Re: [A-List] JP Morgan's *$23tn* derivative bust?

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

Ann,

Not to underplay JPM/Chase exposure to derivative risks, the $23 trillion refers to notional value only, not total exposure.

JPM/Chase Basic and diluted earnings per share have been reduced by $0.01 in the first nine months of 2001 due to the impact of the adoption of SFAS 133 relating to the accounting for derivative instruments and hedging activities.

The BIS Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity on positions in the global over-the-counter (OTC) derivatives market shows that business expanded at a brisk pace in the three-year period ending in June 2001. According to preliminary data, the aggregate stock of contracts outstanding stood at nearly $100 trillion at end-June 2001, 38% higher than three years ago. There was, however, a divergence in the evolution of the two largest market segments, with the stock of interest rate products growing by 58% and  that of foreign exchange instruments contracting by 7%. Moreover, data on credit derivatives show a rapid expansion of that market segment since end-June 1998.

Data on positions in the global OTC derivatives market show that activity remained robust in the three-year period ending in June 2001. Relative to end-June 1998, the stock of contracts outstanding expanded by an average of 11% a year, to $99.8 trillion. This amounted to slower growth than in the previous triennial survey, which had shown an average annual expansion of 15% in the period ending in June 1998.

Overall business in interest rate contracts, the largest segment of the OTC market, grew by 58% in the
three-year period, to $75.9 trillion, with the market for interest rate swaps being particularly buoyant. This
represented a slowdown relative to the previous three-year period, when positions had increased by 81%. As discussed in the following section on the semiannual market statistics, the robustness of activity in the interest rate swap market reflects growing liquidity in a context of structural change in underlying government bond markets and in risk management practices.

The aggregate stock of foreign exchange products declined by 7% in the three-year period, to $20.4  trillion. This was in marked contrast to the previous triennial survey, which had shown a sharp increase in
positions. The contraction in foreign exchange contracts seems consistent with the results of the first part of the most recent triennial survey, which had shown lower turnover in the spot market for foreign exchange. The lower volume of turnover in that market has itself been related to a number of factors, including the introduction of the euro, the growing share of electronic broking in the spot interbank market and consolidation in the banking industry. The main exception to the downward trend in positions involving foreign exchange products was in the area of currency swaps (or cross-currency swaps) with a near doubling of positions over the three-year period.

Meanwhile, equity-linked contracts expanded by 52%, to $2 trillion, while commodity contracts grew by 33%, to $674 billion. These market segments remain much smaller than those for interest rate and foreign exchange contracts.

One of the notable developments of the most recent three-year period has been the rapid expansion of the
market for credit derivatives.7 Positions in these instruments, which are not included in the semiannual
survey of OTC derivatives markets, expanded from $108 billion at end-June 1998 to $693 billion at end-June 2001. Market participants noted that the market for credit derivatives is diversifying beyond transactions aimed at the restructuring of banks' balance sheets with the entry of new market participants such as insurance companies. Indeed, the most recent numbers show that reporting dealers accounted for only 31% of total positions, compared with 55% for non-reporting financial institutions and 14% for non-financial users. The market has also reportedly benefited from a widening in the range of  instruments and from improvements in market infrastructure, such as the introduction of standardised documentation and the development of new rate of return indices. It should be noted that the size of the credit derivatives market remains fairly small, being barely larger than that for commodity contracts.

Gross market values rose from $2.6 trillion to $3 trillion.  However, the ratio of gross market values to notional amounts declined from 3.6% to 3.1%. Although this ratio has been fairly stable over time, it has varied considerably across individual market segments, ranging from less than 1% for forward rate agreements (FRAs) to almost 16% for non-gold commodity contracts. It should also be stressed, however, that gross market values exaggerate actual credit exposures, since they exclude netting and other risk reducing arrangements. Allowing for netting lowers the derivatives-related credit exposures of reporting institutions to $1 trillion.

Data from the BIS semiannual survey on positions in the global OTC derivatives market point to a slight rebound in market activity in the first half of 2001. The total estimated notional amount of outstanding OTC contracts stood at $99.8 trillion at end-June 2001, a 5% increase over end-December 2000. The OTC market has expanded at a slower pace over the past year but some of its segments remain highly active.

