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JP Morgan Aids in the (Fraudulent???) Sale of Restricted Stock and Insider Stock Sales

Reggie Middleton's picture




 

I’ve been harping on banks a lot lately, so why give up a good thing.
Next up, we have a “how to” manual for JP Morgan private bank
salespersons to assist wealthy executives in insider trading and the
liquidation and/or monetization of restricted stock. You see, this gets
sticky because it very well may be against the law to put a hedging
position on your restricted stock portfolio based upon non-public
information. As a matter of fact, I’m pretty sure it is against the law.
This is how JP Morgan presents it…

As quoted from their document: Rule 10b5-1 addresses challenges
associated with Rule 144 requirements by offering flexibility in
restricted stock sales
• This rule establishes broad “awareness” standards prohibiting insider
trades on the basis of material nonpublic information if he/she is
aware of the information at the time trade is made
• Establishes “affirmative defense” – no liability if, before becoming aware of the material nonpublic information, insider:
– entered into a binding contract to buy or sell, or
– gave instructions to another person to buy or sell for the insider’s account, or
– adopted a written plan for selling securities
• The contract, instructions, or plan must meet certain additional requirements

This is how the scheme program works…

1. An insider who has been solicited as  a client transfers their
restricted company stock into a JP Morgan Securities Inc. brokerage
account (of course).

2. The JP Morgan rep then develops works with the insider and the
specialized “10b5-1 team”, to create a ‘phased [in], pre-planned sales
program to be executed at either market or specified prices’.

3. With the use, and of course contingent profitability of the information available to the insider (but of course not available to the public),
the insider and new JP Morgan Private Bank client can decide whether to
execute the sale or not. Since the sales were “pre-arranged” (wink,
wink), they have sidestepped the perception (only by idiots of course)
of a purposeful sale in avoidance of an occurrence that was not privy to
the public investor. Notice how Mozillo, the Countrywide CEO, was able
to sell tens of millions of dollars of stock and get away with it
without being smacked for insider trading. He knew, as sure as I did,
that Countrywide was a goner.

Remember, when dealing with the big investment banks, the house
always wins! Remember my tutorial on Morgan Stanley/Goldman Sachs and
the damn brutal beating and outright fiscal disembowelment investment services offered to their institutional clients? See

The afore-linked piece should be enough to make any institutional or retail investor shed tears. Alas, I digress…

Stanford University Graduate School of Business professor and
academic, Alan D. Jagolinzer, researched of roughly 117,000 trades in
10b5-1 plans by 3,426 executives at 1,241 companies. Hold your breath
now, this is going to be a shocker. The esteemed, yet totally
flabbergasted professor calculated that trades inside the plans schemed engineered
by banks like JP Morgan outperformed the broad market by 6% over six
months. Go figure… This does effect the small retail investor and the
institutional investor alike.

A BoomBustBlogger just posted this comment on the last fraud alert I posted just a few minutes ago (see A New Spin on Bank Fraud: Banks Defrauding Their Invesors, Auditors and Regulators, Which Also Helps Delinquent Mortgagees to join the discussion)…

Reggie,

As an investor who is trying to make
money in this challenging market(back and forth), it is frustrating and
difficult to know that this type of chicanery is going on.  I would
love to know what percentage of residential real estate in the shadow
market is not properly accounted on banks balance sheets?  From an
investment perspective, going short with a longer term put option
(LEAP) could be a costly proposition because companies and markets can
appear to levitate on thin air for a very long time.  In other words,
you can understand the fundamentals on a company and still lose money
because the books are being cooked!

A very sad state of affairs for investors.

Yes, a very sad state of affairs indeed. Reference BusinessWeek/Bloomberg reports:

A Closer Look At Trades By Top Brass November 13, 2006

Late last year, after a seven-month surge
nearly tripled shares in Midway Games Inc. (), CEO David F. Zucker
apparently decided it was time to lighten his load. So on …

Not As Random As It Looks? November 06, 2006

John B. Blystone appeared bullish on the
prospects of SPX Corp. () back in late 2003 and early 2004. In his role
as chief executive of the Charlotte (N.C.) industrial …

Insiders With A Curious Edge December 18, 2006

The confusion over corporate executives
trading on inside information never seems to go away. In 2000 the
Securities & Exchange Commission came up with a way to remove…

Registered BoomBustBlog users can download the entire scheme document here: File Icon JPM Restricted Stock scheme

I would be remiss in leaving you without posting one of our favorite JPM graphics, wouldn’t I???

