Blog: Spirit of Money, Financial Fluidity
by munificent

Derivatives & Interest Rates

I'm gleaning a pattern, most of the "profits" in large markets were being garnered by arbitrage between international market/indices. In the case of derivatives, by arbitrage bewteen financial instruments, between a stock or bond -like GM; in hedgefunds, arbitrage of interest rates...This may indicate that there is not much to make profits in the "owning" of the actual instrument or vehicle. If arbitrage is flat then the margins between the vehicle(s) are inverted or flat....Greenspan addressed this 'issue' with Congress recently...Coinkydink-now that interest rates are rising the spreads are disappearing....Imagine that! No Joke with 272 Trillion globally in these babies (can anyone fathom a trillion?)....Can FOMC actually continue to raise rates?

Date:   6/6/2005 9:23:26 AM   ( 16 y ) ... viewed 1292 times
COMMENT: The Devil & JP Morgan.

Dear A-Letter Reader:
Last week, JP Morgan confessed to some ugly news on trading revenue.

And you have to wonder if it could be the tip of a much bigger problem
lurking beneath the surface.

It seems the big bank made some very bad bets. "Market making and
proprietary trading activity has been worse to date across the credit,
rates and equities businesses, and generally weaker in Europe than
elsewhere," Jamie Dimon, JPM’s president, told a Sanford Bernstein
investment group. He added that the bank's quarter trading results
"are the worst the firm has experienced in sometime."

Hmm...could JP Morgan have received an unexpected trim around the
hedges...hedge funds, that is?

At the Sovereign Society's recent Offshore Advantage seminar in Panama,
I offered up some undervalued offshore opportunities - and also laid
out my list of what I saw as risks hanging over US stocks. And topping
that list is hedge funds.

Here are some figures to think about...

Hedge funds:
* Manage over ONE TRILLION DOLLARS – up from $39 billion in 1990.
* Attracted a record $27 billion of new capital in Q1.
* Now number nearly 8,000 – up from just 600 in 1990!
* Account for as much as 50% of NYSE big board volume.

Now, I'm not against hedge funds as a class – not at all. But when hedge
funds start running from one side of the boat to the other as a group –
and many of them are – this can present a real danger.

Institutions (like JP Morgan) are plowing money into hedge funds to make
big bets on the market. The problem is, those bets can go wrong.

There's no way to know for sure what bad bets JP Morgan is making, but
it wouldn't surprise me to learn the bank got gob-smacked in the Ford
and GM stock and bond trades. Funds bought GM's corporate bonds and
hedged the risk of default by shorting GM stock. The plan was to hold
the bonds, and the funds would lock in the interest rate spread between
the coupon on the debt and the dividend on the common stock.

This trade imploded when GM debt got downgraded (causing its bonds to
go down) and mega-investor Kirk Kerkorian made a tender offer for 3% of
GM's stock, causing shares to rise. Hedge funds got shredded. A similar
thing happened with Ford stock and debt.

And the word on the street is more than a few hedge funds got burned
trading in bonds, interest rates, and credit derivatives. JP Morgan
probably won't be the last to step into the confessional.

How big of a hit is JP Morgan taking? Well, the bank reported $2.2 billion
in trading revenue in the first quarter of this year. Now, it says second
quarter revenue could drop by more than 60% – maybe more.

But this is actually small potatoes compared to the other big bet that
JP Morgan makes in derivatives. The global derivatives market is huge –
somewhere around $272 trillion, according to the recent figures from the
Bank of International Settlements. And three big American banks – JP
Morgan Chase, Bank of America and Citigroup – account for a mind- bending
$77.6 trillion of that.

In simple terms, a derivative is merely a bet. And it can be a bet on
absolutely anything: interest rates, exchange rates, stocks, commodities.
Find a counter-party who's willing to wager against you, and you have
created a derivative. And to make the bet you often only have to put down
a fraction of the amount.

This is where derivatives can become dangerous. Derivatives are mostly
used to guard against risk. But they are also used to make highly leveraged
and highly dangerous bets.

