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The Biggest Surprise In Today's JPM Earnings Report

Tyler Durden's picture




 

The biggest surprise in JPM's Q4 earnings release was not the firm's legal troubles: those are well-known, and largely priced in even if JPM did generously add back 27 cents in EPS to the adjusted bottom line, which means that if JPM were to treat its legal expenses as recurring (as they have been for two years now), its non-GAAP EPS would have been $1.13. No, the biggest surprise by far was that as of this quarter in addition to its trusty use of DVA or a Debt Valuation Adjustment (the old fudge when a bank "benefits" when its credit spreads blow out) JPM also added the use of a Funding Valuation Adjustment or FVA.

The amount of the FVA benefit? A whopping $1.5 billion addback to GAAP EPS, which together with DVA, resulted in a $2.0 billion pretax loss, promptly added back to get boosted non-GAAP EPS (and recall $1.3 billion in GAAP JPM "earnings" came from reserve releases).

Here is how JPM's explained the adoption of FVA as a bottom line fudge:

The punchline: "For the first time this quarter, we were able to clearly observe the existence of funding costs in market clearing levels"

For those not familiar with FVA, here is a refresher from Risk:

Banks that include a funding valuation adjustment (FVA) in derivatives prices may be vulnerable to predatory customers, according to two academics – a claim that is already being attacked by traders.

 

* * *

 

FVA reflects the costs a bank incurs when hedging an uncollateralised trade with an offsetting position on which collateral is required. When the former is in-the-money for the dealer, it will not receive any collateral from its customer and would have to fund its own posting to the hedge counterparty. Many dealers recognise FVA by discounting uncollateralised trades at their own cost of funds, meaning banks with a higher cost will charge a lower price for trades that create a funding benefit – a disparity Hull and White claim customers can exploit.

 

"It's a perverse situation. The FVA is determined by discounting derivative payoffs at your own funding rate, which lowers the price. If your funding cost is sufficiently high, your valuation will be below the market clearing price. Banks can then book mark-to-market profits from the difference – a form of accounting money machine. Some dealers with high funding costs appear to be doing this now, but if they have to reverse the accounting treatment it will result in very large writedowns – heads will roll," says White.

 

The paper claims the arbitrage can be achieved by buying an option from a bank with a higher funding cost – translating into a lower price because the dealer will recognise the benefit generated by the upfront option premium – and selling the same option to a bank with a lower funding cost. Because of the spread between the two banks' prices, each can be offered a small premium above the FVA-inclusive value by the client, which pockets the difference remaining after also hedging its counterparty exposure to the bank with the higher funding cost. Each bank appears to have made a profit relative to its FVA-adjusted price. However, according to Hull and White, because each bank's hedged portfolio will only earn what they refer to as a risk-free rate, the bank with the higher funding cost has priced the trade too cheaply and will actually lose money.

 

"This should be giving people pause for thought," says Hull. "I have spoken to one end-user – I won't name names – and it is seriously considering this. It may take a while but eventually dealers will realise they are on the wrong end of this and correct their prices. If Microsoft – to pick a name at random – can get different prices from Royal Bank of Scotland and JP Morgan, they will look to exploit it."

 

Since the arbitrage would only be available on uncollateralised trades, it appears to be restricted to the shrinking group of clients that enjoys this privilege – typically sovereigns, supranationals and agencies, corporates, special-purpose vehicles and some large pension funds – none of which are traditional arbitrageurs. However, Hull claims others, such as hedge funds, which are usually required by dealers to collateralise their trades, may be able to access it through ingenious financial engineering.

 

"Hedge funds employ a lot of smart guys who are paid a lot to spend all day thinking up ways of making money. I expect there will be people out there now looking at how to exploit this. I've been in the derivatives business for 35 years and I've seen this kind of thing happen time after time. Someone will do it," he says. One way might be for a hedge fund to implement the trade via a corporate, Hull suggests.