Those that don’t subscribe still have a lot of BoomBustBlog JPM
opinion and analysis to chew on, including a free, condensed (but still
about 15 pages) version of the forensic analysis above. You can find
it below this pretty graphic from “An Unbiased Review of JP Morgan’s Q1 2010 Results Yields Less Roses Than the Mainstream Media Presents“…

The 2010 Q2 review can be downloaded by subscribers (click here to subscribe) here: File Icon JPM 2Q10 review

Subscribers should also review our forensic valuation reports, which
have (thus far) proven to be right on the money in terms of JP Morgan:

The JP Morgan Professional Level Forensic Report (subscription only)

The JP Morgan Retail Level Forensic Report (subscription only)

An Independent Look into JP Morgan (subscription content free preview!)

If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It?: Pt 2 – JP Morgan

Is JP Morgan Taking Realistic Marks On Its WaMu Portfolio Purchase? Doubtful!

Anecdotal observations from the JP Morgan Q2-09 conference call

Reggie Middleton on JP Morgan’s Q309 results

Reggie Middleton on JP Morgan’s “Blowout” Q4-09 Results

 

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Fri, 07/30/2010 - 02:39 | 495626 bingocat
bingocat's picture

Rule 10b5-1, if you read it, is pretty clear. By definition, sales programs which abide by the rule are not fraudulent. If I own shares, and at a time when I don't have material non-public information, I enter into a trade which will sell the securities over time, and I don't have the right to amend that contract subsequently when I have material non-public information.

If you are an executive of a company, there are times when you do not have inside information. If I were an executive and owned 15% of the company, I would rather dribble out a stake of 5% over the space of a couple weeks rather than be forced to trade it all in one day, pushing the stock price down. All in all, so would other minority investors.

Given that the SEC actually tracks insider activity quite carefully, and has the ability to look back in time, and brokers are rabidly afraid of customers who trade on insider info (the commission generated on any given trade is peanuts compared to the reputational damage should a customer ever accused the broker of assisting them to trade on insider info.

The level of suspicion of evil-doing on the part of others is so high on this board that one wonders how people venture outside. And perhaps the answer is that people don't...

Fri, 07/30/2010 - 04:58 | 495664 Reggie Middleton
Reggie Middleton's picture

Clearly you must jest. Adherence to the program may be legal, but it can easily and often be abused. The Angelo Mozillo example is a perfect representation. The mere fact that you have a schedule of sales outlined from the past doesn't mean that you cannot, and have not, acted on non-public information. Do you think that I actually knew that Countrywide was going to fail before its own CEO did? Assuming that I ddin't, his stock sales were sales that executed with the information that said stock would be worth much less in the future than it is now. If he knew that the government was going to save his company and the shares would triple, would he have amended his stock sales? Now, if you waived the ability to cancel said sales, then we are on to something.

The SEC has been rather inefficient in tracking and catching securities manipulation over the last few years so I don't think it wise to use their efforts and results as hook to hang your hat on.

Fri, 07/30/2010 - 07:35 | 495706 bingocat
bingocat's picture

Indeed I do not jest.

Nothing in rule 10b5-1 says that individuals cannot trade on inside information. It is against the law, but nothing in any law determines that people cannot break the law. Every law out there may be easily and often abused. I jaywalk from time to time. Hell, almost every day. Insider trading happens. The people who would knowingly and egregiously abuse 10b5-1b safe harbor rules (mostly by cancellation, or timing) would probably trade on inside info if 10b5-1 did not exist.

The Angelo Mozillo example is a perfect representation. The mere fact that you have a schedule of sales outlined from the past doesn't mean that you cannot, and have not, acted on non-public information. Do you think that I actually knew that Countrywide was going to fail before its own CEO did? Assuming that I didn't[sic], his stock sales were sales that [were] executed with the information that said stock would be worth much less in the future than it is now.

Your conclusion (which I have italicized) does not follow logically. Just because you did not know before he knew does not mean that his sales were executed with inside information. That said, he has been served with a Wells Notice for his sales, and one presumes there is some followup (but these things take a fair bit of time).

