Midday Muse: Market Cries '98 Tears

Comparisons have been made recently between the current environment and the 1970s bear market, or to a "slow motion" version of the 1987 crash. But to me, it's starting to look and feel a lot more like the fall of 1998.

Of course, there are myriad differences between now and then. But there are similarities in terms of:

The wildness of the stock market, which Wednesday swung from wide losses early to solid gains at midday;

the Treasury market's dramatic rally -- the two-year note traded with an all-time low yield earlier Wednesday, while the 10-year note's yield slid to an eight-month low of 4.36%;

dramatic movements in currency trading, although the dollar is on the defensive in this cycle and again Wednesday;

declines in major equity averages worldwide -- European bourses tumbled to fresh five-year lows intraday Wednesday before recovering some lost ground as Wall Street recovered; and

worries about the wherewithal of major financial institutions.

Did somebody say "systemic risk?" Did somebody say "contagion?"

Actually, few have used those terms to describe the current environment. But they are very likely to come back into fashion if the current state of confusion persists.

Fat Tails

Back in 1998, Lehman Brothers (LEH Quote) was the firm most frequently rumored to be imperiled. I wrote about those rumors then, and later, why they were wrong.

As reported Tuesday night, the rumor mill is currently churning about J.P. Morgan Chase . In addition to concerns about its role in the Enron debacle -- the subject of congressional hearings Tuesday, when J.P. Morgan's shares fell 18% -- there were rumors the Federal Reserve was convening an "emergency meeting" to deal with the market's meltdown in general and J.P. Morgan's derivatives exposure.

For years now, the hard-core bears have been talking about a "sum of all fears" scenario involving derivatives, which are complex financial instruments used to hedge against or leverage to movements in various financial assets.

J.P. Morgan Chase is far and away the most active participant in the derivatives market. It's involved in $23.2 trillion, or 50.5%, of the $45.9 trillion notional value of contracts involving U.S. commercial banks and trust companies, according to the Office of the Comptroller of the Currency's bank derivatives report.

The Fed declined to comment on the rumors, but Adam Castellani, a J.P. Morgan spokesman, said Tuesday they were "completely untrue and irresponsible."

Foggy Notion

In a conference call Wednesday morning, William Harrison, J.P. Morgan's chairman and CEO, and Marc Shapiro, head of risk management, also addressed such concerns.

"We haven't seen anything unfavorable in our derivatives book, no substantial changes since year-end in the size of the book or its composition," Shapiro said. "Our counterparties' credit quality is very strong and we have no unusual positions affected by changes in equity prices."

About 80% of the company's exposure was with investment-grade counterparties and J.P. Morgan's direct exposure to derivatives was $51 billion, according to the firm, or about 2.2% of their "notional value," which refers to the total value of the contract.

"There's no basis for any significant change in the financial condition of our company," Harrison said in the call. "We are very comfortable with the basic fundamentals of the company starting with our capital condition and our liquidity condition." Later, Shapiro stressed J.P. Morgan has "ample liquidity, more than in the history of the company."

Separately, Castellani suggested the firm's "credit risk management remains among the strongest in the industry," despite J.P. Morgan's exposure to seemingly every major corporate blowup of the past year (Enron, WorldCom, Xerox, Kmart, Global Crossing, etc.) as well as Argentina and Brazil.

The spokesman cited the following measures:

In the second quarter of 2002, J.P. Morgan's nonperforming assets to total assets was 0.59% vs. an average of 1.08% for the six other largest U.S. banks (Citigroup, Bank of America, Wachovia, Wells Fargo, Bank One and FleetBoston).

Similarly, the firm's commercial loan charge-off ratio was 1.17 vs. a peer average of 1.67.

Headline Overhang

In addition, Harrison stressed repeatedly on the conference call a belief "we acted properly and with integrity in all Enron matters. We have not knowingly assisted Enron or any other company in misrepresenting the facts."

Shapiro added that the purported smoking gun email from a J.P. Morgan banker was "inaccurate [and] it's tone inappropriate." All the transactions had been reported on both J.P. Morgan and Enron's balance sheets, he said, although the email in question suggested Enron loved to use the so-called prepay deals to "hide funded debt."

Finally, and perhaps most importantly, both executives argued there was a gross overreaction in the stock yesterday, and that they and other members of the executive committee would be personally buying J.P. Morgan shares today.

The conference call seemed to pay immediate dividends (and J.P. Morgan executives saw "no reason" to change the company's existing dividend policy.) After trading at a 52-week low of $18.22 early on, J.P. Morgan shares were lately up 6.5% to $21.39. Other recently battered financials such as Citigroup were rallying in concert and the Philadelphia Stock Exchange/KBW Bank Index was up 2.4%.

The rebound in the financials was no doubt a big factor in the broader market's midday rally, which has the optimists excited yet again. Still, recall that in 1998 few people knew much about Long Term Capital Management until the Fed had to arrange a bailout by its lenders, who themselves were threatened by the ill-fated hedge fund's implosion.

Maybe there's nothing similarly nefarious lurking today, but the market seems to be saying otherwise -- today's gains notwithstanding.