J.P. Morgan's Warning Is So 1998
Updated from 4:54 p.m. EDT
The echoes of Long Term Capital Management still reverberate on Wall Street, and not just because the Dow Jones Industrial Average is again below 8000, just as it was when the implosion of the notorious hedge fund almost burst Wall Street's bubble in September-October 1998.
Four years later, recent announcements by J.P. Morgan (JPM) and Fannie Mae (FNM) suggest some firms are still vulnerable because they are prepared only for the expected. In sum, they have missed the core lesson of Long Term Capital's shocking fall: At extreme junctures in the market, such as those occurring in the fall of 1998 and this past July and August, financial models based on historic norms are worthless, if not cancerous.
Because of its early successes and high-profile partners, Long Term was able to leverage its roughly $2 billion capital base by a factor of more than 20 to 1 (some press reports in 1998 said as much as 80 to 1). After the Asian financial crises in 1997 and Russian debt default in 1998, Long Term Capital faced huge trading losses, prompting the Federal Reserve to arrange a bailout by its Wall Street lenders, whose own financial health was perceived to be at risk.LTCM faced unusually large losses because it had placed huge bets on emerging markets' debt, expecting they would follow previous patterns in relation to each other, and to Treasury securities. Instead, Russia's debt default, itself a wholly unexpected development, trigged events that invalidated their expectations. Even Nobel laureates such as Long Term Capital's Myron Scholes and Robert Merton proved unable to create "black box" financial models that could adequately shield their highly leveraged hedge fund from huge losses. Yet, recent announcements by J.P. Morgan and Fannie Mae suggest that financial firms still are operating under the delusion that they can control risk by using 'sophisticated' trading strategies. The most commonly used risk-management tools "rely on continuous, normally distributed markets, which isn't reality," observed Diane Garnick, global equity strategist at State Street in Boston. "Market practioners need to rely on expecting the unexpected, which academics can't model." State Street's Garnick, who observed similarities to 1998 back in
Seeing Ghosts, Part 1Late Tuesday, J.P. Morgan warned about its third-quarter results, citing "high commercial credit costs concentrated in the telecom and cable sectors" as well as weak trading results. The former garnered loads of media attention, as it's easy to explain how lending to now-bankrupt telecoms caused J.P. Morgan's level of nonperforming assets to jump by nearly $1 billion in the first two months of the third quarter (even if the company was very circumspect about what, exactly, occurred to cause the jump). As for the latter, Marc Shapiro, head of risk management at J.P. Morgan, said in a conference call Tuesday evening that the firm's trading revenue fell to $100 million in July and August from $1.1 billion in the second quarter, because "the normal diversification benefit we get from trading different instruments was not as prevalent in these periods as in the past." Shapiro stressed the losses were "not particularly concentrated" in any one area and that all trading units were within pre-established risk levels. Basically what Shapiro and Chairman and CEO William Harrison said was that "everybody lost a little, and collectively, J.P. Morgan lost a lot" (or made a relatively paltry sum) observed Jim Bianco, president of Bianco Research in Barrington, Ill. "They should know that's exactly what happens when markets get under stress. In a crisis, markets become emotional and trade off the focal point, which is typically the stock market. In times of stress
Isolated?Nevertheless, many on Wall Street believe the firm's problems are its own and not a "systemic threat." J.P. Morgan's problems were that "they were heavily lending to companies who were never going to produce positive cash flow," according to Sean Reidy, a portfolio manager at Robert Olstein & Associates, which has $1.4 billion under management. But whereas Long Term Capital was writing contracts with almost every firm on Wall Street and able to dramatically leverage its bets, "these guys have reserves," he said. "I don't think the risk of
Select the service that is right for you!COMPARE ALL SERVICES
Jim Cramer and Stephanie Link actively manage a real portfolio and reveal their money management tactics while giving advanced notice before every trade.
- $2.5+ million portfolio
- Large-cap and dividend focus
- Intraday trade alerts from Cramer
- Weekly roundups
Access the tool that DOMINATES the Russell 2000 and the S&P 500.
- Buy, hold, or sell recommendations for over 4,300 stocks
- Unlimited research reports on your favorite stocks
- A custom stock screener
- Upgrade/downgrade alerts
Jim Cramer's protege, David Peltier, identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.
- Diversified model portfolio of dividend stocks
- Alerts when market news affect the portfolio
- Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
All of Real Money, plus 15 more of Wall Street's sharpest minds delivering actionable trading ideas, a comprehensive look at the market, and fundamental and technical analysis.
- Real Money + Doug Kass Plus 15 more Wall Street Pros
- Intraday commentary & news
- Ultra-actionable trading ideas
Our options trading pros provide daily market commentary and over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.
- 100+ monthly options trading ideas
- Actionable options commentary & news
- Real-time trading community
- Options TV