If he knew that the government was going to save his company and the shares would triple, would he have amended his stock sales? Now, if you waived the ability to cancel said sales, then we are on to something.

The cancellation "loophole" is a problem. The law on what constitutes insider trading is part of the problem (insider trading only happens when a trade happens, not when one doesn't happen). This is the main problem with the "written plan" issue, though the SEC is still working on this to my knowledge (the issue is that 10b5-1b gives safe harbor based on the plans and trades; trades which are "cancellable" are not granted that safe harbor - the issue lawyers are still grappling with is whether a "Written Plan" should be deemed a trade based on its initial terms, or based on trades which happen within the plan). Many people are fighting for each side so it will take some time.

To me, the main problem about 10b5-1 "written plans" is that they are not required, upfront, to be registered (details shouldn't be public, but the fact that they exist should be noted when they are struck). The secondary problem is one of cancellability. Not all cancellations are nefarious. Lots of people cancel these trades when they feel it would be inappropriate for them to be selling when new information arises. Sometimes to their detriment. I personally know dozens of insiders who would have loved to sell shares but who decided that the info they had bordered on inside info so did not sell.

Personally, I expect there has been some abuse of the plans. I also think there has been some abuse of selling which has been done outside the plans. As to studies indicating outperformance,  I am pretty sure that the Jagolinzer study did not take into account embedded optionality (where the insider's "planned sale" algorithm has implied optionality, which the broker pays for and then monetizes). If I were an insider executing a planned sale program, I would choose to put limits on the planned sales, which would presumably give me better than average execution (i.e. I will execute at VWAP but only if VWAP is better than $XX). The other faulty aspect of the studies on 10b5-1 executions was that they did not compare whether insiders who sold were selling stock which was overpriced vs the rest of the market. And lastly, it did not adjust for the fact that stock prices were far higher at the beginning of the period of study than they were at the end. If stock prices fall from the start of the observation period to the end, and the VAST majority of insider activity is selling, it is likely that those sales will be made at prices higher than priced observed at the end.

As to the last statement on the SEC having been "rather inefficient," I have not seen any basis for someone coming to that conclusion. Just because someone sees something which looks like manipulation does not mean it is. If someone else has done the research and found the SEC lacking, I'd love to see it. I do not deny that I have questioned their professionalism, but I recognize my own ability to jump to conclusions without evidence. In this case, I have no evidence on the ratio of catchable instances of securities manipulation which are not caught (assuming that they should be caught). Prosecuting crime is always a socio-political matter. If there are vast quantities of "petty mischief" in the manipulation markets (and I have seen that happen more times than I care to count), some of it is not worth chasing (limited resources, limited effect, and the US legal system's "reasonable doubt" aspect makes prosecuting small-fry excessively expensive).

Fri, 07/30/2010 - 07:54 | 495717 Reggie Middleton
Reggie Middleton's picture

And I thought I wrote a lot :-)

I don't have time to respond to this now either, but from the gist of a cursory glance, it appears that you are saying that you agree with me without explicitly admitting it. I will try to return later on if I can.

Thu, 07/29/2010 - 20:52 | 495350 Cheeky Bastard
Cheeky Bastard's picture

Reggie, FYI; the derivatives chart doesn't mean what you think it means. The composition of JPM derivative exposure [+ 100 other things] nullifies the point you try to make by displaying that graph. But for discourse sake; 86% are PV IR and FX swaps, 8% equities, 6 % CDS and CDS-like derivatives. [which when netted reduce the % participation in the composition and the participation % is maybe 2%]. 

Fri, 07/30/2010 - 04:52 | 495661 Reggie Middleton
Reggie Middleton's picture

Actually, that would depend on what you believe it is that it means to me. I doubt very seriously that you read the report attached to it, for if you did you would realize that I walked through much more of the risk spectrum of JPM. As we have seen with Bear Stearns, Lehman, AIG and Ambac, there really is no such thing as effectively netting out several hundred billion of exposure, you simple trade one risk (ex. market risk) for another (ex. counterparty risk). This was clearly illustrated in the report, which was free - but you must read it to truly engage in the discourse). Of course I'm not perfect and do make mistakes, but this is not one of them. Let's have the discussion after you have read what it is you are commenting on, An Independent Look into JP Morgan (subscription content free preview!). In that document we discussed the stated (form JPM's own reporting) market value of their net risk, which is still nothing to sneeze at when viewed as a percentage of thier net tangible equity.Notional value also gives you a clue as to the amount of leverage used, and now that we know how truly difficult it is to offset massive exposure through netting, ex. GS/AIG, ABK, C, LEH, etc.) it should give one pause. The pool of counterparties of adequate size is smaller now than it was in 2008.

