Is Opacity Hiding the Mother of All Ponzi Schemes?
Written by Desputatio Sapiens
The scary thing about the recently announced trading losses at JP Morgan is not that a twenty or thirty something “rogue” trader in London can lose a lot of money. That has happened to many if not most of the Too Big to Fail Banks and the system keeps rocking along. The really scary thing is that, just as with the mortgage mess of the 2000s, we are left with the feeling that no one, including Mr. Dimon, really understands the accounting used to book derivatives transactions.
1. What is VAR, Really?
Derivatives risks are not booked by banks based on the gross exposures of the banks. If so, JP Morgan’s $71 Trillion of derivatives exposure as of December 31, 2011 would totally overwhelm its $2.3 trillion of assets, even more so its $182 billion of net worth. Banks depend on highly complex models to determine the net risk of their derivatives portfolios. By netting out trades and utilizing formulas that only a Fine Hall mathematician could understand, the banks measure what they call “value at risk” (VAR) to determine the net bookings of their derivatives portfolios.
Using these formulas JP Morgan determined that, as of December 31, 2011, it had “only” $348 billion of net credit exposure (or 256% of Risk Based Capital) on its derivatives books. It looks like both of those numbers can come down by a billion or two as a result of the original JPM announcement (or maybe several billion more based on later information and conjecture). So here’s the scary part. While Mr. Dimon was quick to take blame for his team’s sloppiness and bad judgment, it also appears that part of the problem came about as a result of a flawed VAR model and that the bank will go back to using an older model which they now believe may be more accurate.
Can we seriously expect that can be a solution? Bill Black has asserted that the modern derivatives universe provides vehicles that can confound accurate accounting. Could VAR actually be the acronym for “vacuous accounting ruse?” Or could it be “voracious accounting rape?”
2. Who Understands This Mess?
Mr. Dimon has criticized Paul Volcker for speaking out against a trading system he says Volcker doesn’t understand. What if no one can understand the system? If the models being used by the banks cannot be trusted, there is no way for anyone, including Mr. Dimon, to know with certainty what his real risks are. We can say with some certainty that for JP Morgan the risks are likely between their risk estimate of $348 Billion and total notional exposure of $71 Trillion, but that’s a pretty big range.
“Rogue” traders only come to light when someone loses money. Until then they typically appear to be making a lot of money for their employers and have the status of a Roman God. The wild trading comes about when one of these guys incurs a loss, hides it and scrambles to make it up. Things get out of hand and suddenly you’ve got headlines. It would be really interesting to know what was happening in the JP Morgan trading book in question before the “London Whale” began to do his thing.
3. Is it possible that there might be losses built into the derivatives books as a whole that would appear once the gross notional exposures quit growing?
According to the most recent OCC Quarterly Report on Bank Trading and Derivatives Activities, Gross Notional Exposure from derivatives trading at U. S. Banks fell $17 Trillion in Q4 2011, leading to the first year-to-year decline on record. Not surprisingly trading revenues also fell from $8.5 billion to $2.5 billion in the fourth quarter. We have no way of knowing whether the current JP Morgan loss has any connection with the overall shrinkage of the derivatives books or whether our concerns about the booking of derivatives assets are well founded. The accounting is just too murky and we don’t have enough facts. Let’s hope that someone does.
4. What if the entire derivatives structure is an accidental Ponzi pyramid and the players don’t even know?
A Ponzi scheme has a specific definition (from Wikipedia):
A Ponzi scheme is a fraudulent investment operation that pays returns to its investors from their own money or the money paid by subsequent investors, rather than from profit earned by the individual or organization running the operation. The Ponzi scheme usually entices new investors by offering higher returns than other investments, in the form of short-term returns that are either abnormally high or unusually consistent. Perpetuation of the high returns requires an ever-increasing flow of money from new investors to keep the scheme going.[1]
The system is destined to collapse because the earnings, if any, are less than the payments to investors.
As stated in the discussion of the third question, we have no way of knowing whether or not the contraction of nominal value of total derivatives outstanding had anything but a coincidental relationship to the lack of liquidity that led to the large “hedging” losses at JP Morgan. Let us simply leave this fourth question open and ask a fifth, more specific question, which has an indirect relationship to the Ponzi question.
5. What if, when money stops coming in, the liquidity supporting the structure dries up?
It has been alleged by many that a compensation regime is perverse if it compensates for transactions as they occur and does not compensate for the later results of the transactions. By compensation, especially in later time, we mean both positive and negative events. If the well-compensated current transaction proves to have negative consequences later, a logical compensation plan would include claw backs in proportion to the eventual damage realized.