In terms of broad risk categories, the stock of interest rate and foreign exchange contracts expanded by 4%  and 8% respectively, while that of equity-linked contracts remained stable. A comparison of activity on  OTC markets with that on exchange-traded markets shows a divergence in the pace of business on the two types of market in the first half of 2001. Open interest in interest rate and stock index contracts, the most active financial contracts traded on derivatives exchanges, increased by 39% and 28% respectively relative to end-December 2000. If sustained, such a rapid increase would represent a significant departure from previous patterns of activity since the growth of OTC business outpaced that on exchanges for much of the 1990s.

The market for interest rate products expanded by 4%,  to $67.5 trillion, in the first half of 2001. Three significant developments are worth highlighting in that market. First, activity was driven by a return to growth of the interest  rate swaps market, by far the largest segment of the OTC market, with outstandings rising by 5%, to $51.4 trillion. By contrast, business in FRAs and interest rate options continued to be subdued, barely increasing over  the review period. Second, the market for interest rate
products appears to be accommodating a widening range of financial market participants, as illustrated by
the steady growth in positions held by non-reporting financial institutions since 1998. Such a growth pattern  should be set against a context of weakening activity by reporting dealers and lacklustre business involving non-financial customers.9 Third, instruments involving the US dollar are rapidly catching up with those involving the euro.

Activity in the US dollar-denominated swap market was particularly brisk in the first half of 2001, with the stock of contracts rising by 22%, to $15.9 trillion. The US dollar swap market has grown at a rapid pace in recent years on the back of a shift in hedging and trading practices. The global financial market crisis that followed the default of Russia in August 1998 highlighted the risks inherent in the use of government bonds and related exchange-traded derivatives to hedge positions on non-government securities, leading market participants to seek alternative hedging and trading instruments, such as interest rate swaps. A reduction in the liquidity of US government debt following net debt repayments by the US Treasury has reinforced the shift to swaps. More recent influences, such as vigorous US monetary easing in the wake of a pronounced deceleration of economic growth, probably also fuelled hedging and position-taking in the dollar swap market.

The market for euro-denominated interest rate swaps returned to expansion following a notable contraction in the second half of 2000, with the outstanding stock of contracts rising by 7%, to $17.6 trillion.  Euro-denominated swaps expanded rapidly after the introduction of the single European currency, as swaps became a new benchmark for European fixed income markets. The slowdown in market growth since mid-2000 suggests that this stock adjustment process may be reaching completion.

The market for yen-denominated interest rate swaps followed a different path, with the stock of contracts
declining by 12%, to $9.7 trillion. This contraction probably reflects the view at the time that Japanese
interest rates would evolve in a narrow range.

In the area of currency instruments, the value of contracts outstanding rose by 8%, to $16.9 trillion.
While the stock of outright forwards and forex swaps, the largest currency market segment, expanded by 4%, and that of currency options by 7%, that of cross-currency swaps grew by 20%. Cross-currency swaps have grown steadily since the BIS began its regular collection of data on the OTC market. Business
has been fuelled by the large global volume of syndicated loans and securities issues arranged in recent periods.

Activity in the equity-linked sector remained stable at $1.9 trillion, following rapid expansion in the previous reporting period. Business in commodity contracts, the smallest market segment, contracted by 11%, to $0.6 trillion.

Estimated gross market values declined marginally, to $3.0 trillion, following an unusually pronounced increase of 24% in the second half of 2000. The ratio of gross market values to notional amounts declined from 3.3% to 3.1%.

For a more detailed discussion see "Central bank survey of foreign exchange and derivatives market activity in April 2001: preliminary global data", BIS Press Release, 9 October 2001.

The notional amount, which is generally used as a reference to calculate cash flows under individual contracts, provides a comparison of market size between related cash and derivatives markets. The gross market value is defined as the sum of the positive market value of all reporters' contracts and the absolute value of the negative market value of their contracts with non-reporters (as a proxy for the positive market value of non-reporters' positions). It measures the replacement cost of all outstanding contracts had they been settled on 30 June 2001.

The regular survey covers the worldwide consolidated OTC derivatives exposures of major banks and dealers in the Group of Ten countries.

