 / 11) (#1)
by jabber on Tue Oct 16, 2001 at 04:29:24 PM EST

Nevermind a professional analysis.. How about a translation into plain English?

Ok, I admit it, I know precious little about investment banking, trading stock and the black magic that makes the world go round.. The sum total of my knowledge in this area can succinctly be summed up in the phrase 'buy low, sell high'..

Could any of these 'better heads' decipher the article, with a run-down on terminology, in addition to offering an opinion on the matter?

WFIW, I am happy to say that I recognize all the words involved, and can even pronounce them all convincingly.. But as for this context, well, I can barely keep from drooling on my keyboard. ;)

[TINK5C] |"Is K5 my kapusta intellectual teddy bear?"| "Yes"

What I think (3.92 / 13) (#4)
by ucblockhead on Tue Oct 16, 2001 at 04:46:04 PM EST

I think I haven't a fucking clue about any of this.
This is k5. We're all tools - duxup
Skip the first part of the article... (4.00 / 4) (#7)
by Amorsen on Tue Oct 16, 2001 at 05:11:59 PM EST

If you aren't familiar with derivaties, skip down to the paragraph starting "The humble option is..." There is an excellent explanation of options there. After you have read it you can start over at the beginning of the article.

I do think the risk exposure is overestimated in the article. If you buy options, you can only lose however much you've paid for the options, no matter how much you happen to have leveraged.

Also, derivatives are often used to decrease financial risk exposure. Say, I'm a Dane exporting windmills to the US made from German steel. I buy steel in Euro and sell windmills in USD, but I use DKK with my bank. If the Euro rises in value towards the DKK, I will pay more in DKK for my steel and I could go bankrupt. Similarly, if the USD falls, I will get less in DKK for my windmills, and I could go bankrupt. To ensure that I have time to react to such things (changing suppliers or finding new markets), I could buy "get" options for Euro and "put" options for USD. This ensures that I can get the Euro I need without paying through the nose, and that I can get a decent price for the USD my customers use to pay me.

It is not clear from the article how much of JP Morgan's leveraged exposure actually increases risk, and how much decreases it.

Ah, but... (5.00 / 3) (#9)
by trhurler on Tue Oct 16, 2001 at 05:36:14 PM EST

While I think this guy either doesn't know or isn't telling the whole story, the truth is, you can lose a lot more in derivatives trading than you put in. In addition, they're leveraged over 600 to 1, which means they don't have to lose much of their leveraged position to run out of actual cash with which to back it - in fact, only one sixth of a percent loss, and short of a bailout, you can stick a fork in them. You're right that you can reduce some risks using derivatives, but odds are you aren't reducing risk when you're into interest rates(the whole point is to assume risk for someone else in exchange for a fee, which may or may not exceed any loss due to the risk,) which make up the vast majority of their leverage. Think about that.

'God dammit, your posts make me hard.' --LilDebbie

[ Parent ]
Ah but, 2 (4.00 / 2) (#11)
by Amorsen on Tue Oct 16, 2001 at 06:19:08 PM EST

In theory, JP Morgan could be asking others to assume JP Morgan's risk in exchange for a fee... This is highly unlikely of course, especially since JP Morgan would have to be exposed to an large interest rate risk in the first place. However, the article could have looked into the possibilities.

The next question becomes whether JP Morgan are protecting people equally against lower interest rates and higher interest rates. If they do it right, they will end up with little actual risk and a lot of profit. Of course, it is easy to get the balance wrong, and if the interest rate goes completely wacko they will owe so much money to the one set of customers that the profits from the other set can't pay it.

The article fails to give an accurate picture of how risky JP Morgan's endeavour really is. It is a very interesting article, but perhaps crying wolf a little to loudly. On the other hand, they have apparently cried wolf earlier for good reason

[ Parent ]

I'm not certain about that (5.00 / 2) (#12)
by trhurler on Tue Oct 16, 2001 at 06:43:03 PM EST

The thing is, the government report they cited is a listing of risks assumed, I'm fairly certain, and as such would not include them passing interest rate risk off on others. I'm not absolutely sure of this, but fairly.

As for balancing the interest rate risks, you're right, and the theory they offer regarding gold makes some sense in that context, since it would suggest that interest rates are more stable when gold prices are both low and stable. The problem is, we don't have a gold standard economy, or anything even remotely resembling one. Sure, you can pin the price of gold, but since money isn't based on gold, you do not in turn pin the price of money, which is what the article presumes.

