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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.
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.
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.
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
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???"
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.
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!
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.