The JPMorgan (JPM) incident comes at a bad time. Global economic expansion faces "liberalist" headwinds, risk-arbitrage gets a black eye and the race for the White House hits the final furlong.
Economic headwinds: Eurozone efforts to stabilize member nation fiscal issues got hung out to dry last week following recent French and Greek elections. Voters in each country veered sharply to the left. Post-election rhetoric hints at major disagreements to proposed austerity measures.
Francois Hollande's victory in France raises the possibility that Franco relations with Germany could require re-negotiating previous alliances established between former French President Nicolas and German Chancellor Angela Merkel.
In Germany, Chancellor Angela Merkel's Christian Democrats are also threatened as her CDU party took a beating from the left-wing Social Democrats in state elections (North Rhine-Westphalia is Germany's most populous state).
As for last week's Greek elections, they point to the obvious. Greek voters defiantly reject austerity, but are unable to decide (as a majority) who should lead the country.
The inconclusive results were visible in the make-up of Greece's Parliament. The two governing parties - Pasok and New Democracy - yielded their majority to five other parties that campaigned against austerity, winning more than 60% of the vote. Note: new elections have been tentatively scheduled for June 17th.
Western Europe's embrace of socialism signals apathy toward austerity and a good excuse to defer pro bailout discussions for another day.
JPMorgan: JPM's failed hedging strategy appears to have involved large positions taken last year in a credit-default-swap benchmark known as the Markit CDX North America Investment Grade Index (series 9).
Essentially, the index is a tool to speculate on the creditworthiness of large North American companies such as retailer Wal-Mart Stores Inc. (WMT) and aluminum producer Alcoa Inc. (AA) among others.
It was also a hedge against uncertainty in Europe, which likely escalated sufficiently enough in recent months to create a broader disturbance in the credit markets. It also tipped its hand to other traders willing to bet that JPM's positions might get stuck in the sand.
Details are still emerging, but it is thought that JPM may have attempted to offset the index risks by selling protection on a portion of the Series 9 index using leveraged contracts. Presumably, the objective was to capture the difference between the trades.
Exacerbating the situation might have been the sudden political shift in Europe. VaR (Value-at-Risk) or CAPM models aren't designed to estimate the risks of such events. The dispassionate nature of mathematics doesn't discern between what is normal or not.
Unfortunately, the voters of France, Greece, Germany, Italy and others may have signaled that spreads between JPM's trades won't be narrowing anytime soon. That's probability for you, but darn those spreads!
U.S. Politics: To a market participant such as myself, the thought of enduring Sen. Carl Levin's mug splashed all over television (again) might be a worse fate than JP Morgan's "egregious" mistake.
With Dodd-Frank architect(s) Barney Frank (D-MA) set to retire after three decades in Congress and Sen. Chris Dodd (D-CN) retired from 30 years in the Senate, Sen. Levin is one of the last old-guard opponents of big banks left standing.
Levin (D-MI) is Chairman of the powerful Senate Permanent Subcommittee on Investigations and co-author of the Volcker Rule. Levin has been a U.S. Senator since 1979.
The Michigan senator was also a vocal proponent of The Community Reinvestment Act (CRA) and cast a "YEA" vote on Gramm-Leach-Bliley Act (GLB), (aka Financial Services Modernization Act of 1999.) GLB effectively repealed a portion of Glass-Stegall.
Coincidentally, all three men are Democrats, but this is not about the quid pro quo nature of US politics. It's plentiful on both sides of the aisle. However, Mea culpa is rare in U.S. politics and history points this out.
The events leading up to the credit crisis also reveal how politics may have contributed to this disaster. Frank, Dodd and Levin stand out in particular:
- Each was a loud proponent of "easing" lending standards
- Each held ranking or chairman positions in powerful financial and banking committees
- Each accepts no responsibility for his hand in the credit mess
Irony of Situation: Politicians are only human and who would not want to preserve their legacy of public service?
Yet, re-writing history rather than acknowledging it benefits no one. Rather, it speaks more to the need for term-limits than it does "financial reform".
Sub-prime lenders such as Countrywide, WaMu and others were the effect of lax lending standards, not the cause. Unwittingly or not, it was the blessings from career politicians such as Levin, Frank and Dodd who opened the door and let the banks in.
What about the regulators? Former Fed Chairman Allan Greenspan is often criticized by economists and politicians as a primary suspect in the credit crisis. Critics argue that easy monetary policy created the mess.
Greenspan did open the spigot of liquidity, but he had to so something to get the economy growing again. Business cap-ex spending had dried up and it was the consumer who was keeping the economy moving.
Greenspan realized that monetizing home equity (using your home equity as an ATM machine) might help the consumer keep spending. Spend they did! Unfortunately, neither Mr. Greenspan nor most other people for that matter, anticipated home prices would collapse.
The mandate of the Fed is tasked with managing U.S. monetary policy, regulating bank holding companies and other member banks, and monitoring systemic risk.
Summary: Europe is a mess for many reasons. Cultural differences, massive debt, unsustainable public sector and union pension liabilities are a just a few. For many Euro nations, they have more going out than they have coming in. Euro voters say "no" to harsh austerity and embrace socialism.
JPM clearly was on the wrong side of its massive hedge trade, and euro woes likely contributed to its failure. We do not yet know the full extent of losses or if and when they can unwind these positions. Bad risk management at JPM is glaring, but shareholders feel pain, not taxpayers.
With U.S. elections six months away, you can bet our elected officials will be banging the table for hearings and calls to tighten financial regulations. But, this begs a bigger question. Is it more regulation we need or just better regulation?
More important, if career politicians such as Dodd, Frank and Levin were unable to recognize a credit disaster coming down the pike 10 years ago, making JPM a scapegoat now does not say much about their ability to govern.
Mr. Dimon has accepted responsibility for his firm's bum trade and it is reasonable to assume JPM learned a valuable lesson in risk management.
Betting and losing your own money is one thing. But, allowing lawmakers to use a political three-ring circus as a means to gloss over history is far worse.
Who knows, maybe a decade of denial will make JP Morgan's $2-3 billion dollar screw-up seem like a bargain? JPM will be election fodder for anti-bank lawmakers. Whose smoking-gun will voters buy into?
Additional sources: The Guardian-UK, Reuters, The Economist
Disclosure: I am long JPM.
