FT Alphaville has been running a series of blog posts digging in to items raised in the investigation of the fiasco at JP Morgan’s Chief Investment Office. The series is called The Belly of the Whale.
Today’s entry is a must read for anyone who has tried to “control” traders using quantitative risk measures. It’s all about gaming government capital rules. But shouldn’t any corporate officer who has to manage teams of traders have to worry about similar games being played?
Which representation of a bank’s derivative portfolio provides a fairer picture of the risk it presents, the net or gross balances? US banks, operating under US Generally Accepted Accounting Principles (GAAP), report the balance after netting out offsetting exposures with the same counterparty together with collateral. European banks, operating under International Financial Reporting Standards (IFRS), report the balance gross.[1] Consequently, a naïve comparison of banks using total assets as reported under the two different standards gives an erroneous impression that US banks are much smaller relative to their European counterparts. Were the assets reported on a comparable basis, US banks would climb in the rankings. But which comparable basis is the right one? Should the US bank assets be adjusted upward with the netted derivative assets added back, or should the European bank assets be adjusted downward by netting out more of their derivative assets. A number of US banking regulators and experts have recently started calling for putting the gross exposure onto the balance sheet. Not surprisingly, the big US banks and derivative trade associations like the International Swaps and Derivatives Association (ISDA) argue that the net exposure is the right one.
What is at the root of the disagreement?
Representative Dave Camp, Republican Chairman of the House Ways and Means Committee, has released a discussion draft on new rules for the taxation of derivatives. The press release is here. Detail material is found here.
In the draft, derivatives used for hedging are excluded. The criteria proposed here for determining whether a derivative is used for hedging in tax accounting are similar to the criteria already applied in financial accounting. However, a large fraction of derivatives held by non-financial companies are not accounted for using hedge accounting. So, it seems to me that this proposal would probably affect the tax treatment of those holdings.
It will be interesting to see how this discussion unfolds.
In covering the Intercontinental Exchange’s decision to move its energy swap trades onto its futures exchange, the Wall Street Journal’s Jacob Bunge and Katy Burne cited data on the power company Exelon in order to highlight how this move might impact end-user costs:
One company worried about costs, Exelon Corp., said in a regulatory filing on May 10 that “even if the new regulations do not apply directly to us, [its power plant subsidiary Exelon Generation] estimates that a substantial shift from over-the-counter sales to exchange cleared sales may require up to $1 billion of additional collateral.”
But the $1 billion figure is only half the story. The other half of the story is the contingent capital that Exelon saves. But since that contingent capital is off-balance sheet, it is commonly overlooked, leading both corporate executives and reporters to significantly exaggerate the cost of using cleared futures exchanges.[1] In comparing the financing costs of non-margined OTC trades against the financing costs of exchange-traded derivatives, it’s important to look at both the on- and off-balance sheet capital demands.
The finance lawyer who blogs at Economics of Contempt has a very nice summary of what is required for JP Morgan to claim that the trades at the CIO unit are allowed under the Volcker Rule because they were “portfolio hedging”. It is a more comprehensive and textual version of our requirement that JP Morgan “show me”.
JP Morgan’s $2 billion loss on credit derivatives traded by its Chief Investment Office (CIO) has moved the debate over implementation of the Volcker Rule to the front page. Many claim that these trades are a clear example of the type of speculative, proprietary trading banned by the Volcker Rule. JP Morgan CEO Jamie Dimon insists otherwise, claiming the trades were intended as a hedge, which is clearly permitted under the Volcker Rule. Public discussion on the matter is confused, in part because many people are unclear about what defines a hedge and what defines a speculation. Who can blame the public when the premier vehicles for speculative trading are known as hedge funds?
Moreover, the current battle over financial reform and the Volcker Rule gives bankers an incentive to escalate the confusion. They want to continue their speculative trading, and that can only be done by labeling it either hedging or market making. Clarity is not their ally. When regulators, legislators and pundits advocate bright line tests for hedging, these bankers ridicule them as simpletons, accusing them of applying a dangerously unsophisticated understanding of financial markets drawn from a bygone era. These simpletons, they complain, fail to grasp the complexity of the modern world that bankers are tasked with mastering in order to serve the needs of society.
So, in order to try to make some progress and gain some insight from the JP Morgan case, let us first step back from the details of the current trades and losses, and from the debate over the Volcker Rule, and instead gain some clarity on the concept of hedging. Then we can double back and analyze the JP Morgan case in light of a sensible notion of hedging.
