JPM Derivatives Monster Crashes

By: Adam Hamilton | Fri, Jul 26, 2002
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What an extraordinary week in the markets!

It is not every week that the stocks of major money-center banks crash, frantic rumors fly of derivatives meltdowns and secret Federal Reserve meetings, and investors and speculators are left gaping in awe. As the ancient Chinese curse said, we certainly do live in "interesting times" and there is seldom a dull moment in the greatest bear market in three generations.

After the dust settled from this week's chilling bear market carnage and resulting spectacular mid-week bear market rally, I found the equity action for elite money-center bank JPMorganChase (JPM) particularly provocative.

On Tuesday July 23rd, JPM's stock plummeted by an unbelievable 18.1% in a single day! It is hard to overestimate the magnitude of this devastating technical breakdown in the House of Morgan. We are not talking about some fly-by-night dot-com company here, but the flagship US bank which has long been listed as a proud member of the venerable Dow 30 club.

As the graph below vividly illustrates, prior to its fleeting bear market reaction rally in the middle of the week, JPM had hemorrhaged a gut wrenching 66.8% from its all-time high only a couple years earlier! Does anyone else find it disturbing that an elite American bank's stock is behaving like some of the fallen NASDAQ market darlings? What do the sellers know?

The Great JPM Crash of 2002

Crash is indeed a strong and emotionally-charged word, but the sickening 18.1% single day rout in JPM is its greatest daily loss by far since Black Monday, October 19th, 1987, which was the largest daily percentage plunge in US stock market history. The nauseating trading action this week led JPM to slice through its previously unassailable 1998 low like Martha Stewart through veggies on the CBS Morning Show. The stunning record volume spike during the one-day JPM crash is quite evident above as well, with 45m shares of the bleeding banker changing hands.

As a JPM short for reasons I articulated in my past two essays on the colossal inverted derivatives pyramid which the House of Morgan has miraculously cobbled together with duct tape and bailing wire, I was not terribly surprised by the JPM crash. That afternoon, one set of JPM puts we own and had recommended to our clients in our private Zeal Intelligence newsletter in February were up 392%, not too bad in these markets.

I am telling you about our JPM short gains in the spirit of full disclosure. If you want to listen to market prognosticators who have so little confidence in their own advice that they don't even place their own hard-earned capital at risk in their own recommendations, watch CNBC.

The primary reason we were actively betting for a JPM plunge was its unfathomably large derivates positions. To us, the company looked more like a hedge fund gone mad than a commercial bank, a vast Frankenstein's Monster created by the hasty stitching together of countless cryptic off-balance sheet OTC derivatives contracts.

For a comprehensive background on derivatives and JPM's positions, please see my two previous essays "The JPM Derivatives Monster" and "JPM Derivatives Monster Grows." If you are not somewhat familiar with the wild and crazy world of derivatives, I explain all the derivatives terminology I use here in these prior foundational essays.

Amazingly, the bad news for JPM the day it crashed was not a derivatives implosion, although those rumors were certainly flying around the trading desks, but further allegations that JPM helped companies like Enron defraud their shareholders. United States Congressional investigators told the media that JPM specifically structured deals explicitly designed to mislead the investors in major public US corporations by almost magically erasing unfavorable numbers from corporate balance sheets.

US Senator Carl Levin, the Chairman of the Senate Permanent Subcommittee on Investigations, actually released an excerpt from an incredibly damning e-mail from a JPM executive. It said, "Enron loves these deals as they are able to hide funded debt from the equity analysts." For Americans raised by their parents to always abide by an unbendable code of honor and integrity no matter what, the activities of JPM in helping corporate crooks effectively steal the retirements of a generation of Americans by fraud is absolutely repulsive.

I happened to be working out the morning after the JPM crash and was watching pre-market action when JPM paraded its Vice Chairman, Marc Shapiro, on CNBC. Mr. Shapiro proceeded to tell the world that his firm "did nothing wrong" in its dealings with Enron. He went even further and added, "We are not a company's accountant."

This comment in particular is going to cause big trouble! According to the US media, the Congressional subcommittee has audiotapes they listened to Tuesday where JPM officers are telling accountants exactly how to structure offshore entities so they appear independent. If the sham shell companies didn't appear to be independent, then they couldn't be used to materially misstate JPM's clients' financial statements.

Apparently JPM feels there is nothing wrong with structuring deals to help corporate crooks hide debt and expenses from investors. This callous and dishonorable "let them eat cake" mentality is particularly troubling in light of all the scandals already plaguing corporate America. Shouldn't elite bankers at JPM just know that it is immoral and dishonorable to help their corporate clients produce materially misleading financial statements? Have they no honor?

The vultures at the SEC want to rip the flesh off JPM's carcass too. The SEC Deputy Director of Enforcement Linda Thomsen, who is supervising the Enron investigation and involved in the JPM probe, told a group of lawyers earlier this month that bringing criminal cases would be "one of the best ways to get people's attention." The SEC has already subpoenaed JPM records, and Congress wants signed affidavits from its executives.