Why they act like it is so strange that a gold standard economy would relate gold speculation to interest rates for cash is beyond me. It makes perfect sense, but perhaps it conflicts with some aspect of Keynesian theory that isn't occurring to me. After all, Keynes said a lot of very silly things, as you can witness by examining the various failures of the Great Society. :)

'God dammit, your posts make me hard.' --LilDebbie

[ Parent ]
Derivatives Monster (4.71 / 7) (#8)
by nurglich on Tue Oct 16, 2001 at 05:26:16 PM EST

Freshman calculus students are quite familiar with him. And he's got powerful friends like the Non-Linear Partial Differential Equations Monster. What he has to do with investments is beyond me though.

"There are no bad guys or innocent guys. There's just a bunch of guys!" --Ben Stiller, Zero Effect

Standing in front of you is a large, Black monster (none / 0) (#26)
by Anatta on Wed Oct 17, 2001 at 02:00:39 PM EST

Its claws are sharp, deadly. It stares at you, growling. It attacks!

It's a Black-Scholes Option Pricing Monster. I'm sure the math students will deal with it handily, perhaps with a +2 Calculator.
My Music
[ Parent ]

Broken link (5.00 / 1) (#27)
by Anatta on Wed Oct 17, 2001 at 03:54:36 PM EST

Here's the monster.
My Music
[ Parent ]
What about... (none / 0) (#28)
by prosthezis on Wed Oct 17, 2001 at 05:53:04 PM EST

Captain Derivative?

Where is that guy when you need him?

...if you write one more diary entry complaining that you're not cool enough to be invited into the other geeks' role-playing sessions, I'll fucking kill you! - Tatarigami
[ Parent ]

Ignorance maybe... (4.66 / 3) (#13)
by symbiotic on Tue Oct 16, 2001 at 08:02:57 PM EST

...but I have never heard of those people. I am also always suspicious of companies that have an "analyst" side of the house and a "consulting" side of the house. Lately, there have been a lot of investment bankers "chastised" for their bad practices, and in the IT world, it is well known that IT analysts are "biased". Check out this somewhat dated but still very good article published in Upside on the topic at Upside There are many more on investment bankers if you search the WSJ.

Love it. (4.33 / 9) (#14)
by RobotSlave on Tue Oct 16, 2001 at 08:51:51 PM EST

Plus one. Front page.

It is just too cool to watch K5 readers vote this story down for being "not about technology" when the front page is choked with foreign policy articles.

Do yourself a favor. Pick a prominent stock or two and then go lurk on an investment board for a while. Some of them are hilarious. You won't learn enough to become a trader, but you'll at least figure out a few things about this "money" stuff works.

If you lurk long enough, the gold bugs will eventually come out of hiding, and when that happens, you're in for a real treat. They're the grand conspiracy freaks of the investment world. And they wrote the piece that this MLP references. Go find the GATA web site and read as much as you can handle-- it's an exercise in vicarious dementia that only the internet can provide.

On a side note, JPM/Chase is indeed in rough waters these days, but it's not because of their derivatives exposure. The reason? My guess would be credit cards (the most likely reason for the interest rate derivatives hedge), or maybe mortgage exposure. I don't know, I haven't done due dilligence, and I don't plan to, because it's one of the most boring things imaginable.

Wake up, kids. If the Greenspan economy gets hit with a combination of credit card default, mutual fund divestment, and a collapse of the real estate bubble, it will affect you far more than any scrap of anti-crypto legislation on the horizon.

More on Options (4.66 / 3) (#15)
by imadork on Wed Oct 17, 2001 at 12:03:04 AM EST

The K5ers who aren't business gurus but who want to understand options and can handle lots of equations and financial jargon might want to pick up "Options as a Strategic Investment" by Lawrence McMillian. It's practically the Textbook for Options. And it's just as dense as any of my Engineering textbooks.

But it goes into options in painstaking detail, as well as all the funky options plays you can make. I spent some time with the book because I was interested in learning more about options, and came to two conclusions:

- You need Lots Of Money to do anything with options, and you need to not be afraid to lose it, either.

- You also need to be smart. There are ways to hedge your options plays, from something as simple as aiming to have 90% of your Options account in CASH at all times, to complex derivative combinations that trade lower risk for lower returns.

Options aren't the evil things that many people (including this author) make them out to be -- As long as you're smart with them. Stupid People who lose their shirt in Options and didn't do something ahead of time to hedge their losses deserve what they get.

As for my track record, I bought some put options on a rumor, lost it all, and haven't been back since. So pehaps I should have listened to my own advice...

Care to explain? (2.00 / 3) (#16)
by thunderbee on Wed Oct 17, 2001 at 03:11:38 AM EST

As this is not my field, and I suspect it is not the field of a whole bunch of people around here, I guess some explanations might come in handy, huh?