"But for discourse sake; 86% are PV IR and FX swaps, 8% equities, 6 % CDS and CDS-like derivatives. [which when netted reduce the % participation in the composition and the participation % is maybe 2%]." 

But are you telling the whole story? At the time the chart was created, one should have considered the staggering level of derivatives employed by JPM. If you looked under the hood you would have found that the quality of JPM's derivative exposure is even worse than Bear Stearns and Lehman‘s derivative portfolio just prior to their fall. Total net derivative exposure rated below BBB and below for JP Morgan stood at 35.4% while the same stood at 17.0% for Bear Stearns (February 2008) and 9.2% for Lehman (May 2008). We all know what happened to Bear Stearns and Lehman Brothers, don't we??? I warned all about Bear Stearns (Is this the Breaking of the Bear?: On Sunday, 27 January 2008) and Lehman ("Is Lehman really a lemming in disguise?": On February 20th, 2008) months before their collapse by taking a close, unbiased look at their balance sheet. Both of these companies were rated investment grade at the time, just like "you know  who". Now, I am not saying JPM is about to collapse.For the record, I have absolutely nothing against JPM, and I actually believe that they are one of the better run of the big banks with astute management (relatively). Thus, the move to release reserves this last quarter was a departure from what I considered conservative practice that I expected from management.

 

 

 

Fri, 07/30/2010 - 06:24 | 495684 bingocat
bingocat's picture

Reggie,

What dropped both BS and Lehman was funding, not quality of counterpart risk or massive derivatives exposure. Bear Stearns did not go under because of the quickly deteriorating quality of its counterparts. It went under because of its counterparts' quickly deteriorating view of Bear Stearns' credit. All things considered, the derivatives unwind of Lehman exposure went pretty well (other things did not, but that is part and parcel of a bank unwind); it was the senior unsecured risk holders who will get screwed far worse than they could have imagined.

You refer to GS/AIG as an example of how difficult it is to offset massive exposure through netting. I do not understand that. To me that is a good example of how to manage risk through netting, and understanding the difference between derivatives risk subject to CSAs, and net credit risk NOT subject to CSAs. C is also not an example of "how truly difficult it is to offset massive exposure through netting." C is an example of how "mark to market" pricing in a panic can kill anybody (FWIW, it is also an example of how NOT to use balance sheet for illiquid, low-ROA (or low RoRAP) assets), and an abject lesson in the risks of relying on re-hypothecation and short-term funding markets.

As to the "quality of JPM's derivative exposure", I still don't understand where you get the 35.4% number. The only places in the Annual Report I know of where one can get that kind of ratings breakdown of exposure is in the "wholesale credit exposure" section (where the number nets to below 25%), the "CDS protection written" section (where it is gross, not net on an exposure basis), the Ratings Profile of Derivatives Receivables (where it nets to 27% last year, but that is 27% of $64bn (vs the receivable portion of $80trln which is the total derivs book).

In terms of snapshot of exposure, net derivative receivables (netted of collateral held now) is where it matters. That total dollar exposure is but a fraction of the total non-IG exposure held by the firm (roughly a tenth).

None of this, however, addresses the issue of what the net receivables position would be tomorrow if something really bad happened overnight, and that is not knowable, because no bank will tell you what the stresses look like and where those stresses hurt (it could be that the correlations to disaster actually help (i.e., interest rates spike, hurting a host of floating rate paying customers, and the sudden onset of huge numbers of bankruptcies might cause short-term rates to suffer a flight to quality (which would allow the bank to cover their net exposure (after collateral) very well. That said, usually the vast majority of net exposure on derivative receivables (when netted for collateral) are for reasonably short-term trade settlements, or exposure which is viewed by Risk Management as explicit and un-hedgeable credit exposure (which has a cost (presumably earned in spread)).