 

Bankers are not convinced, citing what they see as flaws in the argument, such as the existence of a risk-free rate – considered outmoded in post-crisis markets. They also argue there are few customers, if any, that would be able to take advantage of the arbitrage, because it requires a proprietary trader that has no collateral agreement with its dealers and routinely hedges its counterparty risk.

 

"It's not an arbitrage, end of story. You have credit risk to the higher-funding-cost bank and you can't be so blasé about wishing it away. That costs money and will eat into any profits. And I got a bit angry when I saw them talking about the risk-free rate. There is no risk-free rate. You discount a collateralised trade at the overnight indexed swap rate because it's the rate that funds it, not because it's risk free – it's not," says one emerging markets trader at a European bank. "They keep saying things like ‘prices should not include FVA'. Well, OK – but they do. If they didn't, the banks would go out of business. It's nice theory, but it does not reflect reality."

 

A senior treasurer at a European bank echoes these objections: "This is turning into a religious debate now"...

Religious or not, as of this quarter even the almighty JPM is subject to collateral funding costs. For now, it is an addback. Let's see what happens when it has to subtract from the bottom line...

 

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Tue, 01/14/2014 - 09:28 | 4330266 Headbanger
Headbanger's picture

SHOCKING!

Tue, 01/14/2014 - 09:41 | 4330298 90's Child
90's Child's picture

Bullish

Long PM's

Tue, 01/14/2014 - 11:09 | 4330516 Manthong
Manthong's picture

Don’t forget to add the new Forward Underperforming Capital Keepings on the asset side of the ledger.

Tue, 01/14/2014 - 09:42 | 4330302 Occident Mortal
Occident Mortal's picture

Boy am I glad I didn’t understand a word of that article, otherwise I would have to shoot myself in the face.

Tue, 01/14/2014 - 09:52 | 4330322 90's Child
90's Child's picture

Any negitave news against the TBTF is good for PM's that's all that matters.

Tue, 01/14/2014 - 09:29 | 4330270 Croesus
Croesus's picture

"We were manipulating the crap out of the metals....SURPRISE!!!!"  <--What I thought I'd be reading....

Tue, 01/14/2014 - 09:39 | 4330294 TeamDepends
TeamDepends's picture

They won't admit that until they are on their knees in front of an honest judge.

Tue, 01/14/2014 - 09:41 | 4330299 greatbeard
greatbeard's picture

>> an honest judge.

Heh, thanks for the morning chuckle.

Tue, 01/14/2014 - 09:53 | 4330328 Chupacabra-322
Chupacabra-322's picture

They all involved in an elaborate scheme based on contrat law & Criminal deceit to Fraud The American People by CONSENT (Black Law's Dictionary) & being an accessory to the deceit & Criminal Fraud by contracting with the Criminal State.

Tue, 01/14/2014 - 11:37 | 4330577 Arnold
Arnold's picture

Sooo... I can count on being indited as a conspirator as a fully paid up member of The John Q. Public splinter group?

Tue, 01/14/2014 - 09:52 | 4330317 Croesus
Croesus's picture

@ TeamDepends: 

I was honest in front of a judge, once...

I told her I wanted a private tour of her "chambers"...

Went up for contempt for 60 days...so I figure she must have only had books and a desk in there. 

Tue, 01/14/2014 - 09:38 | 4330290 AccreditedEYE
AccreditedEYE's picture

Like it or not, the "investor" of today is a poor shadow of his former self decades ago. He/she doesn't care about quality, sustainability or complexity in earnings. Just give them buybacks, accounting tricks & more "1 time events". Back in the elder days, if you bought back shares, you were pissing money away. Not collecting profits from sustainable, economically healthy endevors? Crushed. Today we move day by day, qtr by qtr. Long term outlook? Somebody else's problem. That is, till there's a boat load to be made leaning short.

Tue, 01/14/2014 - 09:41 | 4330300 Headbanger
Headbanger's picture

That's because they're not the same people but a younger generation who grew up believing in bullshit because they were never taught the truth.

