With so much investor distrust in the air these days, it doesn't take much of a rumor to roil a stock.

When the stock is J.P. Morgan Chase ( JPM), the juiciest piece of meat you can throw around nowadays is any speculation concerning its massive derivatives trading and underwriting operation.

Just consider what happened last week to the nation's second-largest bank. Not only did it have to deal with the fallout from a high-profile congressional investigation into its business dealings with Enron, it also had to move forcefully to squelch persistent rumors on the Street that the bank was facing potentially huge losses on some of its derivatives transactions.

Quieted Down

For now, the rumor mill is largely quiet. The whispers have all but stopped about J.P. Morgan's estimated $51 billion in net exposure to derivatives -- an amount that's nearly three times as much as any other U.S. bank.

But many investors, not just short-sellers, remain uneasy about J.P. Morgan's derivatives operation, which is far and away the world's largest and most profitable.

Indeed, one reason other banks don't find themselves dogged by similar rumors is because J.P. Morgan is such a dominant player in the market for selling these sophisticated securities, which are used by businesses to hedge themselves against fluctuations in interest rates, commodity prices and currency valuations. The notional, or total, value of all of J.P. Morgan's derivative transactions is a whopping $23.4 trillion, a figure that represents just over half the notional value of all the outstanding derivative transactions done by U.S. banks, according to the Comptroller of the Currency.

"It's our business to take risk and we manage our risk better than our competitors," says J.P. Morgan spokesman Adam Castellani, who points out the bank won an award last year for its derivatives risk-management practices from the trade publication Risk magazine.

Law of Large Numbers

But it's big numbers like $23.4 trillion in total derivatives value and $51 billion in potential credit-risk to the bank that are enough to make many investors jittery, especially with so many companies going up in smoke these days. In fact, some say the poor job J.P. Morgan has done managing its exposure to troubled commercial loans during the economic downturn is helping to feed the unease about its credit-quality of its derivatives book.

Last month, for instance, J.P. Morgan reported that it had $4.38 billion in nonperforming loans, investments and other assets on its books, a 75% increase over last year. So far, the problems on the derivative side have been much less severe. At the end of 2001, the bank reported $170 million in nonperforming derivative contracts compared to $37 million in the year before.

But critics say with J.P. Morgan making so many bad bets in its lending division, investors have a right to be squeamish about the potential for potholes cropping up in its derivatives portfolio.

"Morgan has been burnt in a number of these recent credit blowups, so it calls into question the effectiveness of their credit controls," says Sean Egan, president of Egan-Jones, a small credit-rating agency. "Hopefully they will be smart enough to address this before they have a major problem on their hands."


It's So Derivative
Bank Derivative Contracts'
Total Value
Current Exposure
J.P. Morgan Chase $23.4 trillion $68.8 billion
Bank of America 9.8 trillion 6.9 billion
Citigroup 6.6 trillion 22.4 billion
Source: Office of the Comptroller of the Currency as of March 31, 2002

Complex Financial Instruments

Some of the concern about J.P. Morgan no doubt also stems from the fact that derivatives simply remain a mystery to most investors. And given the limited disclosure that banks are required to provide about their derivative transactions in their corporate filings, investors are left pretty much having to hope that a bank's management is doing a good job handling its own risk.

Banking officials say for proprietary trading reasons and the privacy of their customers, there has to be limits on what they can reveal about derivative transactions. But others say the banks could do more to put investors' minds at ease.

"A lot of this is based on faith," says Stephen Ryan, an accounting professor at New York University's Stern School of Business. "The value of risk assessments are often based on assumptions and these assumptions are made by the banks."

Even though banks are some of the most heavily regulated institutions in the nation, Ryan says that when it comes to derivatives much of what the regulators at the Federal Reserve and the Comptroller of the Currency do is simply review and analyze a bank's risk management strategies. For the most, he says regulators accept the underlying valuations and assumptions banks make about their derivative transactions. So, the regulators are putting a lot faith in what the banks are telling them.

"It's often auditing of the control systems," says Ryan. "Regulators have a finite amount of time and ultimately they rely on the banks to do their work for them."

Latin and Greek

Indeed, the main focus of the regulatory review process are the results from so-called stress tests that banks are required to perform periodically on their derivative portfolios. Relying on a complicated series of mathematical formulas, banks engage in a series of "what if" scenarios to determine how much of their portfolios they could be on the hook for, if everything that could go wrong does -- and all at the same time.

In reviewing the results of those stress tests, the regulators pay particular attention to the creditworthiness of the financial institutions and companies that stand on the other side of bank in a derivatives deal. One bank regulatory official says a worrisome sign is if a bank is engaging in derivative deals with too many companies that lack an investment-grade credit rating.

By that measure, at least, J.P. Morgan appears to be doing a good job of managing its risk. Just over 83% its derivative deals are with investment-grade businesses, most of which are other financial institutions. Banking analysts says that figure is comparable to that of other banks in the derivative business.

Indeed, Moody's Investors Service, which recently changed its credit outlook on J.P. Morgan Chase to negative from stable, says the one thing it wasn't too worried was the bank's derivative portfolio.

"We put a negative outlook on the company, but it doesn't relate to the derivatives business," says Peter Nerby, a Moody's banking analyst. "It relates to (loan) credit quality."

Still, as long as the bad loans continue to mount at J.P. Morgan, concerns about the bank's derivative practice will likely linger on.

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