*swish* (2.75 / 4) (#20)
by boxed on Wed Oct 17, 2001 at 08:07:15 AM EST

You went totally over my head. As a person who is not very knowledgeble about economics and who's native tounge is not english this reads as follows:
[...] an essay which provides a basic explanation for blabla such as blabla and blabla , a history of some of the blabla debacles of the 1990s [...]
and so forth. To sum it up: you went over my helmet?!

The first half of this article is great (5.00 / 1) (#22)
by Anonymous 242 on Wed Oct 17, 2001 at 11:06:23 AM EST

The article linked to by maynard is a great introduction to what derivatives and options are. Ignore the introduction. Pay attention to the description of options and derivatives. It is lucid and informative. Don't bother with the second half of the article on JP Morgan.

Anyone put off by the blurb, ought to read at least the first half of the article. If you don't understand options, this will at least give you an inkling as to what they are about.

It puzzles me why the author seems to think that a cursory explanation of options will serve to make the more technical portion of the article coherent to the novice to the world of economics and finance. The second half of the article might as well been written in Latin for all I was able to understand it. If the first half had been expanded to explain the assorted derivative strategies that JP Morgan was actually using then perhaps I could've understood the second half. Then again, maybe not.

Speaking of Latin, anyone know why Scoop seems to be storing æ as '?' instead of 'æ'?


Lee Irenaeus Malatesta

A good book on investment banking/derivatives (4.00 / 1) (#24)
by FlinkDelDinky on Wed Oct 17, 2001 at 11:37:11 AM EST

Frank Partnoy worked for investment banks and wrote this book F.I.A.S.C.O (Amazon link). It's an extremely well written and engaging book that describes the frightening world of derivatives within investment banking.

There's good reason to be concerened even if you only buy stocks. Some very scary stuff...

hah (2.00 / 2) (#25)
by core10k on Wed Oct 17, 2001 at 01:18:16 PM EST

They don't explain their terminology, but they DO explain what a 'trillion' is. I'm beginning to think this article is crap.

One trillion is a ridiculously large number and almost impossible to visualize in the abstract. Trillions of dollars of derivatives exposure blow the mind! According to MegaPenny, it would take 1.8t pennies to create an exact full-scale replica of the Empire State Building out of pennies.

Look a little closer (5.00 / 2) (#29)
by cameldrv on Wed Oct 17, 2001 at 08:08:07 PM EST

First of all, these guys are nut-job gold bugs. They're trying to convince you that we're all screwed and that you had better get your money into something real before the sky falls. If people actually did this it would be a disaster for the economy, as we would be spending all of our capital digging up gold to put under the matress rather than starting new companies and building factories and such. Now, as to JPM, you have to understand that "derivatives" are not just about speculation. Big banks like Chase and JPM make deals with their customers all the time called forward contracts. These contracts create risk for the bank, which they want to mitigate. They can do this by buying options. Perhaps they want to tweak the risk profile a bit and so they sell some options at different prices and maturities. They also may be doing some arbitrage, and finally, some speculation. The point is, though that "Zeal Research" makes it out like this is all some gigantic gamble. It's not. They are buying and selling risk according to a set of strategies. People learned after the LTCM fiasco that there are limits to how fancy you can get. As a final note, the figures here are highly suspect, as an options position has two sides, and therefore it is impossible for any one party to have more than half of the market (Zeal says 60% for JPMChase), or you would be trading with yourself, which should not be part of these types of calculations.

figures (none / 0) (#31)
by Garnier on Wed Oct 17, 2001 at 09:19:22 PM EST

As a final note, the figures here are highly suspect, as an options position has two sides, and therefore it is impossible for any one party to have more than half of the market (Zeal says 60% for JPMChase)

That could be explained as in the graphs JP Morgan and Chase Manhattan are shown as separate banks.

[ Parent ]

You missed the bigger flaw. (2.00 / 1) (#34)
by RobotSlave on Thu Oct 18, 2001 at 12:11:45 PM EST

The figures in the article apply only to the options activity of commercial banks. Here's the key quote from the article:

We are not sure what percent of the total derivatives market that commercial banks and trusts represent, but we suspect it approaches a majority.

Awful grammar aside, this means that at most, the authors think that commercial banks account for 50% of all options activity. So for the remainder of the article, you've got to at least halve all of the figures quoted (or double them, as appropriate), e.g., JPM/Chase accounts for what may be as much as 30% of all market activity, rather than a definite 60%.

The screed is so insane that I would suspect the submission of being a troll if I were not aware of the surprising credulity of the average K5 poster in any field outside the purview of computer technology.

[ Parent ]

not convinced (4.00 / 1) (#30)
by Garnier on Wed Oct 17, 2001 at 08:44:56 PM EST

Apart from the obvious stuff such as the extreme sensationalism (e.g. three paragraphs to describe how much a trillion is, constantly appealing to the JPM investors, bringing up the collapse of Barrings and the LTCM fund more times than I can count etc) I think there are quite a few things that make this a particularly bad article.

