Thursday, 03 September 2009 01:00

Why Doesn't the Media Take a Truly Independent, Unbiased Look at the Big Banks in the US?

JPM derivative and off balance sheet lending commitments and guarantees exposure

Warning!!! This is the type of investigative, unbiased and independent analysis that you will never find in the mainstream media. Long live the Blogoshpere!!!

As we step through the various exposures that this most esteemed bank has, keep in mind that as of June 30, 2009 JPM's common shareholder's equity and tangible common equity stood at $147 bn and $79 bn, respectively. You tell me if the risk inherent in our banking system has been mitigated, please!

Off balance sheet lending commitments and guarantees

As of June 30, 2009, JPM had exposure of $85 billion (or 108% of its tangible equity) towards off balance sheet lending commitments and guarantees. The contractual amount of the off balance sheet lending commitments and guarantees represents the maximum possible credit risk should the counterparty draw upon the commitment or JPM be required to fulfill its obligation under the guarantee, and the counterparty subsequently fail to perform according to the terms of the contract.

Click any and all graphics to enlarge to printer quality.

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Derivative exposure

As of June 30, 2009, the total notional amount of derivative contracts outstanding as of June 30, 2009 was about $80 trillion (or 101,846% of its tangible equity). I hear a lot of you smart guys and gals out their saying, "But hold on a minute there, big fella! Notional amount quotes are misleading. It is the net exposure that truly determines economic risk." Okay, smart guys and gals. I guess I can buy that, at least in part. The only issue is that there is no free lunch. Let's move on to see how this can play out. Let's ascertain the fair market value of JPM's derivative exposure.

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Gross fair value (before FIN 39) of the derivative receivables and derivative payables was $1,798 billion (or 2,276% of its tangible equity) and $1,749 billion (or 2,214% of its tangible equity), respectively. The, fair value of JPM's derivative receivables (after FIN 39) was $84 billion (or 106% of its tangible equity) while the fair value of JPM's derivative payables (after FIN 39) was $58 billion (or 73% of its tangible equity). FIN 39 allows netting of derivative receivables and derivative payables and the related cash collateral received and paid when a legally enforceable master netting agreement exists between JPM and a derivative counterparty.

How does JPM swap out $1.8 trillion dollars of fair value market exposure to the much smaller $84 billion (which is still more than 100% leveraged at 106% of its tangible equity) net amount? What magic has the financial engineering wizards that have created the original FrankenFinance monsters (see Welcome to the World of Dr. FrankenFinance! for more on this scary alchemical mischief) used to accomplish such a feat? By netting the risk out, of course! Hey!!! Doesn't that mean that JPM has swapped one form of risk for another? If one were to consider the $1.8 trillion amount to be invalid due to the claim that JPM has offsetting agreements with other entities, then JPM is reliant on the solvency, liquidity, and management of said "other entities". Thus, JPM has swapped a more than $1.7 trillion of market risk for roughly more than $1.7 trillion of counterparty risk. I think it is quite misleading to simply pretend the credit and/or market risk just,,,, well,,,,, disappears. Ask Lehman Brothers', AIG's or Bear Stearns' counterparties if that market risk (which was allegedly netted out) simply disappeared - or was it just transformed into another form of risk? I think Goldman Sachs knows above all, if it wasn't for strong government connections, about $13 billion of "netted" market risk would have shown up on the books as a loss due to counterparty failure. Luckily, they manage their "political risk" quite well through the strategic purchase of key government (ahem) opinions, at least thus far...

So, if JPM has more than $1.7 trillion of counterparty risk (or 2,152% of its tangible equity) that is NEVER mentioned in the mainststrem or popular financial media, exactly what are the chances of that counterparty risk being tested? Let's stroll through the credit quality of their derivatives and offbalance sheet portfolio from a bird's eye view.

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About 23% of the derivative receivables (in terms of fair value after FIN 39) were below investment grade (less than BBB or equivalent) while 12% were rated BBB or equivalent.