For instance, remember Long Term Capital Management, a hedge fund that
careened to the brink of failure in 1998? Its derivatives shenanigans
almost triggered the collapse of the entire global financial system – and
would have if the Fed had not organized an emergency bailout.

Again, we don't know what particular bets JP Morgan is making, but you have
to wonder, if its trading models aren't working, how secure are its bets
in the derivative markets? Just how much trouble could the bank be getting
into? There might be the devil to pay.

Sure, JP Morgan may just take its lumps on trading and bounce right back.
But that doesn't seem like a smart bet to me. In fact, a look at a weekly
chart of JPM shows me a stock that is in a downtrend – the smart money is
exiting – and potentially poised for a big leg down.

And here's something else to consider: We're in a low interest rate
environment. If a bank like JP Morgan has trouble making money when rates
are low, what will it do when rates go higher? Heck, its earnings growth
and dividend ratio already lag the industry, while it trades at a
higher-than-average multiple to earnings.

I'd say this stock is primed for a plunge, and it's a good short candidate.
As always, I'd use a trailing stop.

SEAN BRODRICK, Editorial Director
The Sovereign Society Ltd.
* Here's JP Morgan's confession of bad trading results. As usual,
it's not what they say, but what they don't say, that's interesting.
* Bank of England dep. gov. Sir Andrew Large warns that explosion of
credit derivatives could undermine the financial system's stability.
Sadly, he's only a small voice in a whirlwind.

Not So Fast, FAS 133

FASB has delayed a new project that would deal with the creditworthiness of derivatives issuers, but it issued another new standard that essentially adopts a position of the International Accounting Standards Board.

Ed Zwirn,
June 06, 2005

For the moment, revisions to Financial Accounting Standard 133 — Accounting for Derivative Instruments and Hedging Activities — are on hold. Last Wednesday, the Financial Accounting Standards Board delayed ruling on the need for a new project that would deal with the creditworthiness of derivatives issuers (see last month's article "Should FAS 133 Be 'Marked to Market'?").

FASB is very likely to return to the issue, however: At last week's meeting, three of the seven board members were already prepared to consider revisions, two members asked for further study, and two were opposed. The movement to revise FAS 133 began with comments by financial companies like JPMorganChase and Goldman Sachs Group in response to last year's exposure draft on the Fair Value Measurement project.

Fair-value guidelines allow for the consideration of credit factors, but are financial markets taking credit into account when making their own valuations? Should this logic necessarily apply to derivatives valuation?

During last week's meeting, board member Leslie Seidman, for one, maintained that "New York Stock Exchange-listed bonds change value on a daily basis because of credit risk." As for "the various forms of contractual obligations that are specifically designed to mitigate credit issues," as she put it, Seidman and board member Katherine Schipper argued that FASB should continue to study how collateral that secures derivative instruments can address the credit question.

Last Wednesday the board also issued Statement No. 154, Accounting Changes and Error Corrections, effective with fiscal years beginning after December 15. According to a FASB statement, under 154 all "voluntary changes in accounting principle" must be retrospectively applied to prior financial statements unless this is "impracticable." It replaces APB Opinion No. 20, which had required that most such changes be recognized cumulatively in the period in which the change occurred.

Statement 154 "enhance[s] the consistency of financial information between periods" — and essentially adopts the position of the International Accounting Standards Board on this issue. "This is one example where the board concluded that the IASB requirements result in better financial reporting," says FASB board member Michael Crooch. "We were able to make a meaningful improvement in U.S. GAAP while converging with the IASB."

Items to be discussed at this Wednesday's FASB meeting include:

• Liability extinguishment: rights and obligations associated with enforceable one-sided offers to sell goods, and whether those rights and obligations satisfy recognition criteria.

• Stable-value investments: the limited circumstances in which contract-value accounting is appropriate for fully benefit-responsive investment contracts held by an investment company.

• Financial guarantee insurance: discussion of whether to add a project that addresses the accounting for this insurance.

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