Monday, May 14, 2012

The collateral losses...  

It's likely most of us just snickered when the now-infamous trading blunder by JP Morgan was revealed. But since then, a little more thought and information adds to the curious nature of what is now our financial system.

To begin with there is question of scale.  While farmers are arguing about a new farm bill that will cost (ostensibly) about $18B per year for farmers, it should be measured by this supposedly huge mistake.
The number that you have not heard is the cost of the legislation, which is $995 billion over the course of the next 10 years, for the mandatory elements of the Farm Bill. 
1.    $772 billion or 78% is for domestic nutrition assistance programs, primarily the Supplemental Nutrition Assistance Program (SNAP).
2.    $223 billion, is divided among various agriculture-related programs,
    a.    Crop insurance ($90 billion, or 9%),
    b.    Farm commodity price and income supports ($63 billion or 6%),
    c.    Conservation ($65 billion, or 7%).
    d.    1% of the baseline is for international trade ($3 billion)
    e.    Horticulture programs ($1 billion).

Of course, the shallow-loss provision is an unexploded budget bomb that could balloon those numbers should prices drop drastically. 

But note that we are fighting over a few billion per year and JPM just bungled away $2b is a matter of hours.

But the big jolt is, it's peanuts for JPM.
Over at Seeking Alpha, Gene Kirsch tried to put Hedgegate into a broader context. "JPMorgan losses are reported to be actually $800 million in Q2 with the potential for legal and other losses up to $4.2 billion over a longer period of time, possibly exceeding one year," he wrote. "The banking unit of JPMorgan Chase alone made $12.4 billion last year. The holding company has over $2.26 trillion in assets and is the largest U.S. bank and 8th largest in the world. The holding company made $29.9 billion in operating income and just over $20 billion in net income for 2011. So, this initial loss of $800M represents approximately 4% of its total net profit for all of 2011, less than 2.7% of its operating income."
The firm, in other words, can manage it. Though as Brad DeLong was quick to point out, tallying the direct losses misses the episode's larger impact on the firm's value. "The revelation that JPMC did not have control over its derivatives book--even though accompanied by promises of multiple firings and deep reforms--destroyed 1/7 of JPMCs franchise value." Turns out the market doesn't much like it when what's reputed to be the safest bank on Wall Street turns out to be incompetent.
Jared Bernstein draws out the larger lesson nicely, and so I'll quote him at some length. "The fundamental truth here is the one known since Adam (Smith, that is) and amplified by the great financial economist Hy Minsky: humans underprice risk. Their proclivity to do so increases as the business cycle progresses and confidence takes over (remember, JP’s bet was unwound by the fact that the economy wasn’t as strong as they thought). The advent of a global derivatives market with notional trades in the trillions greatly amplifies the risks."
"The fact that humans like Jamie Dimon—he who presided over JP’s self-proclaimed 'fortress balance sheet'—he who inveighed against financial reform as imposing unnecessary oversight on such skilled risk managers as he and his staff—fall prey to this fundamental truth only underscores the lesson of this episode in financial hubris."
"And that is this: financial markets are inherently unstable. They will neither self-correct nor self-regulate. Their instability poses a threat to markets and economies and people across the globe. Therefore, they need to be regulated. That’s not to say that anyone knows the best way to do this yet in order to balance the necessity of oversight with the dynamics of the markets. We don’t know where to set the speed limits. It must be an iterative process. But we do know they need to be set, and JP’s loss should be taken as a warning that our tendency is to set them too low." [More]
Our world is now one where all the behemoths are not governments when it comes to economic clout.
It also indicates to me that this sector is not so much about "allocating capital efficiently"anymore. It's about finding things to bet on. Or deriving them from thin air.

The bottom line for me: the more distance I can put between me and Wall Street the stronger my future finances. Participating directly in derivative markets (options) is a sucker's game, and will be subject to lightning raids when JPM-like entities decide to swoop in for whatever reason using the latest quantitative strategy.

Marketing partnerships (contracts) with our grain merchandising industry (coops, ADM, etc.) at the least throws them under the finance bus before my farm is hit. Thinking I can play with these guys, regardless of my preparation, smarts or adviser is a bad idea. They operate on another level where I am defenseless.


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