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Credit derivative positions

JPM's credit derivative positions include positions in the dealer client business as well as positions entered for credit portfolio management. The total notional amount of the credit derivative positions as of June 30, 2009 was $6.8 trillion

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Within the dealer/client business, JPM utilizes credit derivatives by buying and selling credit protection, predominantly on corporate debt obligations, in response to client demand for credit risk protection on the underlying reference instruments. Protection may be bought or sold by the Firm on single reference debt instruments ("single-name" credit derivatives), portfolios of referenced instruments ("portfolio" credit derivatives) or quoted indices ("indexed" credit derivatives). The risk positions are largely matched as the Firm's exposure to a given reference entity under a contract to sell protection to a counterparty may be offset partially, or entirely, with a contract to purchase protection from another counterparty on the same underlying instrument. Any residual default exposure and spread risk is actively managed by the Firm's various trading desks. After netting the notional amount of purchased credit derivatives where the underlying reference instrument is identical to the reference instrument on which the Firm has sold credit protection, JPM has net protection purchased of $82 billion along with other protection purchased of $77 billion.

So that's it. They are square, then. Of course unless the sellers of their protection default. If they do, then it may very well cause a daisy chain reaction that could get very ugly (see Counterparty risk analyses - counter-party failure will open up another Pandora's box). If you thought Lehman caused problems, compare Lehman's counterparty exposure to JPM's. Of course, JPM is one of the government's favored sons, clearly articulated as being "too big to fail". I posit this though - imagine Tim Geithner going back to congress saying, "I know my predecessor extorted $780 billion out of you by threatening the collapse of the entire financial system, and I know Bernanke has been handing out barely collateralized loans by the hundreds of billions like a pervert in a porn shop without security, but JPM is just too big to fail and they have $1.7 trillion plus of exposure that looks to be about blown up - chain reaction style - and they only have $79 billion of tangible capital to make good on it. How much TARP did you say was left again???"

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Looking at the credit quality of the reference entity under the protection sold by JPM, about 34% of the credit sold (before the benefit of legally enforceable master netting agreements and cash collateral) was below investment grade as of June, 2009.

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Gains and losses on derivative exposure

In 2Q09, JPM recorded net gains on derivatives of $16 million in earnings after recording $6 billion of gains from trading activities offset by losses of $4.6 billion on risk management activities and by losses of $1.4 billion on fair value hedges. Risk management activities include fair valuation of the derivatives used to mitigate or transform the risk of market exposures arising from banking activities other than trading activities. Now, you tell me... With the advent of FASB caving in to politicians and Wall Street special interests and allowing financial entities to basically rewrite the profit and loss statements of non-marketable (actually there is no such thing, let's call it "assets whose market price management does not like the sound of") assets, what are the chances that JP Morgan fudged the results just a little bit, in order to eke out that $16 million gain, which is actually about a 0.267% profit margin!

Exposure to unconsolidated VIE

As of June 30, 2009, maximum exposure to loss from unconsolidated VIE included $32.3 billion under arrangements with multi seller conduits, $7.9 billion from nonconsolidated municipal bond vehicles, $27.2 and $6.0 billion through derivatives (the exposure varies over time with changes in the fair value of the derivatives) executed with the VIEs. This exposure to off balance sheet loss is basically all of JPM's tangible equity - nearly all of it, and this is just the off balance sheet VIE stuff!

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I will be offering a full blown forensic analysis and valuation to subscribers (click here to subscribe) since I have always believed JPM to be insolvent (if one were to mark all assets to market and take the appropriate capital charges for the risk that it has undertaken) but never really took the time to find out if my hunch was correct. I will try to get it out in the next week, and we shall see if my hunch concerning this bank was on point or not.

Last modified on Thursday, 03 September 2009 01:00

10 comments

  • Comment Link NDbadger Tuesday, 08 September 2009 21:59 posted by NDbadger

    I am a paying customer and I wanted to let you know I have no problem when you offer stuff for free. It is often important that as much of the information you provide is as widely available as possible. Indeed, you may want to consider after a certain period, 2mo, 3 mo, etc, making everything free.

    I believe JPM is a dog. Even without the insolvency issue (and I do believe that is a real risk), they will likely have to shrink dramatically for several reasons: they will likely have to turn over much of their OTC business to open exchanges and if the G20 gets its way, they will likely have to raise significantly more capital. Both of these will mean very weak if not negative returns going forward. Owning this thing is completely irresponsible.

    Out of curiosity, did anyone jump onto CBY when I put it out there? If this deal goes through as is, KFT is getting a steal.

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  • Comment Link Mark Hankins Tuesday, 08 September 2009 10:59 posted by Mark Hankins

    One more thought.

    If you spent as much on advertising in big media as they do, you would get a free pass on the editorial side too!