Tue, 01/14/2014 - 09:44 | 4330306 AccreditedEYE
AccreditedEYE's picture

Yup. Will have to learn the hard way that "overly complex" is actually a very bad thing. And a waste of everyone's time.

Tue, 01/14/2014 - 13:33 | 4331001 csmith
csmith's picture

"overly complex" is the only way to hide the fact there is nothing there...

Tue, 01/14/2014 - 10:05 | 4330358 i_call_you_my_base
i_call_you_my_base's picture

Young people aren't in the stock market and they aren't making decisions about investing.

Tue, 01/14/2014 - 10:27 | 4330403 Dr. Engali
Dr. Engali's picture

You're right,. It is a rare exception for a young person to be in the stock market. The majority of retail investors are boomers and they are primarily renters, not investors, and they expect the market to go only one way...and that is up.

Tue, 01/14/2014 - 09:40 | 4330293 AynRandFan
AynRandFan's picture

I'm going to wait for the translation into English.

Tue, 01/14/2014 - 09:44 | 4330309 Ban KKiller
Ban KKiller's picture

"Innovative bookkeeping = risk free trades".....there, translated. Or..."Crooked accountants = any profit you care to claim."

Tue, 01/14/2014 - 09:47 | 4330311 Dr. Engali
Dr. Engali's picture

The system has become so damn convoluted that nobody has any clue as to what is going on. This is why they can't afford a major down tick in any of the "markets", once it does they won't have any idea as to who can honor what trade. Another reason why the fed will never stop printing, we must grow or die.

Tue, 01/14/2014 - 09:56 | 4330339 Chupacabra-322
Chupacabra-322's picture

Wrote this yesterday. Might give insight why the Criminals must continue to lie & print.

We are "Governed" into a Political, Educational, Religious & Economic UNITED STATES, CORP based on contract law which is based on Criminal Fraud, deceit & illusion.

The Private Corp UNITED STATES, CORP uses the cover of being a functional Government when in reality they are not. Much like the Criminal Federal Reserve uses The "Federal" in their name & use it as cover to give the illusion that they are a branch of the US Government when they are not.

Through bankruptcies, Criminal Contract Fraud & deceit the Charlatans have incrementally incorporated the US as well as your souls (birth cert) which are securitized via the Criminal Federal Reserve through to the IMF.

They're functioning off corporate version of the THE CONSTITUTION. It's the reason why The Global Criminal Oligarch Cabal Bankster Intelligence Crime Syndicate continues to lie, cheat, deceit, rape & pillage with impunity.

The only power the have over you is with CONSENT (Black Law's Dictionary). Pay no Taxes. Peaceful Non-Participation, Non-Compliance & being an accessory into their Criminal system/s based on Criminal Fraud, Debt Bondage & Enslavement.

Tue, 01/14/2014 - 09:47 | 4330313 max2205
max2205's picture

It looks like a good time to start a bank....

Tue, 01/14/2014 - 12:59 | 4330847 waterhorse
waterhorse's picture

lol - it's a big club, but you (we) ain't in it.

Tue, 01/14/2014 - 09:52 | 4330326 Whoa Dammit
Whoa Dammit's picture

If only I could profit from my costs. What a crock.

 

Tue, 01/14/2014 - 10:27 | 4330404 Dineroguru
Dineroguru's picture

The biggest surprise is that anyone believes anything coming out of an obviously crooked organization.  Maybe they should move the HQ to Sicily and make it official!

Tue, 01/14/2014 - 10:50 | 4330461 ItsDanger
ItsDanger's picture

FVA, an 'industry' migration????  Not GAAP?  Lets lump financing costs in with derivative book valuation.  LOL.  Why dont they incorprorate all related expenses into their valuations (you know their big bonuses)?  Why not just have one big number only? 

Tue, 01/14/2014 - 12:59 | 4330849 waterhorse
waterhorse's picture

Fuck Jamie Goddamned Dimon.

Tue, 01/14/2014 - 13:23 | 4330963 csmith
csmith's picture

Too big to fail - the biggest "FVA" of all.

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