last week’s big story about the JPM $2b trading loss highlights what we perceive to be a major risk factor in the market and banking system, that is the consensus and regulators are still focused on the wrong risks. There is no better risk manager on Wall Street than Jamie Dimon and all you have to do to find out how intense he is in the risk department is read A Demon of our own Design by Richard Bookstaber to get a sense of his focus. It would be highly unlikely that JPM would face this kind of a loss on a bad investment or loan and the fact that this occurred in the credit hedging book gives us more confidence that Mr. Dimon will right the ship. The details are still trickling out but the miscalculation of Value-at-Risk (VAR) suggests they had too much delta and maybe too much gamma in the CDX position. They were actually over-hedged.
After the news broke everyone started to pile on, Fitch downgrades and S&P lowered outlook. In a barrage of “I told you sos” the financial media loved criticizing JPM all day for playing in the credit derivatives market seen as a major contributor to the financial crisis. People in D.C. caused for an investigation and you heard rumblings of whether JPM violated the Volcker Rule and even the need to bring back Glass Steagall. As usual we think everyone is getting this wrong.
Credit derivatives were a major contributor but not because of what most people think. It’s not because the credit goes bad, it’s because the structure goes bad. Since the crisis of 2008 the Fed has continued to focus on credit markets and liquifying the system by printing money and pushing down long term interest rates to stimulate borrowing and refinancing. Mr. Bernanke likes to highlight the benefits of low interest rates but there is a cost and its getting to be more and more severe as time goes on.
The cost of negative interest rates is that someone has to buy that bond and make that loan. That someone is the banking system that is currently loading up on long duration negative coupon negative convex assets. Ironically, the Fed by focusing on the risks that didn’t cause the meltdown, credit deterioration, is increasing the risks that did cause the meltdown, negative convexity.
As we stated in Upside Down Monetary Policy we pointed to the correlation between the Fed Funds rate and the Loan to Deposit Ratio at US banks over the implied carry in the curve with the amount of securities banks hold as a percentage of total credit. The last time banks owned this many securities and the carry started to flatten, in ’94 and ’04 it preceded major back ups in yields. The very fact that this time these banks are holding negative coupons makes this much riskier. Many banks have no doubt been buying higher yielding callable paper to compensate for the lower yields but that extra yield is not free, you are short the volatility.
That brings us to the current situation in the bond market. As we have been suspecting for a couple of months, an equity market correction would be the catalyst to propel bond prices to new highs and thus far that play book is working. The TY_F contract has seen new all time highs after holding our 132-00 support level. The short base by the large specs continues to support prices and though they’ve covered some they still have a long way to go. The consensus views these rising prices (falling yields) as a discount of slower growth but we caution that interpretation. Bernanke long ago took the discount out of the discount rate and we think price is being driven by a short squeeze that could be the last leg of the bull market.
We aren’t worried about the shorts covering and taking us higher, we are worried about what happens when they are flat. The Fed has been a major bid under this market as have been the shorts. The Fed supposedly will be walking away in June and the shorts may be finally flat by then. If the Fed is wrong and Gross is right about stock v flow we could be in for a very bumpy ride this summer. Ironically it would be because the Fed threw gasoline on the fire they started in the first place and we know Bernanke loves blowing up his own trades.