    If you were in the business of crucifying infants they would go find you some parents who would talk in glowing terms about what a great thing it is to have their infants crucified.

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  • Comment Link Reggie Middleton Tuesday, 08 September 2009 10:48 posted by Reggie Middleton

    We are finishing up our deep dive into JPM and this company has more skeletons in its closet than a graveyard. I am considering posting even more findings publicly, just to blow the whistle.

    If there are any responsible journalists reading this, I suggest you contact me via the email link in the top menu (contact us).

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  • Comment Link Mark Hankins Tuesday, 08 September 2009 10:29 posted by Mark Hankins

    One more thought.

    If you spent as much on advertising in big media as they do, you would get a free pass on the editorial side too!

    If you were in the business of crucifying infants they would go find you some parents who would talk in glowing terms about what a great thing it is to have their infants crucified.

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  • Comment Link shaunsnoll Friday, 04 September 2009 17:23 posted by shaunsnoll

    http://www.theonion.com/content/news/nations_unemployment_outlook?utm_source=b-section

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  • Comment Link shaunsnoll Friday, 04 September 2009 15:06 posted by shaunsnoll

    ummm..... we are currently [u][b]already [/b][/u]in TWO wars over scarce resourced....

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  • Comment Link RobieB Friday, 04 September 2009 12:34 posted by RobieB

    How will we finance a war? We have no money? We are a debtor nation. We could have an internal war, that happens. We could have a war for resources with Mexico not likely. We can print more money but the dollar might not be accepted outside the US as a fair unit of exchange. We can support a War effort within the country with our own printed dollars yes. As a past Military pilot, where am I going to get JP-4. US and Mexico go to war with Venezuela or some such story. Maybe! Someone would have to get agressive with an oil rich country who then hire the US as mercs, I mean we are really broke. Possible ! There are probably a limited number of scenarios that are predictable.
    Mexico has a huge amount of natural resources just cannot put together the funding and structure to go after them.

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  • Comment Link Rumi Friday, 04 September 2009 12:20 posted by Rumi

    /The end result of that effort is that certain nations will be deprived of certain important resources which they will observe to be in the possession of weaker neighbors. To the extent alliances are still intact, the violation of those weaker neighbors by one means or another will lead to retaliation by allies, which at some point will become military./

    That's been the traditional beat of history, but I think most of Asia has gone through a lot of war over the last couple of generations, and my bet is that they won't want it. America and Europe are probably a different story, though

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  • Comment Link Mark Hankins Friday, 04 September 2009 11:08 posted by Mark Hankins

    Money is simply a means to make more efficient the allocation of resources. When the monetary system fails (as it seems poised to do), the bankers and politicos have very difficult choices to make: rapidly and fairly allocate the losses amongst themselves (almost impossible), or quickly erect financial, legal, trade and even military barriers to isolate their nations from as much of the global damage as possible.

    The end result of that effort is that certain nations will be deprived of certain important resources which they will observe to be in the possession of weaker neighbors. To the extent alliances are still intact, the violation of those weaker neighbors by one means or another will lead to retaliation by allies, which at some point will become military.

    To a certain extent we have already seen these sorts of things taking place since the end of the Cold War ... Gulf War I, Gulf War II and Afghanistan (all driven by petroleum, including Afghanistan where the building of a pipeline is very much a key dream of petrobarons). Of particular note is China's recent announcement that it is looking to keep key rare earth metals mined only in Inner Mongolia to itself (depriving the world of erbium, terbium, dysprosium, etc. that is key for many high-tech applications).

    The free flow of commodities at market prices must continue in order to avoid war. I can't see that happening with a broken international monetary system, and I fear diplomacy is not equal to the Herculean task of untangling this mess.

    Israel will pay a lot of the price because Jews hardly ever escape being scapegoated.

    Rudyard Kipling didn't write a lot of science fiction, but when he tried his hand at it the result was "As Easy as ABC", a story freely available on the net and well worth the read despite having some jarringly archaic terms here and there... It covers the concepts beautifully.

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  • Comment Link gjk313 Friday, 04 September 2009 10:42 posted by gjk313

    Reggie, every time I read your posts it feels like my heart drops into my stomach. This is scary. My question is regarding historical comparisons during past banking crises particularly the early 90s. Do you have any comparisons to that time period or is the industry so different now that comparisons don't really mean anything?

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