Along with JPM, fellow elite money-center bank Citigroup was also taken out behind the woodshed and crashed in the middle of the week. A New York Times article the day of the crash discussed how JPM and C had structured loans designed to specifically mislead equity analysts and investors by disguising them as legitimate commodity trades, which they almost certainly weren't according to Congressional investigators.

More of the same you grumble, no big surprise, why is it relevant if JPM bankers conspired to defraud American investors from their life savings by disguising debt which could have warned investors of problems early before stocks like Enron imploded? These same amoral people running JPM, who apparently believe they have no responsibility to treat investors honorably, have constructed the biggest derivatives pyramid in the history of the world.

I discussed the JPM Derivatives Monster in my two past essays, but here is a brief update. As the following graph shows, JPM controls 51% of the total notional value of all the derivatives of all the US banks playing the incredibly dangerous derivatives game, but only commands about 11% of the total assets of all the banks dabbling in derivatives.

Per the latest official US Office of the Comptroller of the Currency bank derivatives report, Q1'02, JPM alone had $23.5 trillion notional value in derivatives outstanding! To put this gargantuan number into perspective, every man, woman, and child in America all working together can "only" manage to produce $10.4 trillion worth of goods and services every year. JPM's derivatives book is almost two and a half times as large as the entire US economy! Here are the quarterly OCC numbers since 1998, the same time frame shown in the JPM stock graph above.

JPM Derivatives Dominance

A single bank, JPM, utterly dominates the derivatives market like an 800-pound gorilla. I discussed some of the startling implications of this unbelievable fact in my previous two essays on JPM's derivatives. Isn't it more than a little disturbing that the once-proud company that now apparently has no problem charging exorbitant fees to other companies to hide their debt from their investors has a virtual monopoly on the bank derivatives market in the United States?

The next graph farther illustrates just how far out of whack JPM has mutated compared to the 378 other US banks playing the dangerous derivatives game that are required to report to the Office of the Comptroller of the Currency. All data in this graph is either direct from official OCC quarterly bank derivatives reports or the official 10-K and 10-Q financial reports JPM filed with the US Securities and Exchange Commission. Surely JPM wouldn't illegally misstate their own SEC filings on purpose even while they were allegedly helping other US companies do the same, would they?

JPM Derivatives Leverage

Since 1998, all US banks other than JPM playing the derivatives game supported an average of 4 times their total assets in notional derivatives value. The JPM Derivatives Monster, on the other hand, had an average of 41.9x its total assets leveraged in notional derivatives terms, an order-of-magnitude greater exposure than all of its peers combined! These numbers are so absurd that I truly hope you don't take my own word for it, but visit the OCC, download the bank derivatives reports, and crunch the numbers yourself. I would have never believed this hyper-extreme leverage was possible without seeing these reports with my own eyes!

Amazingly, even JPM's stellar leverage on assets really understates the true magnitude of its enormous derivatives positions. Commercial banks do have large asset bases, but most of these assets are offset by liabilities. When you open a bank account, the cash you deposit becomes both an asset of the bank and a liability of the bank owed to you as they are merely holding your money.

You can pull your funds out of a commercial bank at any time, often without any warning to the bank depending on what kind of account you have. Unlike a typical manufacturing corporation, much of commercial banks' asset balances are offset by short-term liabilities that can be called at any time if depositors want their money back.

Because of the fleeting nature of commercial bank assets contingent on depositors' collective good faith, I strongly believe that the derivatives positions that any bank has amassed should be measured on equity. Equity is what you have left on a balance sheet after all liabilities are subtracted from all assets. The black line above, tied to the right axis, shows JPM's recent incredible leverage on equity in notional derivatives terms.

Since Q4'99 the House of Morgan has averaged an astounding derivatives leverage on equity of 618x! An elite money-center bank or mammoth hedge fund gone mad? 618 times leverage on equity! Unbelievable!

Per the latest OCC quarterly bank derivatives report and JPM's Q1 10-Q SEC filing, the elite mega-bank was still sporting a 571x derivatives leverage on equity as of the first quarter of this year. This is a small improvement but the absolute level still utterly defies rational thought. As I explained in my past JPM Derivatives Monster essays, with hyper-leverage inevitably comes unavoidable hyper-risk. Just ask the rocket scientists who blew-up Long-Term Capital Management in 1998 about the wicked double-edged sword of derivatives hyper-leverage!

The derivatives world is a funny place. Most of the big derivatives deals are private over-the-counter transactions that are not exchange traded like the common options we buy and sell on individual stocks. These OTC contracts are made between a mega-bank like JPM and an individual company that either seeks to offload its risk by hedging or assume additional risk by speculating. Because the OTC contracts are private, customized, and unregulated, the reputation and honor of the bank writing the contract are of paramount importance.

