But first, the crisis in Greece didn't come to a head over night but it can't be far away. Rival political parties have been unable to form a government. New elections are scheduled for the second week in June. The financial has definitely become political. The people have run out of patience with unsound money and the world built on it.

All that said, the Greeks managed to make a €430 million payment to hold-out creditors last night. Nearly 97% of Greek creditors agreed to the restructuring of the country's debt in March. That wiped off over €100 billion in Greek debt and resulted in 70% losses for some of the bondholders who accepted the deal. Not all of them did.

Yesterday, the bondholders who didn't accept the deal got paid in full. There is still about €6 billion worth of debt owed to creditors who refused to participate in the restructuring. You can imagine that the Greek decision to pay the holdouts would anger the creditors who agreed to the deal. They look like schmucks now. Schmucks.

But in the current scheme of things, €430 million is chump change. The real issue is whether the Greeks are going to default on €150 billion worth of government debt. If those bonds are owned by foreign creditors – let's call them other European banks – then the Greek crisis becomes a European crisis. We'll come back to this issue of 'containment' shortly.

For the Greek people, the most alarming aspect of what's going on is that their life savings are at serious risk of a massive, overnight, non-voluntary devaluation. There are a lot of words for the magical process of turning one thing into something else: alchemy, transmutation, and transubstantiation come to mind. But to the Greeks it's going to look a lot like highway robbery.

You'll go to bed one night with your life savings denominated in euros. You'll wake up the next day with them denominated in drachma. And your euro savings will be automatically converted to drachma at an exchange rate not of your choosing. For example, your 1,000 euros will become 100 drachma...or even 10,000 drachma. The nominal amount won't matter. What matters is that the devaluation strips you of 70% or 80% of your purchasing power.

Most people would avoid that kind of value destruction if they could. Maybe that explains why €700 million was withdrawn from Greek banks on Monday, according to remarks made by Greek President Karolos Papoulias and reported in the Wall Street Journal. The Journal reports that between €2 and €3 billion in deposits have been withdrawn from the Greek banking system each month for the past two years. January was a high point, with €5 billion.

A bank run by any other name would look as desperate. And who wouldn't be desperate now? Leaving the euro, devaluing the drachma, and defaulting on debt owed to foreign creditors are Greece's best long-term economic survival strategy. But the unavoidable side-effect is to destroy the savings of the people, not to mention usher in a period of lower standards of living. That won't win you many votes. It may start a revolution.

And how do you prevent the Greek precedent from being imitated by the Spanish and the Italians? To be candid, we don't think it matters much now. Greece can't afford to stay in the euro. The Spanish and the Italians can't afford to leave it.

The economies and banking systems of Spain and Italy are indispensable to Europe. If they leave the euro, there is no euro. The Greeks can leave, devalue, default and use a weaker currency to claw their way back to economic competitiveness. If the Spanish and Italians leave, they lose access to private capital, they lose access to the ECB and they take down Europe's banking system. They can't leave. More importantly, they can't be allowed to leave.

This makes the task of the European Central Bank (ECB) much easier. It simply has to guarantee Greek debt owed to all non-Greek creditors. Or, it could simply buy that debt. This would solve the problem of anyone outside Greece taking losses on Greek debt.

This is what corporatism looks like, when the Big State and Big Finance become the Big Power in the economy. Losses cannot be tolerated. Any loss results in lower equity capital at a financial firm would require selling assets. Since everyone owns a piece of everyone else, and owes to everyone else, any major loss in one place results in losses everywhere.

Of course it's absurd that Europe is moving toward this kind of 'extreme socialism'. The people most responsible for the crisis are not accountable and the people who have saved get punished. The elite are enriched and everyone else is enslaved.

This is why the financial crisis could so quickly become a political and social crisis. When people don't think they can get justice from the courts or the cops, and when they think that cheating is the only way to get ahead in a system, the political and financial order is on borrowed time. The clock is ticking.

Regards,

Dan Denning
for The Daily Reckoning Australia

From the Archives...

Is the Australian Economy... Booming...or Busting?
2012-05-11 – Greg Canavan

The Art of Value Investing: How to Value a Business, Not a Stock
2012-05-10 – Greg Canavan

When Financial Markets Decouple From Reality
2012-05-09 – Dan Denning

Low Interest Rates Are A Dangerous Addiction!
2012-05-08 – Satyajit Das

The Bear Hunters and the Trigger Event for the Aussie Dollar
2012-05-07 – Dan Denning

• Don’t Invest in Europe’s Debt
• Debt Is a Bummer
• How Bailouts Encourage Bad Behavior
• The Euro is a Symptom of Centralisation
• Does Greece 2010 = Austria 1931?

Capital in flight – and that's what a bank run is, whether it's an individual depositor or a global hedge fund – has to find sanctuary. The easiest (most liquid) place is the US bond market. But Henry likes to think that Australia has developed the reputation as a 'safe haven' for global risk capital. 'The good news side of it is that it is possible, maybe even likely, that any capital flight associated with the euro could make it easier for Australia to finance its current account deficit,' Henry told the ABC last night.