The place where JPM has ALWAYS had significant sub-investment grade exposure is on its loan portfolio (where the non-IG percentage is more like 40%) and commitment lines. The risk there is many, many  times higher. The implied sub-investment grade risk in JPM's card and auto-loan business is also many times higher than the net derivatives credit risk. The risks to American sub-IG corporate borrowers and to American individual borrowers is where the bank lives or dies (and really where every major American bank lives or dies over the next ten years now that most have made fundamental changes to funding/liquidity risk assessment/understanding). That risk is "socio-political risk." That risk is that of millions of Americans deciding they will not abide by their contracts. That risk is risk of dramatic change in financial behavior by consumers.

Net derivatives exposure to counterparty credit risk is actually probably the star of most banks these days as everyone under the sun has tightened up margins, shortened observation lags, and because of CSAs in place (and most banks' strong efforts to avoid double gearing net exposure), event risk on derivatives is not a bank-killer in most cases.

Fri, 07/30/2010 - 07:45 | 495713 Reggie Middleton
Reggie Middleton's picture

You wrote a lot and I can't address all of it now, but I will address the first part.

It went under because of its counterparts' quickly deteriorating view of Bear Stearns' credit.

Exactly! BSC had a bunch of junk on its books that were carried above actual market value. I called this in January of 2008 and it was corroborated by more than one BSC employee. BSC's counterparties recognized this and became wary. The same thing happened with Lehman. Do you really think JPM's book is actually worth what they are carrying it at if they needed to unwind (and I don't mean a firesale, and orderly unwind)?

You refer to GS/AIG as an example of how difficult it is to offset massive exposure through netting. I do not understand that. To me that is a good example of how to manage risk through netting, and understanding the difference between derivatives risk subject to CSAs, and net credit risk NOT subject to CSAs. C is also not an example of "how truly difficult it is to offset massive exposure through netting." C is an example of how "mark to market" pricing in a panic can kill anybody (FWIW, it is also an example of how NOT to use balance sheet for illiquid, low-ROA (or low RoRAP) assets), and an abject lesson in the risks of relying on re-hypothecation and short-term funding markets.

You're right about the balance sheet part and I couldn't agree more, but GS/AIG/C is a perfect example of how you cannot truly offset hundreds of billions of dollars of market risk for free. All GS did when it hedged its AIG exposure was trade the market risk for counterparty risk. That counteryparty risk was excessive, and would have definitely resulted in a big loss if not for the government giving $180 billion or so of cash and investment. GS allegedly hedged their AIG exposure with C and LEH. We all know how that would have went had GS would have had to call those in. The basic point is that these banks are not truly offsetting risks when they allegedly "hedge" through "netting" in a very closed, incestuous circle of other banks in the same or very similar businesses sporting the same or very similar risks using the same or very similar trades. Think correlation, think dispersion, think risk concentration.

2008 has shown us that this "so called" netting is truly a fallacy. If it wasn't, then lets rewind the tape and try it again without the US taxpayer as the ultimate counterparty of last resort and see what happens.

Fri, 07/30/2010 - 09:14 | 495850 bingocat
bingocat's picture

We will probably have to agree to disagree about the details.

As for BSC, you missed my point. It was not the risk of the assets. It never was. It was always about funding mismatches. It was the risk of being the last lender to BSC. Liquidity mismatch is a virtuous circle or a vicious circle.

As to JPM's assets being worth what they say they are if they have to unwind... no I don't. But that is because if one had to unwind JPM in an orderly fashion, it would be because markets were not orderly. Unwinding in an orderly fashion in panicked markets would mean assets were underpriced. Like triple-A corporate bonds or prime mortages in Feb/March 2009.

I think you would be surprised at how good CVA desks' understanding of the issues really is (correlation is explicitly understood and hedged (and the fact that there is a risk of the "incestuous circle" is the reason why this risk is managed through netting and CSAs - it allows a very fast observation of who is putting money through)). CVA desks hedge the hedge, then hedge the hedge on the hedge. That's their job.

"We all know how that would have went [sic] had GS would have [sic] had to call those in"

You imply two things here. One is that GS had not hedged its exposure to C. The other is that C had naked exposure. I would make neither assumption.

