Sent: 15-05-2012 09:08:02
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J P Morgan Losses another Blow to Retail Investor Confidence
J P Morgan's $2 billion trading loss hinders the rebuilding of global market confidence as it rekindles debate about the stability of financial institutions. The message: no matter how competent managers appear, investors carry an ongoing (and perhaps rising) risk of adverse earnings surprises.
The J P Morgan Chase trading loss announced by its chief executive on Thursday prompts several thoughts about financial institutions and the markets in which they operate.
Firstly, if something is going wrong, chief executives may be among the last to know. This is true of any commercial organisation. Frequently, chief executives are sought out for their insights into market and economic conditions giving the impression that they know more than they do.
If there is a change in market condition, the first reaction of the people at the pointy end of the sales process whose income depends on meeting budgets is to see what can be done to stop the rot. If nothing can be done to remedy a sales shortfall, the change gets reported up the line and, eventually, the chief executive is briefed on what is happening.
In the case of J P Morgan, press reports as long ago as early April were highlighting unusually large trades coming from the London investment office of the bank. Jamie Dimon, the chairman and CEO of the bank, has now admitted that he should have taken more notice of those reports (and by implication less notice of the denials coming through internal channels).
Secondly, use of the term 'hedging' may lull people into a false sense of security. Unfortunately, what companies often pass off as hedging is nothing but a blatant speculation about the direction of markets.
The classic hedge arises in the context of a processor of raw materials. A copper refiner, for example, buys mine output and, some weeks or months later, sells a refined product. During the time taken to process the raw material, copper prices can change. To eliminate the risk of having to sell the final product at a lower price than the price at which the inputs were purchased, the refiner can simultaneously sell its copper purchases in an offsetting forward contract.
According to detailed reports coming from the Wall Street Journal and other London press sources, the J P Morgan transactions apparently involved portfolio hedging or trading against the overall assets of the company. They were not offsetting specific transactions to eliminate a price exposure thus blurring the distinction between proprietary trading and hedging. With a 2.3 trillion dollar asset base, the scope for trading large positions, dressed up as hedging, is enormous
The simple commercial bank model contains a natural hedge. The banks take funds from depositors and lend at higher interest rates to borrowers. Liquidity is a key risk to manage but there is no need for hedging in this model. Trading may occur to modify the value of the asset base but this is erroneously and misleadingly referred to as hedging to give it a legitimacy that it would not otherwise have. It is simply taking a view on the direction of the market.
Thirdly, once more, there is evidence that the biggest banks and highest profile managers are not safe.
In recent months, and largely unconnected with the global financial crisis, MFS Global came unstuck through bad trades and a big ego leading the way to oblivion and UBS made large losses as a result of poor governance and risk controls.
J P Morgan had established a reputation for having a strong management team. Jamie Dimon came through the financial crisis with an enhanced reputation. Female hosts on business programs referred breathlessly to his good looks. His star power gave him access to Washington where he lobbied hard against regulations designed to restrict the very activity that has got the bank into trouble.
The J P Morgan experience highlights that managing increasingly complex organisations from the top as they implement trading strategies beyond the wit of even the most financially astute graduates may no longer be possible. If a manager with Dimon's credentials cannot control such risks, some will conclude, there will be little chance for lesser mortals.
The JP Morgan episode could result in greater pressure to divide banks along business lines with independent supervisory boards to achieve greater rigour in monitoring financial market exposures. This suggestion surfaced in US congressional hearings reviewing the financial crisis but was rejected then. It could come up again. If it does, its impact may not be confined to the USA.
Fourthly, investors might have to simply resign themselves to accept that an investment in a large bank is going to bring with it the occasional shock loss as a consequence of trades gone wrong. This might require everyone to become less sensitive to apparently big numbers.
The message from the bank is 'do not worry because a two billion dollar trading loss is not big in the context of the overall business'. This was the same argument used at the beginning of the 2007-09 financial crisis. Sub prime loans for housing were reckoned to be such a small proportion of the assets of the US banks - some estimates at the time were as low as 3% - that a fall in the value of the housing stock was not going to jeopardise the system.
In earlier years, current Australian banks have also had near death experiences and some Australian financial institutions no longer exist because of their inappropriate borrowing and lending practices.
Investors need to take account of this ongoing pattern. The likelihood of periodic large losses might be greater now as the global economic environment attracts banks to synthetic means of making profits while they remain cautious about engaging in traditional commercial lending.
Finally, perhaps, trading profits should be reported, too. J P Morgan lost $2 billion. That means somebody, or some group of people, made a similar profit. What a pity that, for the sake of balance and market confidence, the other side of the ledger does not get reported so we can see who the smart guys really are and invest accordingly.
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