We suspect Henry would like that capital to flow into a new infrastructure bond market. Those bonds would be floated by State governments and finance the infrastructure required for Australia's growing population. We wrote about this new bond market in the most recent issue of Australian Wealth Gameplan. With new exchange traded funds (ETFs) in the fixed income market, it's now possible to fill the 'bond' portion of the Permanent Portfolio with fixed income ETFs.

But back to Henry's point, is Australia a safe haven for capital? Well, we'll see. Obviously we like the place well enough or we wouldn't have been here for seven years. But enjoying the climate and the footy is not the same as deciding to plough your life savings into the share market or the property market.

For a country that managed to run a persistent current account deficit during the greatest ever commodity boom AND managed to stack on about $220 billion in government debt at the same time, the 'safe haven' tag seems misplaced. As we wrote a few weeks ago, the last crisis shows that foreign money flows out of Australia in a crisis, not into it. But maybe this time it will be different.

Maybe what Australia needs is Don Corleone. We bet you didn't know that Australia needs a 'godfather'. As if the disintegration of the euro wasn't enough to wrap your head around, the Chinese have seized on this moment of anxiety to put pressure on Australia geopolitically. A former officer in the People's Liberation Army (PLA) has told Australia that it needs to choose who is going to be its Big Daddy in the Asia-Pacific for the next 100 years.

Song Xiaojun told the Age, 'Australia has to find a godfather sooner or later...Australia always has to depend on somebody else, whether it is to be the 'son' of the US or 'son' of China [It] depends on who is more powerful, and based on the strategic environment.' He inferred that, while Australia has been basking in the glow of record mineral exports to China, it's been lazy about looking after its strategic interests. 'Frankly, it has not done well politically.'

This must be the 'bad cop' part of the interview. It's hard to imagine these kinds of remarks winning you influence and friends in Australia. It's quite possible that Song means 'godfather' in the paternal way, as an older, wiser hand that looks after the interest of a 'son' the way a father might. But he could also mean Don Corleone. Is he making Australia an offer it can't refuse? Hmm.

Assuming this is a two-man job, that means the 'good cop' must be Li Keqiang, the man slated to be China's next Premier. He's meeting in Beijing with new foreign minister Bob Carr. The men are celebrating the 40th anniversary of Australia establishing diplomatic relations with China.

Why would China try to get Australia in line, strategically speaking, right now? Is it because America is weak? Because Australia is vulnerable? Because China is strong? Or because China is weak?

Surprisingly, the last part may be more likely than you think. We don't mean weak in economic terms, although you could make the argument China IS getting weaker. In fact, Li Keqiang made the argument himself to the Financial Times when he cited electricity consumption, rail cargo volumes, and the disbursement of bank loans in the Chinese economy.

Li said these three factors paint a truer picture of China's growth model than do 'man made' GDP figures which are 'for reference only'. Electricity output grew just 0.7% in April, year-over-year. In March, it increased by 7.2%. Rail cargo volumes are growing at half the pace they were this time last year, according to the FT. Banks are extending fewer loans as well.

Let's see...less power used in making goods means fewer rail cars used in transporting them and fewer bank loans taken out purchasing or making them. That all adds up to slower growth. But is it a lot slower? Or is it just a little slower? That's the big question.

And that brings us back to the issue of political strength, not economic strength. The 18th National People's Congress of the Communist Party of China (CPC) will meet later this year. Among other things, the Congress will elect nine new members of the Standing Committee of the Politburo (SCP). This is the most powerful group in China. It's the group that controls Chinese economic and political policy.

In case you've missed it, there's been a power struggle going in the CPC. To make a long story short, we'd suggest it has to do exactly with what kind of 'growth model' keeps the party in power. The 'Chongqing Model' adopted by the ousted Bo Xilai relied heavily on selling land for development and then building massive state-funded housing and infrastructure projects. This investment-led growth has been great for Aussie resources.

But outgoing Premier Wen Jiabao – a CPC rival of Bo's – has called this model 'unbalanced, uncoordinated, and unsustainable.' This is a point Dr Paul Monk elaborated on his presentation at our After America conference in Sydney. There's disagreement within the Party over which growth model delivers sustainable benefits to the people, and thus keeps the Party in power.

What's more, China has a lot less 'policy flexibility' to deliver growth on demand than some analysts imagine. Dr Savvas Savouri, the bloke we quoted yesterday, says, 'On practically every measure, such as bank reserve requirements or interest rates, monetary policy is much tighter in China than in the West.' He reckons all the Chinese have to do is lower interest rates here, adjust reserve requirements there, and voila...growth is back at 8.5% a year.

But that entire model of management is under review in China because it's failing globally. It's also under review because it's fake growth...or growth for the sake of politics. All the signs point to the end of this global growth model. And if Li knows this better than anyone, he may be maximising China's political leverage over Australia while it still lasts. Stay tuned for more on this geopolitical game.

Regards,

Dan Denning
for The Daily Reckoning Australia

From the Archives...