I beg to differ on the "so-called netting" being a "fallacy." Derivatives did not kill banks  or cause the need for TARP (if they had, the bulk of TARP would not have been paid back - the fact that it has been paid back (by the banks, not the investors like FNM/FRE/AIG/SLM/etc) means that the risk was very clearly liquidity risk, not asset price risk). Derivatives exposure will not be the achilles heel in the future either. The claim that banks are not offsetting similar risks through netting because they are all in the same business with the same risks is inherently problematic. The vast majority of net risks taken by the "incestuous circle" member banks are risks against corporations and individuals. Net risk to other financial institutions is actually quite small (though transaction flows are quite large). The fact that those flows are generally managed on mark-to-market basis with collateral netting agreements actually serves to protect the system from itself, not vice versa. The only time that risk to the whole circle is a problem is when there is worldwide systemic panic. And in that case, the far larger net risks will be a problem too.

The difference between collateralized agreements and uncollateralized agreements is absolutely key.

 

Lastly, the taxpayer ALWAYS steps in when there is systemic financial crisis. It is just a matter of timing. It either happens on the front end (like TARP and the acronymed secured lending programs) or it happens on the back end when everything is allowed to fail, and governments fall into net debt more assuredly over a longer time (when GDP drops 10-30% over a couple of years, outflow increases and inflow decreases, to an extent that would have made TARP and aid to AIG/FNM/FRE look like peanuts). There is no way around deleveraging of over-extended private sector long-term liability. It happens quickly, or slowly, but the amount of bloodletting is basically the same.

Fri, 07/30/2010 - 09:32 | 495885 Reggie Middleton
Reggie Middleton's picture

I'd love to address all of your points (since I like to debate) but it is just too much for right now. First, your comparison of net JPM exposure above should be made to sanitized tangible equity, and not to JPM's total asset base. Assets as a proportion to tangible equity give a much more accurate depiction of risk and leverage to the equity shareholder.

Next, I understand the funding mismatch of BSC, but which bank didn't have one in 2007/8? The reason BSC got called on its long/short mismatch is because the collateral behind it was bogus. After BSC and LEH, all of the banks started looking around because they all knew most other banks were in a similar boat, just not to the extent of BSC.

You imply two things here. One is that GS had not hedged its exposure to C. The other is that C had naked exposure. I would make neither assumption.

You are falling into that circular, incestuous trap again. Suppose GS had hedged its exposure to its hedge (C), which is starting to sound silly to the practical layman, and for very good reason, exactly who would they have hedged it with? Bear Stearns? Ambac? MBIA? FNM? FRE? The circle is too small and too interconnected, and definitely too correlated in illiquid in a time of need. Suppose C didn't have naked exposure... Aww, I think you get the point by now.

If there are 5 guys in a bar, each with one dollar (leveraged 20x, meaning that each guy really only has a nickel, but they borrowed 95 cents each), and one guy borrowed 50 cent from the next and so on until we got to the 5th guy - do you really think that things will go well when the first guy defaults on the loan on payback? Everybody gets wiped out because the risk never really left the room.

Fri, 07/30/2010 - 13:04 | 496496 bingocat
bingocat's picture

Para1: Comparing net JPM derivs exposure to tangible equity and comparing total assets to tangible equity means that one is also comparing derivs exposure to total assets. Net exposure to sub-IG counterparts IS an asset. The other $150bn of net loans and commitments to sub-IG, $550bn of credit card exposure, another few hundred billion of Alt-A and subprime mortgage exposure not to mention autoloans, student loans, etc are also assets. The net $17bn is peanuts. Where it becomes a problem is the 

Para2: Funding mismatch is its own concentration risk. Illiquidity of short-term repo and unsecured call borrowing is highly correlated, and as everyone found out, highly auto-correlated.

Para3: I am not falling into a circular trap. There is no circular trap. Your insistence on it shows a lack of appreciation of netting. The gross accumulation of net credit deriv exposure at banks (after collateral) is limited, even if you assume that every bank is long everything else every other bank is. The gross accumulation of net credit exposure among "long-only" investors is VASTLY larger. The "circular" part of this is where the dealers trade marginal exposures among themselves because they are the clearing houses for their customers. The other side of this is the fact that those same investment banks created securitizations of credit exposure, and re-securitizations of those securitizations. These were in many cases fully-funded transactions. It generated cash, and created the inventory of credit protection which allowed investment banks to sell credit protection to each other and the street. One cannot have a situation where the banks stuffed their customers AND did not net buy protection from their customers.