Currency swaps commit two counterparties to several cash flows, which in most cases involve an initial exchange of principal and a final re-exchange of principal upon maturity of the contract, and in all cases several streams of interest payments. By contrast, foreign exchange swaps commit two counterparties to the exchange of two cash flows and involve the sale of one currency for another in the spot market with the simultaneous repurchase of the first currency in the forward market.

Credit derivative contracts enable market participants to transfer credit risk exposures. They take a variety of forms, including credit default and total return swaps.

There are a variety of sources of data on the market for credit derivatives, including the British Bankers
Association, the International Swaps and Derivatives Association, government agencies and a number of trade publications. Coverage and data collection methodologies vary widely. While some of the sources collect data on a  gross basis, others attempt to make adjustments for double-counting. The BIS numbers offer a global coverage and are adjusted for double-counting.

The weaker growth of inter-dealer exposures could reflect financial industry consolidation to the extent that mergers and acquisitions lead to a consolidation of bilateral transactions and consequently to a reduction in the outstanding stock of contracts.

http://www.bis.org/press/p011220.htm

If size counts, then the engine that is JPM?s derivatives business cannot be ignored. The bank is among the world?s largest derivative houses, with notional outstandings of nearly US$8.4trn as of June 30 1999.
More pertinently, it is almost certainly one of the largest revenue-earning derivatives houses globally, with US$709m generated in the second quarter of 1999 alone. JPM also scores highly in terms of diversity, having a first-class outfit in almost every derivatives product line in nearly every region.  In the interest-rate sector, JPM has a strong presence across both vanilla and exotic products. It is one of the three top swap houses in both the US and Europe, and is also highly rated in exotic structures such as
constant-maturity swaps and mortgage structures.

In credit derivatives, it is a similar story. JPM is a top-three dealer of credit default swaps, with a 48% market share among US domestic and branches of insured commercial banks in the first and second quarters of 1999. It is also at the forefront of structured credit products, and has been one of the key participants in the booming synthetic collateralised debt obligation business.

Lastly, Morgan?s equity derivatives operation ? which has historically been less dominant than its interest-rate and credit groups ? is finally getting up to speed. The bank has a well-respected listed products operation and is also one of the main providers of cross-holdings solutions for corporates.

For senior JPM professionals, explaining the bank?s powerhouse derivatives presence is straightforward. "It?s the core of our firm. It?s as simple as that," said Winters, adding that nearly every one of the bank?s
seven-man board had been involved with derivatives at some time in his career.

Lying at the core of the bank, derivatives enjoy unparalleled integration with underlying cash markets at JPM. Interest-rate and credit functions in both cash and derivatives markets are run under one global group. Equity derivatives, while remaining separate from both cash and other derivatives, operates in close proximity to equity capital markets and is tightly linked to the convertibles effort.

"This is a business that gets a huge amount of recognition within this firm. We?re very big as a bank on how things fit together and integrate," said Thomas Regan, joint global head of equity derivatives.

Such is JPM?s success, that its organisational model is increasingly held up by competitors as a derivatives blueprint. "Other banks have aspired to derivatives leadership as part of a standalone strategy, or have tended to subordinate their derivatives business to their cash business. It is now clear that this does not work, and that the JPM approach to derivatives is the way forward," said a senior European banker at a rival house.

But while the size and diversity of JPM?s derivative revenue-generating machine is impressive, the bank?s operation is perhaps even more notable for its vision. This aspect of the business was brought to the fore in 1999,  when the bank reaped the rewards of previous strategies, and put in place key plans for the future.

In the former category lies JPM?s use of credit derivatives to revamp itself from a capital-intensive commercial bank into a dynamic advisory-based investment bank. First thrashed out in a 1997 strategic plan, the objective was to transform the bank?s debt securities and lending businesses into an           integrated credit model, thereby boosting the bank?s return-on-capital and its share price.

Credit derivatives were central to this objective because they allowed the bank to remove lending risk and capital exposure from its balance sheet without destroying client relationships.

"The role that JPM wants to play in pure credit markets is origination and distribution. Credit derivatives allow you to succeed in that activity," said Bill Demchak, global head of structured products.

