Wednesday, May 23, 2012

WHY JP MORGAN'S BILLION DOLLAR DERIVATIVE DEBACLE MATTERS

A few years back officials from Goldman Sachs and JP Morgan Chase went in front of Congress to defend the practice of  betting trading for and against complex investment products that are also known as derivatives. Their argument was that derivatives allowed them to hedge their trades, which is critical for "risk management." This is what "sophisticated investors" and "smart money" do we were told.

What they were really defending was the practice of trading in artificial markets that produce little - if any - economic value.

Conceptually what Goldman and JP Morgan want everyone to believe is that they were doing little more than what the country farmer does. You know, the guy who hedges his bets when he plants corn just in case the wheat crop doesn't produce. Instead Goldman and Morgan executives sounded like a bunch of hucksters peddling toxic crap from the back of a showman's wagon.


Are they really con men? In my view, yes. In the aggregate their efforts at "risk management" in derivative markets amounts to little more than financial snake oil.

Con men or not it really didn't matter what they said in the hearings because many members of Congress are financial and economic illiterates (don't believe me ... check this out). Many only understand economic concepts if they fit on a bumper sticker.

What Goldman and Morgan executives were really trying to do was defend the practice of selling their clients certain products - some of which were designed to fail - with the idea that they could get another client to bet against it. For JP Morgan and Goldman Sachs it didn't matter who won the bet because they collect fees on both ends.

And they they certainly didn't have to worry about the derivative products once they dumped them on others either. They could always hide behind the market refrain caveat emptor ... you know, buyer beware.


Because many members of Congress are financial illiterates - who do the bidding of Wall Street - the executives of both firms gave testimony and left Washington with only a public slap on the hand. Business as usual would be the result. Bonuses were paid out. Mergers continued.

Not surprisingly, after appearing in front of Congress JP Morgan paid a $153 million fine to the SEC for misleading investors, while Goldman Sachs was caught rigging the game against their clients, and then made big bets with FDIC backed money (though they claim it's their money). But along the way the biggest banks got even bigger ...



And the casino continued.




Why do I bring all of this up (again)? Simple. JP Morgan's recent derivative debacle has them losing 2 ... 5 .... or 8 billion dollars. Nobody knows how much just yet. Even they aren't sure (they claim). JP Morgan would like everyone to believe that it's all an anomaly. They even let go of a few culprits (with the now standard golden parachute for screwing up).

My primary concern is that we have been here before.

Now I could take us back to the S&L debacle, the 1987 scare, the LTCM Fed-orchestrated bailout, or even back to 1929 (or any number of other "unforeseen" market failures). But let's not go there. Instead, let's go back even further to see how the "smart money" did things a really long time ago, and then decide whether what we're seeing today is really an anomaly.

The following is drawn from Chapter 4 of my book The Myth of the Free Market:

In A Short History of Financial Euphoria, John Kenneth Galbraith discusses the famous case of “Tulipomania” in Amsterdam at the beginning of the seventeenth century. What started as simple prestige for those who possessed novel tulip bulbs turned into wild speculation over successive price increases throughout 1636.
Specifically, competition over tulips turned into mania, with single bulbs trading for new carriages and homes, or fetching as much as $25-50,000 each. Demand reached such heights the Amsterdam Stock Exchange developed a futures market for the bulb. This market, as well as the dreams of many speculators, would collapse under the weight of its own nonsense and spectacular avarice.

As sellers demanded their tulip contracts be enforced, they were disappointed when their petitions fell on the deaf ears of the courts. Because the market had little to do with the production of actual goods and services, the courts viewed Tulipomania as little more than a gambling operation. As is the case throughout these histories, panic, default, and bankruptcy followed. Galbraith wrote “no one knows for what reason” the speculation and mania ended, but there’s little doubt common sense finally prevailed in a market spun out of control by deluded buyers and sellers.

Now replace "Tulips" in the story with "derivatives" and ask yourself how much has really changed since 1636. With at least a hundred trillion in derivative bets (or more) placed by Americas biggest banks we need to think about what this means for our nation today. Like our Tulip-crazed market players above, many of today's biggest market gamblers are simply interested in extracting wealth from artificial markets.

Oh, look at the pretty flowers ...


Anyways, we need to remember that at the hearings Goldman Sachs' executives sat in front of Congress and brazenly dodged questions as to whether it's their responsibility to "act in the best interest of their clients" (FF to 25:30 in this clip). What this suggests is that simply making money is the dominating mind-set of Wall Street — even if it means deliberately burning clients, or creating the conditions for another market meltdown (which they never see happening).

The focus on wealth extraction instead of wealth creation has been widespread in America for some time now. The following from Chapter 10 of my book helps illustrate the point:

Founded by a group of Wall Street hotshots and leading academics with Nobel prizes on their resum├ęs, Long-Term Capital Management (LTCM) was created in the 1990s to search markets for price anomalies in goods that had shown historical relationships. It didn’t matter, for example, why the price of toothpaste was diverging from the price of tooth brushes; the fact that a price divergence existed was all that traders needed to make a move.

But LTCM was not trading in tooth brushes and toothpaste. They were trading in complex financial instruments that, according to their formulas, had price relationships that rarely diverged. Because the price anomaly in each “product” that they tracked was small, LTCM had to spend big to make money.

After securing hundreds of millions from investors, no doubt impressed with their pedigreed analysts, LTCM still had to borrow big to make their wagers pay off. At its height, LTCM was highly leveraged and owed investors and banks billions of dollars ...

In many ways, LTCM had fallen into the same trap as the purchasers of tulips. The company was comprised of speculators who wanted to make a quick buck. As Martin Mayer put it: "The work done at LTCM, while not illegal or sinful, was totally without redeeming social value. This is not 'investing'; it enables the production of no goods or useful services. It is betting."
LTCM came crashing down in 1998 after Russia defaulted on loans, an event that neither LTCM’s computer models nor it's Nobel laureates in economics anticipated ... The company owed so much money to the banks that the Federal Reserve of New York stepped in and brought the banks to LTCM. The Federal Reserve wanted to make sure that LTCM didn’t suddenly dump their assets to pay the banks.

The Federal Reserve feared that if LTCM was forced to sell its assets they would depress markets by forcing losses on others. The Federal Reserve’s then new chairman, Alan Greenspan, even went so far as to testify that an LTCM “fire sale” could have ended prosperity in our time. The Federal Reserve had to intervene to — in what has become by now a standard refrain — “save the system.”

At the end of the day, if you are betting on the price direction of tulips (the Dutch) ... or betting on the price direction of market anomalies (LTCM) ... or betting on the price direction of derivative products (Wall Street / JP Morgan Chase) one thing is clear. You are not investing (or even hedging). You are gambling.

These guys shouldn't be on Wall Street. They should be on the Vegas strip ... far away from taxpayer funded bailouts.

- Mark

ADDENDUM: With the biggest recipients of taxpayer bailout money controlling over 90 percent of the $135 to $592 Trillion derivative market (yes, that's $592 Trillion) we need to ask more questions about the conditions that created the financial holes at JP Morgan Chase, led to the collapse of MF Global Financial, and other slow drip market "aberrations" coming out of Wall Street. This is especially the case when you consider that the global derivatives market - which takes its cue from the United States - has grown to about $1.14 quadrillion (that's 15 zeroes)

With the total U.S economy producing about $15 trillion in goods and services in 2011 this should be cause for concern.

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