The bar analogy is good. But it is not 5 guys. It is billions - the financial asset owners of the developed free-market economies of Earth. It just so happens that there are brokers inside the bar who rather than trading debt securities issued by bar patrons, trade chits to and with bar patrons, on other bar patrons (and brokers). Each broker writes down the underlying exposure on a pair of chits (double-entry book-keeping). They give one to their patron customer, and one to their bag. Once they put the chit into their bag, they can't take it out. If they want to trade that risk away, they have to make a chit with a negative sign on it and trade it away. Then the brokers write chits on each other to other customers and to other brokers in the bar. Patrons are not allowed to trade directly with each other. Each of the 5 brokers has a different color of chit. They are only allowed to write chits in their own color. If a bar patron wants the red chit broker to buy the blue chit offering Patron #678 risk, the red chit dealer will buy Patron #678 risk from the customer, and buy blue broker risk, but will do so on a red chit. In the end, everyone will have a bit of risk of everyone. The brokers will have the gross risks, but they will also have the most ability to hedge their net risks, and make money doing it. The people who cannot easily net out are the non-broker bar patrons, who are just taking risks on the underlyings, and assuming that the broker is good for it. At the end of the day, it is not necessarily the broker who gets nailed. It is the guy who made the wrong bet and was overly concentrated.

Leverage is a bitch when volatility hits. Volatility and intracorrelation assumptions proved wrong for many people (like all those individuals who worked in real estate or construction and bought houses and had only a few percent down, and had no cash on the side). Just because that is the case does not mean chit brokers get nailed. The question is then not what your gross chit position is, it is how exposed you are to the correlation that the billion bar patrons are all going to be wrong at the same time. It is not because the brokers own bar patrons' chits that it is going to be a problem. Brokers hang out after the bar closes to settle net positions before they go home. It is because when everyone leaves the bar, the brokers also have outright exposure to the bar patron's house, car, education, furniture, and credit card balance. 

This is why the idea of breaking up banks will not prevent this from happening again. It doesn't matter how many brokers there are: 5, 50, 5000. It matters what the net position of the rest of the bar patrons is when something goes wrong, and how levered they are (which is why the taxpayers were doomed anyway - we did it to ourselves). 

Fri, 07/30/2010 - 02:58 | 495635 bingocat
bingocat's picture

Thanks CB.

People tend to throw numbers around without knowing what they mean. I'm glad there are people who are around to explain them.

When you say "participation in the composition" surely you are not talking about the net risk they take? If so, I would have expected it to be more like a fraction of a percent (imagine the DV01 of a $1trln net exposure to interest rate moves implied by a 2% net exposure).

What very few people realize is that banks' largest risks in derivatives are rarely things so prosaic as market risk. They are issues like counterparty exposure management, legal precedent risk, settlement ladder risk (understanding that "market risk" understanding rarely incorporates things like knowing that your settlement dates on your hedges may settle on a different date than your hedge, even if the observation periods are the same), and systems backup.

Fri, 07/30/2010 - 07:28 | 495704 Cheeky Bastard
Cheeky Bastard's picture

I did stated the figure a bit too high. Netted single name non-index CDS volume may, as you say, be only a few basis point of the whole 90T gross notional outstanding. Also in the total netted CDS volume majority of "exposure" is to indexes for which JPM serves as a primary dealer and a market maker. The comment wasnt trying to present the exact figures; I just "mapped" the ISDA ones onto JPM portfolio. 

And I could not agree more with you re: People tend to throw numbers around without knowing what they mean. 

People just dont want to dig deep into this and actually understand it. 



Fri, 07/30/2010 - 08:03 | 495720 bingocat
bingocat's picture

I checked.

For JPM, net derivative receivables for credit derivs was $18.8bn as of Dec31, 2009. In toto, it was something like $80bn (as per p178 of the 2009 Annual Report). A separate section (p111) showing the ratings profile of all derivative receivables (no matter the underlying, and presumably that includes both underlying and counterparty risk) shows non-IG at $17.4bn (out of $65bn) as of same date.