In 1999 this labour finally bore fruit. The bank succeeded in sharply cutting its loan exposure, leading just 80 Americas deals valued at US$28bn in the first three quarters of 1999, down from 135 deals valued at
US$64bn in the same period of 1998. It also announced impressive earnings figures together with a US$3bn share buyback. Third-quarter net income was US$442m, or US$2.22 a share ? up nearly three-fold from US$156m (US$0.75) in the third quarter of 1998.

All of this made an impact where it really mattered ? in the bank?s share price. Having slumped to a nine-month low of US$106 on October 15, the stock climbed steadily following the buy-back announcement to close at US$140 on November 12 ? a rise of over 30% in under a month.

"You may fault JPM?s investment banking strategy. But you certainly can?t argue with its use of derivatives," said a senior market professional.

But 1999 was not a year in which JPM sat back on its laurels in derivatives. In a period of profound change in the financial markets, JPM reacted to that change and put in place foundations for future growth.   "We?re in a great situation now. The market?s consolidated; we?re ideally situated to cope with changing conditions, and there?s no less risk in the world," said Winters.

A list of developments that already started to impact derivatives markets in 1999 would include the European single currency, development of the internet, stockmarket volatility, Y2K and the explosion in credit markets. In  each of these areas, JPM was a key participant, and in several it was the clear market leader. Moreover, JPM continued to be willing to drive overall market development, even at the cost of market share. The idea was simple: a small piece of a big pie is often better than a big piece of a small
pie.

Take the internet. In 1999 JPM developed what it called Financial Product Markup Language (FpML) ? a method of internet communication that is  rapidly becoming the standard for the derivatives industry in the growing field of electronic commerce. It is based on the computer language XML and enables the integration of a range of services, from internet-based portfolio dealing and confirmations to the risk analysis of client portfolios. BNP, Chase, CSFB, Deutsche Bank, Lehman Brothers, Merrill Lynch and
Morgan Stanley all agreed to support the initiative.

The bank was also active in risk management, implementing the present value (PV) swap concept ahead of the market. With PV swaps, each derivative trade, from the very vanilla to the highly exotic, is priced to take into account the level of counterparty credit risk generated by the trade and how that credit risk would fit in terms of JPM?s existing portfolio. So rather than taking account of credit risk at portfolio level, JPM analyses it at the time of pricing ? a mammoth task but one that has drawn theoretical support.
 

J.P. MORGAN CHASE & CO.
CONSOLIDATED STATEMENT OF INCOME
(in millions, except per share data)
Third Quarter
2001 - 2000
Revenue
Investment Banking Fees $ 811 - $ 1,013
Trading Revenue 1,301 - 1,455
Fees and Commissions 2,331 - 2,427
Private Equity ? Realized Gains 204 - 656
Private Equity ? Unrealized Gains (Losses) (311) - (676)
Securities Gains 142 - 90
Other Revenue 212 - 415
Total Noninterest Revenue 4,690 - 5,380
Interest Income 7,709 - 9,423
Interest Expense 5,050 - 7,080
Net Interest Income 2,659 - 2,343
Revenue before Provision for Loan Losses 7,349 - 7,723
Provision for Loan Losses 745 - 298
Total Net Revenue 6,604 - 7,425
Expense
Compensation Expense 2,883 - 3,135
Occupancy Expense 339 - 338
Technology and Communications 663 - 632
Merger and Restructuring Costs 876 - 79
Amortization of Intangibles 182 - 157
Other Expense 992 - 1,011
Total Noninterest Expense 5,935 - 5,352
Income before Income Tax Expense and Effect of Accounting Change 669 - 2,073
Income Tax Expense 220 - 675
Income before Effect of Accounting Change 449 - 1,398
Net Effect of Change in Accounting Principle -- --
Net Income $ 449 - $ 1,398
Net Income Applicable to Common Stock $ 436 - $ 1,374
Net Income per Share (a)
Basic $ 0.22 - $ 0.73
Diluted $ 0.22 - $ 0.69

SFAS: Statement of Financial Accounting Standards.
SFAS 133: ?Accounting for Derivative Instruments and Hedging Activities.? (Pages 7, 10-11, 14, 47 and 50)