One thing I noticed is that he implies that since:
a. interest rates have an inverse relationship with gold prices, and
b. JPM possibly had inside information on the manipulation of gold price,
JPM therefore had information on how interest rates would develop. I think that this is untrue: gold prices are affected by fluctuations in interest rates but not vice versa. The gold market is really tiny, and its impact on anything else is almost insignificant (and decreasing). Interest rates are determined by other things e.g. inflation (increasingly common) or growth.

Another thing he does not justify is why even though Wall Street analysts say that notional amounts are not related to the risk of a position, he dismisses that, and goes on to justify the subsequent FUD entirely on the notional amounts of JPM's positions.Extending his own example, lets say that someone else is offering options to purchase stock at a strike price of $65 for 10c an option. With the same capital ($5000) we can now control the gains and losses of 50,000 shares, a leverage of $2.5M or 500 times our capital. This is in the order of magnitude of the exposure of JPM, but it is still obvious that we can only loose the original 5000. So why does he care so much about the notional amounts, which he describes himself as "fictional numbers"?

I could probably go on (especially about the stuff he says about gold, which seems to be contradictory), but I think you get the picture. I'm still voting +1 because even though I think the article is flawed, biased (did the guy loose money on the gold market and wants to get back at JPM or something?), and depends more on sensationalism than facts, I would like to see what people with a better understanding of economics will comment. I could be totally wrong as well after all :-)

Allow me to dumb this down a bit (4.33 / 3) (#33)
by ennui on Thu Oct 18, 2001 at 10:41:47 AM EST

Think of JP Morgan like an off-track bookie, and derivatives as skells at the tracks who place bets on his behalf. Since JP does a lot of business, he's got to keep his shills busy fixing his bets, so it means a lot of money in the pools (markets). Saying their exposure is a staggering "$26 Trillion" would be true if all the markets they're in simultaniously went to 0 and near infinity, but because their options are straddled they make money as long as the markets move, just as the bookie knows that even though his skells are laying out tons of money on long shots he'll make it back on smaller payouts on winners and in the rare cases the long shots come in, because a long shot and the favorite don't come in 1st on the same race.

"You can get a lot more done with a kind word and a gun, than with a kind word alone." -- Al Capone
"When Genius Failed" is closer to the pr (4.33 / 3) (#35)
by tz on Thu Oct 18, 2001 at 08:36:33 PM EST

The problem with JPM is that some of their positions exceed the size of the physical market.

When it comes to something like US banks, they take a dollar in for savings and loan out 10. What happens if everyone demands their deposits all at once or even if the loans can't be repaid? Bank-ruptcy. But in practice the FDIC comes in with a bag of money or the FED so can shore this up. If you don't believe me, just study the history of the Savings & Loan debacle and the Resolution Trust Company. The FSLIC didn't have enough money to shut down some of the insolvent thrifts, so the hole got deeper until it imploded.

The Gold (and Silver) bugs have a point. www.gata.org has a document for those interested. The FED can print money, but can't mine gold. The derivative position is likely a "short" which means they promise to deliver X ounces of gold for a given price. If X ounces don't exist in accessible form (and there are a few tons below the WTC which can't be delivered), they have to buy it or convince enough people to melt their jewelry to make good, or to buy back the contract at market value. Of course if you are producing Film, you can't stuff options and futures contracts and have photographic film come out.

Long Term Capital Management was supposed to have everything wrapped up. In order to get over 10% on a few billion, they had to leverage over 100 Billion. They were careful to make sure they would pick bets that were impossible to go wrong - like converging interest rates for the introduction of the Euro. It worked fine until Russia defaulted and one side of the trade started going into areas that statistically should not have happened for 1000 years. Then they were losing a half Billion per day when they only had a few billion to play with, but still had 100 billion leveraged. When Genius Failed chronicles this.

The World Trade Center is also an example. They never insured against both towers collapsing because they didn't think it possible. Currently many insurers are going to be in trouble.

The same idea can hit home. How many K5 readers could handle losing their job, having something expensive (some uncovered medical or dental expense, home damage, etc), and still be able to pay off their credit cards on time? You might be able to handle one or two things, but after a time it would be impossible. If you haven't been unemployed in 10 years you are generally less cautious than if you haven't had income in the last two.

The economy has been very good for the last 10 years. There was the asian crisis, but we are in the Western world where nothing can go wrong... go wrong... go wrong...

Is JP Morgan leveraged to death on derivatives? | 35 comments (24 topical, 11 editorial, 0 hidden)
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