Saturday, May 19, 2012

Doug Noland's essay for the week - The Jig Is Up !

The Jig Is Up

  • by Doug Noland
  • May 18, 2012
May 18 – Wall Street Journal (Monica Langley):  “J.P. Morgan & Co. Chairman and Chief Executive Officer James Dimon had just committed the most expensive blunder of his 30-year career, failing to detect the risk of trades that had begun to generate huge losses at the bank.  On April 30, associates who were gathered in a conference room handed Mr. Dimon summaries and analyses of the losses. But there were no details about the trades themselves. ‘I want to see the positions!’ he barked, throwing down the papers, according to attendees. ‘Now! I want to see everything!’  When Mr. Dimon saw the numbers, these people say, he couldn’t breathe.   Those trading positions have produced losses that could total as much as $5 billion, tarnishing the record of an executive who had thrived through the global financial crisis and who has long been known for paying close attention to the bank’s trading activity, its risk profile and the activities of its senior employees.”
It’s stunning that Mr. Dimon had not closely examined J.P. Morgan’s high-profile trades prior to April 30th.  The Wall Street Journal’s (Gregory Zuckerman and Katy Burne) “‘London Whale’ Rattles Debt Market” article acquainted the financial world to Bruno Iksil on April 6th.  A follow-up article (Katy Burne) on the 10th further detailed Mr. Iksil’s “massive derivatives sales” and the intriguing revelation that “dozens of hedge funds” were now betting against J.P. Morgan.  In response to a question during J.P. Morgan’s April 13th quarterly earnings conference call, Mr. Dimon made his regrettable comment, “It’s a complete tempest in a teapot. Every bank has a major portfolio. In those portfolios you make investments that you think are wise, that offset your exposures.”  And fully two weeks later he apparently still had not seen the detailed positions.
Mr. Dimon has been incredibly complacent, but he’s not the focus of this CBB.  It’s more important to contemplate that the entire world has been incredibly complacent - for years now.  I recall being bewildered when reading inside accounts of the months and weeks leading up to the collapse of LTCM back in 1998.  How could so many operating in the bowels of derivatives and speculative trading have been so oblivious to what was unfolding?  Where were the regulators?  And then there was the spring and early-summer of ‘08 when the S&P 500 rose back above 1,400 (broader market indices posted record highs) and the VIX traded below 20.  No worries, the Fed will handle it.
For years now, I’ve had a fascination with trying to better grasp how seemingly apparent crises invariably catch everyone unprepared.  True, a crisis wouldn’t really be much of a crisis if the marketplace was prepared for it.  But over the centuries there have been scores of major Bubbles and monetary fiascos.  And having read numerous detailed accounts of manias and Credit busts, on virtually every occasion I would find myself asking, “How could they not have seen it coming?”  Important insight is garnered from accounts of the weeks and months heading into the 1929 stock market crash.  When stock traders were asked after the Crash why they weren’t worried about all the leverage, speculation and shenanigans, a general response went somewhat like this:  “We were all worried about these issues in 1927, but you can only worry about things for so long.”  Sure seems that way.
Faith in policymaking was an important aspect of 1929 complacency, as it is today.  The Federal Reserve had intervened repeatedly in the marketplace during the “Roaring Twenties.” Similar to now, repeated Fed interventions had market players confident in the notion of a market liquidity backstop.  And each intervention worked to enrich, enlarge and embolden the speculator community.  By 1929, the financial Bubble had grown so enormous and economies so maladjusted that when the crash hit policymaking was to be found impotent. 
It’s a different era of course, but the scope of global policy interventions over the past two decades (and especially since 2008) makes 1920’s policy measures look rather microscopic in comparison.  It has been an important aspect of my thesis that aggressive fiscal and monetary stimulus has become increasingly ineffective, destabilizing and dangerous.  Actually, a strong case can be made that “activist” policymaking some time ago turned dysfunctional.  This, rather importantly, is in stark contrast to the conventional marketplace view that policy measures will continue to underpin global securities markets.  This equates to a frightening gulf – and a widening one at that - between market perceptions and reality.
I’ll again highlight J.P. Morgan as a microcosm of what today ails global finance.  While details remain sketchy, there has been some reporting that J.P. Morgan’s trading strategy evolved over time.  Some have noted that a couple years back J.P. Morgan assumed a more aggressive risk-taking posture.  And apparently at junctures along the way, decisions were made to hedge its portfolio of risks (loans, securities and derivatives), only later to reverse course and move to hedge (offset) the risk hedges.  As the market “whale,” said to dominate trading in many of the involved so-called “exotic” derivative instruments, it was apparently much easier for J.P. Morgan traders to initiate new trades (so-called “hedges”) than it was to unwind ones already on the books. 
There were certainly liquidity issues associated with their big trades.  Pricing surely played a prominent role in the accumulation of huge (less than liquid) trades on both sides of various markets, a vast portfolio of derivative trades that were to offset and counterbalance global market risks.  To be sure, losses can mount (and “sharks” can gather) rather quickly when a major player moves to unwind big losing positions.  And when markets dislocate, as they’re prone to do when there’s excessive leverage and rampant speculation, all bets are off when it comes to expected performance and cross-correlations of a portfolio of illiquid derivative exposures. 
May 18 – Financial Times (Sam Jones, Tracy Alloway and Tom Braithwaite):  “The unit at the centre of JPMorgan Chase’s $2bn trading loss has built up positions totalling more than $100bn in asset-backed securities and structured products – the complex, risky bonds at the centre of the financial crisis in 2008. These holdings are in addition to those in credit derivatives which led to the losses and have mired the bank in regulatory investigations and criticism. The unit, the chief investment office (CIO), has been the biggest buyer of European mortgage-backed bonds and other complex debt securities such as collateralised loan obligations in all markets for three years, more than a dozen senior traders and credit experts have told the Financial Times.”
