Here's Part 2 from Walter, if you still haven't read Part 1, here you go.
Some more about Walter:
A graduate of New York University’s Stern School of Business. Walter has more than 30 years experience in international banking and corporate finance having started his career with Bankers Trust Company, New York. He has been an active private investor in both listed and alternative investments for more than forty years. He lectures, consults and trains extensively in Europe and emerging markets and has authored a book on venture capital investing. During the course of his career he was a founding member of the Bankers Trust. management buy-out group, London, Head of Acquisition Finance for Security Pacific Hoare Govett, a senior vice president of Instinet Corp.
- LTCM was a hedge fund founded by a famous / infamous ex-Salomon Bros. bond trader, John Merriwether, he of “Liar’s Poker” fame, supported by several Nobel Prize winning academics such as Myron Scholes of the Black-Scholes option pricing formula.
- LTCM was a super leveraged trader of what are called “Basis Trades”. LTCM’s trading strategy was advertised as being “riskless” – an impossibility in finance given the fundamental financial and economic concept of no risk = no reward. It was also advertised as being “directionless”, meaning it did not require taking a view on whether financial markets would rise or fall and profits would be made regardless of market direction. This is an attractive concept, no risk and no need to guess which way the market’s going. Needless to say this was a product structured by “Quants”
- What is Basis Trading? Basis trading consists of shorting (selling) one asset class and buying (going long) a related asset class. The asset class most commonly and easily used are financial indices such as an index of Triple A Corporate Bonds and an index of similarly rated Government Bonds.
- How does it work? As many of you know corporate bonds trade at a spread over government bonds. Government bonds being considered as “riskless” (well, okay, they used to be!) and Corporate bonds are considered to have risk.
- Now, over any time period the spread between governments and corporates tend to stay within a fairly constant, predictable range. For example if the Govt. Bond index had an average yield of say 5% then the Triple A Corp. Bond index might have an average yield of 5.15%, the spread here being 15 basis points.
- A simple basis trade would be predicated on a couple of possible scenarios. One is that the spread becomes suddenly higher or lower than its recent historic average so a trader bets that the spread will revert to mean (go back towards or to its historic level). Another possible trade finds the trader predicting a recession or some event that will increase investors’ perception of the risk of holding Corp. bonds.
- Let’s say the trader makes the latter bet. A recession occurs and the yield on Corp. Bonds rises to say 5.30%, furthermore as a result of the perception of increased Corp. Bond risk there is an “investor flight to safety” which brings down the yield on Govt. Bonds to say 4.90%. The spread has now greatly widened from 15 bps to 40 bps. If the trader was long Governments and short Corporates he would have profited by the widening of the spread (the capital value of the Govt’s would have risen thus lowering the yield and creating a capital gain and the capital value of the Corps would have fallen raising the yield and making them cheaper to buy back to close the short and hence realise a profit, another capital gain
- However!! Sometimes this all comes undone as it did for LTCM. Sometimes a so-called Black Swan Event or Long Tail Event occurs and expected basis relationships fall apart because of investor behaviour. This is what happened to LTCM. The ’97 Asian Crisis and the ’98 Russian Crisis were the cause of the financial market Black Swann Events which undid LTCM. LTCM also undid itself through its arcane trading strategies which were exacerbated by 3 factors:
- 90:1 to type leverage, huge amounts of debt funding for its trades which not only cost money to maintain but worse, were subject to margin calls and default calls when market conditions and LTCM’s trades began to deteriorate. Even worse, LTCM has to close out trades to meet margin calls which exacerbated trading losses because there were few if any counterparties / buyers for closing out the defective trades
- LTCM’s trading portfolio was a complex web of trades, counter-trades, hedges and counter-hedges often in illiquid instruments, many of which were over-the –counter trades not on exchange trades, tailored by bank counterparties for which there were no “markets”, meaning no other traders to sell to in order to close. Additionally, LTCM was often such a big trader of an asset, arcane or otherwise, that it was essentially the “whole market” and there simply was no liquidity for them to enable an orderly trade exit
- Lastly, other big players in the market came to understand LTCM’s strategy and trades and when the going got tough for LTCM the market took advantage by trading against LTCM’s positions thus exacerbating their problems and losses.
That brings us back to JPM and Ina Drew. Just like LTCM, JPM evolved a complex, arcane trading strategy that was supposed to be “riskless” and in the JPM case a hedge against risk not a creator of risk. Drew knew the LTCM debacle intimately and many at Morgan Chase were almost as familiar with LTCM as Drew, they “were in the market” at the time of the LTCM debacle.
So, truly history repeats itself.
- JPM’s problem, at first blush, was a type of basis trade. As a bank JPM is naturally long “credit”, credit in the sense of its core operations: making loans, taking deposits, investing in assets and establishing long positions in its trading book. It went short “credit” as a hedge by selling credit default swaps and similar instruments.
- When Central Banks resumed so called quantitative easing (printing money and undertaking bond market activities designed to increase liquidity and depress market interest rates) all of JPM’s billions of dollars of short positions went against it and hence the losses to date
- JPM’s Chief Investment Office (see below) then exacerbated its problems by also taking enormous positions which themselves are not hedges and are of above average risk especially when taken up in great size relative to the total size of the market for the asset being traded
Subsequent to the May 17 article we now learn through further information from market participants that JPM’s hedging strategy also consisted of ownership of around $100 bn. of asset backed securities, including lots and lots of residential mortgage backed securities, exactly the kinds of instruments that exacerbated the 2007-08 financial bust.
Furthermore (no it just doesn’t stop there) JPM’s position in certain assets such as UK mortgage backs completely dominate the post 2007 -08 market for this asset, so much so that there is no (you guessed it) liquidity in the market. JPM has now made rumblings of selling these assets and replacing them with Treasury Bonds. Great idea if a bit late but, as one London trader noted, “sell to whom”, they, JPM, are the market in the asset.
Not to be overly glum but where does this end? Let’s say JPM stocks up on Treasuries what happens in a few years when the western world government bond bubble bursts because of inflation? JPM will have to be out there hedging its hedges.
What’s the “take-away”?
I am an ex-banker and an unabashed advocate for restoring Glass-Steagall, the depression era regulation that separated investment banking from commercial banking. I’m also an adherent of the so-called Volcker Rule, a modest re-interpretation of Glass-Steagall.
Commercial banks (UK Clearing Banks) are utilities in the same way the electric company and the water company are. The utility services they provide are critical to modern economy: deposit taking in a secure manner, payment services including checking accounts, mortgages and small business loans. Hybrid banks (part investment bank and part commercial) like JPM are not utilities, that critical role is undermined by the “casino” aspect of investment bank trading.
Pure investment banks, of which few remain, can do anything they want (within reason). They’re not FDIC protected, they’re not Bank Holding Companies and they should never be bailed out or otherwise assisted by the taxpayer. The current situation is untenable particularly when we have the likes of Goldman Sachs re-organizing itself as a Bank Holding Company so that it can literally feed off the taxpayer in the next crisis.
Jamie Dimon is a vocal critic of the Volcker Rule and Dodd-Frank and yet....what can be said, both sets of regulation are aimed at avoiding what just happened. Dodd-Frank is severely flawed and should simply be scrapped and replace by Glass-Steagall Part II – a simple, straightforward separation of activities to the benefit of the financial system, the socio-political system and the economy.
Arise investors of the world!! You have nothing to lose but Jamie Dimon (and Lloyd Blankfein et al).