NOTE 3 ? ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
On January 1, 2001, JPMorgan Chase adopted SFAS 133, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and used for hedging activities. The adoption of SFAS 133 resulted in an after-tax reduction to net income of $25 million and an after-tax reduction to other comprehensive income (?OCI?) of $36 million. The impact of reclassifying certain SFAS 115 securities from available-for-sale to trading was not material at the adoption date. The majority of JPMorgan Chase's derivatives are entered into for trading purposes and were not affected by the adoption of SFAS 133. The Firm also uses derivatives as an end user to hedge market exposures, modify the interest rate characteristics of related balance sheet instruments or meet longer-term investment objectives. Both trading and end-user derivatives are recorded in trading assets and liabilities. For further discussion of the Firm's use of derivative instruments, see Note 3 of the JPMorgan Chase March 31, 2001 Form 10-Q in addition to Note 25 and page 50 of the JPMorgan Chase 2000 Annual Report.
The following table presents derivative instrument and hedging related activities for the periods indicated.
(in millions) Nine Months 2001
Fair Value Ineffective Hedging Net Gains (a) $ 84
Cash Flow Ineffective Hedging Net (Losses) (a) (9)
Cash Flow Hedging Gains on Forecasted Transactions that did not occur 40
Expected Reclassifications from OCI to Earnings (113) (b)
Net Investment Hedging Gains (Losses) on Forward Points (19) (c)
(a) Includes ineffectiveness and the portion of the hedging instrument excluded from the assessment of hedge effectiveness.
(b) Represents the reclassification of net losses on derivative instruments from OCI to earnings that are expected to occur over the next 12 months.
(c) Represents the forward points on forward foreign exchange (?FX?) contracts used to hedge the investments in foreign subsidiaries in foreign currencies.
http://www.jpmorganchase.com/chase/gx.cgi/Applogic%2bFTBlobServer?blobtable=Document&blobcol=urlblob&blobkey=name&blobheader=application/pdf&blobwhere=jpmchase/ir/financial/10Q_3Q01.pdf

MARKET RISK MANAGEMENT
Aggregate VAR Exposure
Value-at-Risk (?VAR?) is a measure of the dollar amount of potential loss from adverse market moves in an everyday market environment. VAR calculations are performed for all material trading and investment portfolios and for market risk-related asset/liability management (?A/L?) activities. Due to procedural differences at the heritage firms, combined VAR is not available for periods prior to the merger date.
Although no single risk statistic can reflect all aspects of market risk, the tables that follow provide an overview of the market risk exposure of JPMorgan Chase at the dates indicated. The following table represents JPMorgan Chase?s average and period-end VARs for its trading portfolios and its A/L activities.
Aggregate Portfolio
Nine Months Ended September 30, 2001
Average Minimum Maximum At September 30, 2001
(in millions) VAR VAR VAR
Trading Portfolio $ 65.3 $ 48.9 $ 87.5 $ 62.6
Investment Portfolio and
A/L Activities (a) 103.7 79.8 120.2 91.9
Less: Portfolio Diversification (42.5) NM NM (32.6)
Total VAR $ 126.5 $ 98.2 $ 163.8 $ 121.9
(a) Substantially all of the risk is interest rate related.
NM ? Because the minimum and maximum may occur on different days for different risk components, it is not meaningful to compute a portfolio diversification effect. JPMorgan Chase?s average and period-end VARs are less than the sum of the VARs of its market risk components due to risk offsets resulting from portfolio diversification.
Market Risk-Related Activities
Value-at-Risk: JPMorgan Chase is exposed to interest rate, foreign exchange, equity and commodity market risks in its trading portfolio. The table below reflects VAR data for the trading portfolio by risk category. See the Aggregate VAR Exposure section above for average and period-end VARs for the total trading portfolio.
Marked-to-Market Trading Portfolio (a)
Nine Months Ended September 30, 2001
Average Minimum Maximum At September 30, 2001
(in millions) VAR VAR VAR
Interest Rate $ 45.3 $ 26.1 $ 82.4 $ 53.4
Foreign Exchange 7.4 3.9 16.9 6.9
Equities 24.3 15.8 36.9 19.3
Commodities 4.5 2.5 7.1 4.7
Hedge Fund Investments 3.0 2.5 4.2 3.0
Less: Portfolio Diversification (19.2) NM NM (24.7)
Total Trading VAR $ 65.3 $ 48.9 $ 87.5 $ 62.6
(a) Although aggregate VAR has been calculated throughout 2001 using a single methodology, VAR by risk category prior to July 2001 was calculated based on the methodologies used by the heritage firms, assuming no correlation between the heritage firms' exposures.
NM ?Because the minimum and maximum may occur on different days for different risk components, it is not meaningful to compute a portfolio diversification effect. JPMorgan Chase?s average and period-end VARs are less than the sum of the VARs of its market risk components due to risk offsets resulting from portfolio diversification.