One assumes that the effort at unwinding netted exposures across counterparts will go a long way to unwinding gross notional exposures, but because swaps are bilateral anyway, and the vast majority of gross notionals are traded by a relatively small number of counterparts who trade often (whether it be interbank, institutional, or corporate), gross means little to anyone except people who get themselves wound up by big numbers.

In both cases, the net exposures are a far cry from  $80-90trln of gross numbers. And given that these net numbers are but a tiny portion of actual balance sheet assets of net credit risk and net non-IG risk, the "danger" is not in the exposure, but in the higher-order intracorrelation stresses which occur OUTSIDE the realm of where CSAs matter. If internal counterparty credit limits are observed, and CSAs work, then there should be little problem. If everything goes at once, the question is whether the stress event causes a reactionary event which helps to unwind the exposure at rubberband breaking point, or whether the risk exposure and the intracorrelation causing the "event" are on a self-reinforcing feedback loop.

Thu, 07/29/2010 - 20:47 | 495340 rd
rd's picture

I'd risk saying that Reggie has some unresolved issue with JPM that comes from long ago...it's clearly personal has it shows in his writings about them.

Thu, 07/29/2010 - 17:58 | 495100 anonnn
anonnn's picture

In 2001, concerned w an investment in  modest telecom Intellectual Property, my amateur due-diligence uncovered this ruse...

There is a deliberate loophole in insider trading rules, such that submitting to SEC awritten plan for future sales of stock will bypass accusations of insider-trading .

Namely, the pre-arranged plan to sell can be cancelled anytime prior to such date of sale

Expect negative news?...arrange a sale plan.

Expect positive news? Cancel the plan.

Did you expect authors of SEC rules/actions would deliberately arrange for their own misfortune?....or put themselves at risk? Risk is for the small people suckers. 

"Survival of the fittest", and all that insanity.

Thu, 07/29/2010 - 16:46 | 494942 Hephasteus
Hephasteus's picture

Did Reggie razzberries finally find their 10b-5 program. They cleansed its info from the web about a year and half ago.

Thu, 07/29/2010 - 16:42 | 494929 alibabaandthefo...
alibabaandthefortythieves's picture

RM's post is very similar to one written in 2009 (also uses the same slide).

http://wikileaks.org/wiki/Whistleblower_exposes_insider_trading_program_at_JP_Morgan

Thu, 07/29/2010 - 16:34 | 494899 Problem Is
Problem Is's picture

The Fraudster of Finance Capital Oligarchy That IS Jamie Dimon...

"Lessons taught but never learned
All around us anger burns
Guide the future by the past
Long ago the mould was cast.

For they marched up to Bastille Day..."

Unknown Poet.

Thu, 07/29/2010 - 17:24 | 495015 Jasper M
Jasper M's picture

Hardly unknown - written by Niel Peart, drummer for Rush. 

Thu, 07/29/2010 - 16:12 | 494849 Mad Max
Mad Max's picture

100% totally corrupt, but not surprising.

We're a banana republic, ship is going down, etc.

Thu, 07/29/2010 - 16:07 | 494835 h4rdware
h4rdware's picture

Dire. Dire dire dire.

But so real.

I have long considered the possibility that JPM will die the death of ultimate hubris - by becoming it's own competitor. It will become so overpoweringly dominant, that it trades against [self + noise].

...like a parasite that becomes larger than the host, with no room to grow.

In fact, I have concluded that JPM has a dept. dedicated entirely to that very problem.

 

Thu, 07/29/2010 - 15:59 | 494807 RockyRacoon
RockyRacoon's picture

Clever!   Legal?

Thu, 07/29/2010 - 15:40 | 494747 Chemba
Chemba's picture

Reggie, please remove and/or modify this post.  You are only allowed to attribute nefarious bankster activity to Goldman Sachs on ZH.  If you wish to post this information, please photoshop and replace all references, logos, etc. "JP Morgan" and replace with Goldman Sachs.

Thank you.

Thu, 07/29/2010 - 16:41 | 494927 Ripped Chunk
Ripped Chunk's picture

Sez who?

Thu, 07/29/2010 - 15:34 | 494730 Ripped Chunk
Ripped Chunk's picture

That's business as usual at JPMC. What is the issue?  Oh, right. It used to be illegal.

Do NOT follow this link or you will be banned from the site!