Companies come to JPM to hedge their risks through private derivatives contracts because the bank has an incredibly sterling reputation going back over a century. The House of Morgan name has been above reproach for a long time due to the hard work of JPM's employees over many decades. Unfortunately though, reputation is a fragile thing. Even a single major headline breach of trust can quickly destroy the fruits of decades of hard work in building a name and brand.

As Arthur Andersen proved, decades of goodwill can be obliterated overnight by one high-profile fraudulent action in a small portion of an entire firm. The elite Big Five public accounting firm was considered blue chip and invincible a few years ago. Today it is thrashing in grisly death throes like an Ebola Zaire victim. If JPM is tarred and feathered and its derivatives clients lose confidence in its integrity, it too can certainly see decades of goodwill vaporize as if trapped at ground zero of a thermonuclear explosion.

JPM's unprecedented $23.5t inverted derivatives pyramid is hyper-leveraged and carefully built upon the irreplaceable trust of every entity that signs derivatives contracts with it. With the US Congress now investigating JPM for explicitly designing financial smoke-and-mirrors for corporate crooks like the Enron rogues trying to materially mislead and defraud their shareholders, I can't help but suspect that some of the companies on the other side of those $23.5t notional value derivatives contracts may grow a little nervous.

After all, companies pay mega-bucks to offload their risk to JPM via OTC derivatives contracts. These companies have to believe, have to have complete faith and confidence, that no matter what happens JPM will be able to make good on its side of the contracts.

This is called "counterparty risk" in the derivatives world. A private OTC derivatives contract made with a counterparty that doesn't have the financial strength to back the contract even in the worst-case scenario is worthless. In addition, a private OTC derivatives contract made with a counterparty that doesn't have the honor to be trusted in even the worst-case scenario is worthless. Trust and confidence is everything in the private OTC derivatives world!

I have witnessed a lot of legendary financial carnage that turned my stomach since the supercycle bubble burst, but I can't even describe the anger and revulsion I felt when JPM paraded their executive on CNBC and he looked in the camera and implied that JPM did nothing wrong by helping Enron cheat investors by cooking its books.

As a small businessman, I will not do any important deals with amoral people, folks who don't believe in right and wrong and don't abide by ancient codes of honor and integrity. It is just not worth the risk. If I can't trust someone, I will never put any serious money on the line with them. In the Information Age honor and integrity are more important than ever as new technologies make it even easier to mislead and steal than in past decades. I know I am certainly not the only one in business who still feels this way!

JPM has worked hard and led corporations to sign derivatives contracts controlling $23.5t in notional value. JPM's website proudly boasts that it does business with 99% of the Fortune 1000 US companies. What if some of these high-profile JPM derivatives clients see the writing on the wall and lose their confidence and faith in JPM's honor and integrity? What if JPM begins hemorrhaging derivatives clients so fast that its enormous inverted derivatives pyramid book cannot remain balanced?

I can scarcely conjure up a more frightening scenario for the global financial markets than a humongous $23.5t inverted derivatives pyramid rapidly unwinding and perhaps imploding if it spins out of balance if systemic confidence and trust in JPM fail due to its abhorrent recent activities!

A US Congressional firestorm is brewing. It is an election year. The supercycle bear market bust is well on its way to utterly destroy the savings of a whole generation of American investors. Americans are furious and want to see arena bloodsport ending in death for anyone they perceive to be even remotely related to the corporate criminals which they believe defrauded them. I have never witnessed such an insatiable bloodlust and naked rage amongst the American populace regarding the financial markets. Heads will roll, because Hell hath no fury like a politician in an election year!

And along comes the House of Morgan, its name suspiciously popping up in virtually all the major corporate scandals in the States. According to US Congressional investigators, JPM designs and aggressively markets financial structuring explicitly designed to remove bad stuff like debt from balance sheets so investors will be misled and not know the true financial condition of the companies in which they have placed their precious capital at risk.

Will JPM, rightly or wrongly, be perceived by Congress as the common denominator in the widespread corporate frauds, the giant spider at the center of the web selling the corporate crooks the very weapons used to defraud their investors? Is JPM the ultimate financial arms dealer in the dirty war against American investors?

To make matters worse, JPM executives are now telling the burned investing public with a straight face that they did nothing wrong in helping US companies misstate their financial statements.

Where is the honor? Where is the integrity? Where is the accountability? If JPM's legions of derivatives counterparties begin to waver in their trust of the falling giant, its derivatives business is doomed.

It will be most interesting to see what happens to JPM's massive derivatives business and positions now that the company is apparently telegraphing to the world that it has no honor, that it can merrily help other companies cheat investors for large fees, and not feel a tinge of remorse about it after the fact.

Perhaps some distressing systemic derivatives bombshells will be spawned in the current quarter by the failing confidence in the JPM Derivatives Monster. The release of the OCC's Q3'02 bank derivatives report is still several months away, but it may be incredibly interesting to behold.


 

Adam Hamilton

Author: Adam Hamilton

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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