Value at Risk (VAR) failings: (a) it does not take into account liquidity risk; (b) it ignores distributional stability issues and outlying, catastrophic risks, and the fact that financial risk is not stationary.            The sense in which VaR was a culprit: too many people who look at VaR and think that is how bad it can get - rather than planning what their strategy will be once they have lost two or three times the VaR.  For all LTCM's genius, their highly leveraged spread trades went the wrong way and they didn't have enough capital for an event that wouldn't be captured in a 99% confidence VAR.  The distinction about whether VAR was the culprit is not material. The risk management "culture" shared by many firms (and of which VAR is a part,  if not the cause) created correlations between markets and risks that can  not be traced to structural dependencies among those markets and risks.

Henry C.K. Liu

Anne Williamson wrote:

Well, yes, the price of gold is the critical element in the overall
game -- as the gold market is the "alarm bell" that rings when
irresponsible money pumping becomes imprudent; today the
game is criminally imprudent.  Keynes's "Gibson's Paradox"
addresses the historic relationship between the price of gold
and interest rates (they are inverse of one another).  Larry Summers,
who wrote about this paradox with a co-author when he was still
just a humble man of Harvard (!) in the late 80s.  Summers concluded
the only way to beat it was for the govt to "fix" (rig) the price of gold,
which is just what has happened.  Of course, the dollar as the reserve
currency is greatly affected by this game, thus Rubin's "strong dollar,"
which is crushing US manufacturers and producers (esp. agriculture,
a California farmer can not sell an avacado as cheaply as one imported
into his own local markets!), and enabling the swift and relatively easy
looting of foreign nations (Argentina, sacrified to the gold game due to
their
peso/dollar peg is a real time demonstration of what the rigging can do.)
But Morgan has taken it a step further, exploiting the artificially-obtained
low gold price as the "underlying asset" which has allowed them to place
interest rate derivative bets of $23 trillion - simply unbelievable. A
rising price of gold and/or volatility due to the action of the bond
vigilantes
in the market would ruin them.  So they are threatened by a free gold
market and/or current market action involving the constant threat to
those employing "shorts," i.e. a "short squeeze."  If gold is allowed
to find its natural level in the market, however, all hell truly breaks
free for Morgan.  -A.

----- Original Message -----
From: Mark Jones <mark.jones@xxxxxxxxxxxxx>
To: <a-list@xxxxxxxxxxxxxxxxxxx>
Sent: Sunday, December 23, 2001 6:05 AM
Subject: Re: [A-List] JP Morgan's *$23tn* derivative bust?

> At 23/12/2001 00:08, Christian wrote:
> > >With a rigged gold market and a constantly strong dollar, J.P.  Morgan
> >Chase built up a 23 trillion dollar derivative rate position that is ON
> >THEIR BOOKS RIGHT NOW! That unfathomable mega-position is one that cannot
> >tolerate interest rate and general market VOLATILITY as they are SHORT
> >volatility.
> >
> >Does anyone have any idea of how you would short volatility? Would this
mean
> >short selling fixed rate interest swaps?
> >
> >Also, if Henry or anyone else has article or book references for the gold
> >market situation, I'd appreciate it.
>
>
> presumably he means they couldn't stand a *rise* in the price of gold, ie
> fall in the dollar, because this would force Greenspan to raise rates.
Wild
> guess I'm afraid.
>
> Mark
>
>
>