From what I’ve been able to discern, it’s all consistent with traders being incentivized by policymakers to take an aggressive “risk on” approach in the marketplace.  Yet resulting highly speculative markets and an evolving debt crisis in Europe at times led to bouts of market worry that policymakers didn’t in fact have things under control.  Both 2010 and 2011 had serious albeit brief bouts of “risk off,” where J.P. Morgan and other speculators were likely forced into partially hedging major “risk on” market exposures.  Importantly, late-2011 LTRO and concerted global central bank liquidity operations then likely incited many to offset/hedge their risk hedges to ensure full profits (and big bonuses), from what was anticipated to be yet another bout of reflationary “risk on” policymaking.  But when things then unexpectedly began unraveling in Europe in April, at least for J.P. Morgan, the whole thing seems to have become an unmanageable mess.  The Jig is Up.
So, global finance again approaches the brink of severe crisis.  And we all know what that means.  Market participants have been conditioned to expect aggressive policy responses – and policymakers have been conditioned to dare not disappoint the markets.  So the critical question becomes how close we have come to that perilous juncture where policymakers are unable to deliver.  When does the scope of market and economic imbalances overwhelm policy tools?  Or, more precisely and critically, when do the markets begin to lose faith in the efficacy of policy measures (not to mention, the actual policymakers)?  
There is overwhelming evidence supporting the view that European policymakers have lost control of their debt crisis.  While LTRO altered the short-term market liquidity backdrop, a strong case can be made that it actually worsened the debt situation.  “Periphery,” certainly now including Spain and Italy, banking systems today have much greater exposure to sovereign debt.  Indeed, the sovereign and banking system nexus has become only more toxic.  And with the ECB today highly exposed to Greece and Portugal, there are myriad issues that will have the European Central Bank treading cautiously when it comes to accumulating Spanish and Italian debt.  The Europeans will have to use the “firewall” they had hoped was fashioned only for show.
It’s clear that policymaking has hit a wall in Greece.  There will now be a second round of elections on June 17th, which has the potential to lead again to inconclusive results.  Mr. Tsipras, head of Syriza, or “The Coalition of the Radical Left,” has in the limelight become only more radical and nationalistic.  He is content to play hardball with the EU (and Germany, in particular) and dare them to cut off aid.  European policymakers haven’t to this point had to deal with a character like Tsipras, and it would be seen as a bad precedent to let him win this game of chicken.  The hope is that a majority of Greek voters will look for an alternative to Syriza’s obstinate approach.  I was not comforted by today’s New York Times article (Rachel Donadio), “With Little to Lose, Many Greeks Shrug Off Dire Warnings.”  The fear is that the “we have no fear.  We have nothing to lose” view quoted in the article is becoming deeply entrenched in Greek society.
This week was replete with troubling talk of bank runs in Greece and Spain - and finance more generally on the move.  There will be a lot of work to do to ensure a functioning Greek banking system.  Bank runs, even the contemporary electronic version, are destabilizing.  It is also clear that worries have engulfed Spanish and Italian banks, with very real concern that the uncertainty associated with a Greek exit from the euro could unleash enormous deposit flight.  And it was leaked today that the EU is hard at work with an emergency plan for Greece’s exit from the euro system.  Such extraordinary uncertainty beckons for “risk off.”
If the European debt fiasco wasn’t enough, it is increasingly clear that China is faltering.  Recent economic data confirm the Chinese economy has commenced a meaningful downturn.  Housing markets continue to weaken, and there has been increased focus on rising inventories of apartments, automobiles, steel, raw materials, commodities, etc.  Shanghai News this week reported that China’s four largest banks essentially had zero net loan growth in the first two weeks of May, confirming that April’s sharp lending slowdown gained momentum.  It is also apparent that, despite recent reductions in bank reserve requirements, finance has tightened throughout important markets for non-bank finance (including securitizations and corporate bonds).  I don’t see China’s economic and financial systems responding well to an abrupt Credit slowdown.
Importantly, global markets have begun to question the widely-held assumption that Chinese policymakers have their economy and financial system under control.  A counter-argument would be that the massive post-2008 Chinese stimulus package pushed China’s system to unwieldy Bubble status.  There is ample support for the view of a historic Chinese Bubble replete with massive leverage, financial engineering, fraud and epic economic maladjustment.  This is important because such a Bubble dynamic connotes acute fragility.  And such latent fragility takes on much greater significance with Europe rapidly deteriorating and global finance now convulsing.   
Working at my desk today was somewhat surreal.  Global risk markets were closing out a dreadful week.  Newswires were full of disconcerting articles – J.P. Morgan, Greece, Spain, Italy, China, etc.   Meanwhile, CNBC was in the midst of blanket coverage of Facebook's initial public offering.  Mark Zuckerberg rang the bell to open Nasdaq trading, while helicopters provided live video of the employee gathering at Facebook’s Menlo Park headquarters.  Insiders are now worth billions, the “average” employee millions.  Even U2’s Bono pocketed $1.2bn (with a “B”).  I noted above how I see J.P. Morgan’s current predicament as a microcosm of global financial woes.  Well, it is difficult for me today not to see Facebook as emblematic of the incredible transfer of wealth associated with Credit Bubbles.  It’s almost as if this historic Bubble has been waiting to end with just such an exclamation point.