Two points about hedging…
Brokers dealers and investment banks get a substantial amount of their funding from the repo market. In a typical repo, party #1 (the borrower) gets funds from selling securities to party #2 (the lender); when the repo matures the transaction is reversed: party #1 repurchases the securities by paying party #2 the initial funds plus interest (the repo rate).
To protect the lender, the funds initially received by the borrower are less than the market value of the securities used as collateral. The difference, reflecting the credit risk of the repo borrower and the volatility in the prices of the securities, is commonly referred to as the haircut. To make matters straight, a repo contains bilateral credit risk for both the lender or the borrower might default.
U.S. accounting standards determine that repos be treated as secured financing (FAS 140, §218) in the case of arrangements to repurchase or lend securities typically with as much as 98 per cent collateralization (for entities agreeing to repurchase) or as little as 102 per cent overcollateralization (for securities lenders). In secured financing the loan is reported by the borrower as a liability, while the funds received go to the asset side of the borrower’s balance sheet. More important, in secured loans, the securities remain in the books of the borrower. The idea is that the borrower maintains control of the collateral because it has received sufficient funds to repurchase the securities even if the lender defaults.
The problem is that setting an interval [98-102] opens the opportunity for dubious accounting. Suppose that a borrower agreed to a $1M repo with a haircut higher than 2 per cent for liquid fixed income securities, say 4 percent. Then, it would be judged as not having received sufficient funds to repurchase the securities. The repo transaction would then be reported as a sale of securities plus a forward contract to repurchase for $1M securities valued at $1.04M. The sale of securities would be recorded as a credit entry for $1M in cash, but no associated loan. The repo does not increase the liabilities. Furthermore, the cash can be used to pay off additional loans.
This is how an increase of $1M in liabilities can show up in the books as a reduction of $1M in liabilities. According to the Valukas report (2010) this is how Lehman systematically deceived the markets.[1]
[1] See “Hidden debt: From Enron’s Commodity Prepays to Lehmon’s Repos 105s”, Donald. J. Smith, The Financial Analysts Journal, October 2011.
Something about yesterday’s earnings announcement by JPMorgan has folks rattled:
Third-quarter results included the following significant items:$1.9 billion pretax ($0.29 per share after-tax) benefit from debit valuation adjustment (“DVA”) gains in the Investment Bank, resulting from widening of the Firm’s credit spreads…
The market is pricing JPMorgan’s outstanding debt with higher spreads, i.e., at a lower value, so JPMorgan books a GAIN equal to the creditors’ market value losses.
Commentators on JPMorgan’s announcement are troubled by the paradoxical result that a higher probability of default–or some other cause of higher spreads–produces an earnings gain. Readers can find commentary on this here, here and here, among many other places.
If assets and liabilities are going to be accounted for using any version of market value, then there is no way to get around the fact that a drop in the market value of a liability must be a gain to the company. The problem arises not from the market valuation of JPMorgan’s debt, but from a failure to see how this one item fits into the larger picture of the company’s earnings and valuation. If the market’s assessment of the company’s future is driving down the value of the company’s debt, that’s not good news for the company as a whole. If the company’s future is less secure, then the multiple that’s applied to its regular earnings should be much less. Properly assessed, this bad news will always swamp the bump in value from the market valuation of liabilities. In the case of JPMorgan, that means the “value” of its other long-term earnings has declined by a lot more than the $1.9 billion pretax bump from the debt valuation adjustment. It’s that decline that analysts ought to be discussing.
By the way, it’s not just bank accounting statements that occasionally exhibit this paradoxical result. It strikes non-financial companies, too. Here’s some text from Constellation Energy’s FY 2007 10K, as that company began to adopt SFAS No. 157, Fair Value Measurement:
SFAS No. 157 requires us to record all liabilities measured at fair value including the effect of our own credit risk. As a result, we will apply a credit spread adjustment in order to reflect our own credit risk in determining fair value for these liabilities which will reduce the recorded amount of these liabilities as of the date of adoption. As a result of this change, we expect to record a pre-tax gain in earnings of a range of approximately $10-$15 million in the first quarter of 2008.
But for most non-financials, the scale of the valuation adjustments in liabilities on the books at market value are usually much smaller than they are for financials.
 John Parsons MIT |
 Antonio Mello UWisconsin |
Betting the Business 
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