Thus, if the purpose for the build-up of derivatives is primarily driven by the compensation derived by process, the interest in further transactions of such vehicles should reasonably decline if the money to be made has left the house with the originators. The trade becomes purely defensive as every player tries to cover his exposures; one side (the risk side) of many trades can wither away. Too many want to hold the protection and too few want provide it. Liquidity is finis.
6. Is the continued growth of the TBTF sucking the air out of the room?
Let’s take a step back from the liquidity problem for derivatives and look at the larger economy. Why you might ask should ordinary mortals living everyday lives in Des Moines or Duluth or Dahlonega (the Main Street economy) care about the machinations of a few traders in London or New York. It’s pretty simple. If you’re a $15 million company in Des Moines growing to $50 million, you’re the heart and soul of the American economy, part of the small business engine of jobs growth that the politicians are fond of championing these days. And you’re NOT going to get a loan from JP Morgan – they are too tied up in this huge derivatives game. You depend on community and regional banks or private capital sources for your growth. The big money is otherwise occupied.
Community bankers around the U. S. all tell the same story. They have a multitude of great opportunities, but no capital to fund them. As a country we’ve put the entire banking system at risk to the success of the derivatives traders and as a result it appears that a third of the community banks in the U. S. will be merged or go out of business over the next several years. If America wants to succeed in the 21st century, it’s time to turn the equation around and put capital in the hands of the guys who know how to produce real jobs, not just jobs for the seven figure traders at the big banks, if it is not too late.
7. What if a declining global derivatives portfolio starts sucking the air out of the TBTF banks?
If the TBTF banks have been sucking the air out of the real (Main Street) economy, this question considers what happens when the “air” accumulating each quarter in the casino center banks reverses and a declining derivative notional volume collapses the former cash center into an expense center. The result is not likely to be that the air previously denied to Main Street will come rushing back. Main Street is not likely to see any benefit from the reversal because the air has been captured outside of the financial system and has been carried away by the high compensation and bonuses paid for cash flow and the winnings of players at the derivatives casino without consideration of the cost of that flow down the road.
Instead, a day of reckoning may draw nigh for the TBTF and their sovereign currency backers. And the former victims on Main Street would then be victimized further.
8. Will this produce the final resolution for The Great Financial Crisis with the collapse of the TBTF?
Herbert Stein is famous for saying:
“If something cannot go on forever, it will stop.”
The growth of the super-bank oligarchy has continued on an exponential growth path, seeming to ignore the hick-up of The Great Financial Crisis. As Elliott Morss has pointed out, the big four U.S. banks are much larger at the end of 2011 than they were at the end of 2007 before the Great Financial Crisis of 2008. The growth for three of the banks (Wells Fargo (NYSE:WFC) is not included because that banks asset growth is distorted by the merger with Wachovia Bank) is 23% over the four years compared to nominal GDP growth of 8%.
The growth of the financial sector has taken earnings from 15% of the S&P 500 20 and 30 years ago to more than 40% recently.
These types of relative growth numbers are unsustainable, and to be blunt, are simply unwarranted. Perhaps the wisdom of Herbert Stein may yet be brought to focus on the financial sector.
Conclusion
The one thing I know is that derivatives are a zero sum game. In the case of a true hedge, one party is willing to pay the other for insurance, but there is a winner and a loser. In a purely speculative derivatives market, all the parties are playing to win the night at the tables. It is likely that 95% plus of the trading is something other than true hedges, because the size of the derivatives market dwarfs the size of real assets which would be hedged. So we have to assume there are winners and losers, even though a vast majority came to the casino tables to win.
At a minimum, the croupier is there to take her tips. Where else do eight and nine figure bonuses come from? Maybe the trading profits are just another way the banks take it out of the hides of the poor suckers who are buying CDs at negative spreads and corporate or governmental borrowers who are paying too much for credit, but it just seems easier for me to believe that some of the trader salaries and reported profits are being capitalized in the long term contracts that are written and booked for five to twenty year durations at par. What a racket: long-term capitalization of short-term expenses. It’s just too much of a stretch to believe that this is the one time when everyone is playing it straight and no one has been tempted to take advantage of the money creation black box.
Thus I have asked eight challenging questions. It would have been interesting if these or related questions had been asked during congressional testimony. But they would probably have been “academic” because it is almost certain that they would not have been answered.
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