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 June, said yesterday, "I don't see a specific organization behaving like Long Term Capital." Clearly, there are major differences between J.P. Morgan, Fannie Mae and Long Term Capital, not the least of which being the former two are regulated entities. Still, J.P. Morgan is the second-largest U.S. bank while Fannie Mae has the largest fixed-income portfolio. Furthermore, they are the world's largest dealer and customer of derivatives, respectively. Problems with either firm would have widespread implications for the financial markets, and the Fed is less able to help today than it was in 1998, what with the fed funds rate already at a 40-year low.
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 [their 'diversified' portfolio] becomes a giant bet on the S&P 500." Such damaging correlations will happen to J.P. Morgan "again and again," he predicted, suggesting "the only thing that's going to bail them out is a bull market. Unless we have one, they've got real problems." Because of J.P. Morgan's dominance of the derivatives market -- it's involved in $25.9 trillion, or 51%, of the $50.8 trillion notional value of contracts involving U.S. commercial banks and trust companies, according to the Office of the Comptroller of the Currency's second-quarter bank derivatives report -- some believe its potential problems have immense implications, on a far greater scale than even Long Term Capital Management. "This isn't a bank but a hedge fund -- a hedge fund that makes LTCM and Enron look like T-bill money market funds," said Jim Puplava, president of Puplava Financial Services, a Poway, Calif.-based firm with about $200 million under management. The majority of J.P. Morgan's derivative contracts are not exchange traded, Puplava noted, meaning "you don't know what the value is until you are forced to sell them in the marketplace." Recalling past debacles, the fund manager and radio personality observed: "Most blowups occur when a financial entity has to unwind its positions and finds no buyers. The same thing that happened to Long Term Capital and Enron could happen to J.P. Morgan." In the recent past, J.P. Morgan has countered such criticisms by noting that the vast majority of its derivatives exposure is with investment-grade counterparties and that its direct exposure is a very small percentage (less than 5%) of the derivatives' notional value, which refers to the total value of the contract. Yesterday, Bloomberg quoted a company spokesman as saying the firm's capital ratios and cash reserves exceed adequate levels and that the firm's liquidity is strong. In the wake of the company's profit warning, Standard & Poor's lowered J.P. Morgan's credit rating to A-plus. The downgrade will have "some impact [but] a small impact" on J.P. Morgan's derivatives business, said Dina Dublon, J.P. Morgan's head of finance, on the firm's conference call. But she noted that J.P. Morgan maintains a double-A rating on its senior bank debt and "doesn't expect any meaningful impact" on its derivatives book. Such comments did not alleviate the concerns of Puplava, among others. J.P. Morgan "really is a house of cards standing on itself," he said in an interview Thursday. Puplava was particularly concerned about comments from S&P analyst Tanya Azarchs. In a conference call yesterday Azarchs said "we don't think the worst is over" for J.P. Morgan and that the firm needs to show "no other fundamental issues or surprises" in 2003 to avoid another ratings cut. That's significant, because while an A-plus rating "may not hurt them all that much," another downgrade to single-A or below "is a breakpoint that has some significance," Azarchs said. "It could cause a downward spiral, [and] we can't not downgrade just because it might cause that downward spiral."
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 [nonperforming] loans is going to effect them materially in the long run." Olstein & Associates has no position in J.P. Morgan. The fund manager suggested late Wednesday that the declines in names it does own, including Morgan Stanley (MWD) and Merrill Lynch (MER), were based on "sympathy with J.P. Morgan, not fundamentals." Such attitudes suggest why each of the aforementioned closed well off session lows Wednesday, as did the Amex Broker/Dealer Index, which ended off 0.7% to 390.54 after having traded as low as 382.95. Thursday afternoon, the index closed down 5.6% to 368.73, thanks largely to Morgan Stanley's disappointing earnings repot Thursday morning, which is a fundamental issue. Meanwhile, Bianco agreed that J.P. Morgan is not likely to be named "Miss Long Term Capital Management 2002." But he does worry that Fannie Mae could be a potential heir to Long Term Capital's tainted tiara, an argument we will examine in Part 2.
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