Is the Australian Economy... Booming...or Busting?
2012-05-11 – Greg Canavan

The Art of Value Investing: How to Value a Business, Not a Stock
2012-05-10 – Greg Canavan

When Financial Markets Decouple From Reality
2012-05-09 – Dan Denning

Low Interest Rates Are A Dangerous Addiction!
2012-05-08 – Satyajit Das

The Bear Hunters and the Trigger Event for the Aussie Dollar
2012-05-07 – Dan Denning

• The “China Story” is Not Dead Yet
• China – The BRIC About to Smash Through Australia’s Windscreen
• How China Will Defeat the US
• The Dark Underbelly of Australia’s Resource Boom: Chinese Resource Demand
• Is Australia’s Economy Decoupled From the Rest of the World?

Gold sinking.

Oil sinking.

Copper sinking.

Yields sinking.

We struggled with this, Dear Reader. We meditated. We prayed. We drank heavily.

And finally...we overcame the rank desire to say: "We told you so!"

As you know, Martin Wolf, of the Financial Times, is the voice of The Economics Establishment. All that is great and good in the field – which isn't very much – is given voice by Wolf. Then, it is acceptable for policymakers, Treasury ministers, and central bankers, not to mention the people you talk to at cocktail parties.

And lo! Here cometh the neo-Keynesian economist. What saith he?

He says the world is drifting towards Japan.

Of course, that was the message 10 years ago from a certain feral economist who will not be mentioned. He maintained that Japan was a leader, not a follower...and that the US would follow in Japan's footsteps...with about a 10-year lag.

He even wrote a book on the subject, with Addison Wiggin: Financial Reckoning Day.

Where he got these ideas, we don't recall. What we do recall is that almost everyone laughed at him. "Japan?" they said. "The US is nothing like Japan. We have a dynamic, robust economy. We have Lehman Bros., Bear Stearns and Countrywide 'low doc' mortgages. We have Alan Greenspan. And George W. Bush. We have 'mission accomplished' in Iraq. We have Silicon Valley, Bernie Madoff and a housing boom. Japan has none of those things. Ha. Ha."

But now, the last laugh is on the other foot!

Japan's market topped out in 1990. The US market topped out – in real terms – in 2000. Thereafter, Japan saw on-again, off-again recession...sinking prices, generally...and slumpy conditions. The US economy staged a limp recovery in the '02-'03 period...then gave investors a bubble head-fake. Now, it's back to the slump...

...and now, both Europe and America are looking more Japan-like every day.

Martin Wolf explains:

On May 10, 2012, the yield on the German 10-year bund was 1.44 per cent, on the US 10-year Treasury was 1.85 per cent and on the UK 10-year gilt was 1.9 per cent.

These are extraordinary numbers. They are particularly striking in the cases of the US and UK, which unlike Germany, run very large fiscal deficits and are experiencing very rapid increases in public sector indebtedness.

This combination of falling government bond rates with very rapid rises in public sector indebtedness reminds us, of course, of the experience of Japan since 1990.

At the end of 1990, when its "bubble economy" went pop, the Japanese government's 10-year bond was yielding 6.7 per cent. As the economy subsequently declined, deflation took hold and fiscal deficits and public debt exploded. But yields on 10-year Japanese government bonds (JGBs) fell to close to 2 per cent in 1997 and then, with sizeable fluctuations, to troughs of 0.8 per cent in 1998, 0.4 per cent in 2003 and, recently, to 0.9 per cent. In short, the worse the Japanese government's present and prospective debt position has become, the lower the interest rates on JGBs has also become.

Similarly, in July 2007, just before the beginning of the crisis and consequent explosion in fiscal deficits and debt, the US 10-year Treasury yielded 5.1 per cent. Now, almost five years later, the bonds of this alleged fiscal basket case yield less than 2 per cent. Again, in the UK, another supposed basket case, with huge fiscal deficits and a slipping austerity programme, yields have fallen from 5.5 per cent in July 2007 to below 2 per cent.

What does it mean?

Well, if the US and Europe are following Japan...and Japan is going nowhere...then three of the world's large major areas are dead in the water.

And if that is the case, you can expect the entire world economy to "go Japan."

That will mean lower commodity prices. A lower price of oil. A lower price of gold. Lower interest rates – yes, look for the yield on US 10-year notes to drop below 1%. Bad unemployment figures. Low...or negative growth...falling real estate prices.

...and probably a stock market crash.

Hold onto your hats!

Regards,

Bill Bonner
for The Daily Reckoning Australia

From the Archives...

Is the Australian Economy... Booming...or Busting?
2012-05-11 – Greg Canavan

The Art of Value Investing: How to Value a Business, Not a Stock
2012-05-10 – Greg Canavan

When Financial Markets Decouple From Reality
2012-05-09 – Dan Denning

Low Interest Rates Are A Dangerous Addiction!
2012-05-08 – Satyajit Das

The Bear Hunters and the Trigger Event for the Aussie Dollar
2012-05-07 – Dan Denning

• Japan and its Economy Did Not Have Secret to Everlasting Success
• Japanese Government Displays Generosity as Prices Fall in Japan
• Investing in Japan…
• Not So Big in Japan
• Recession for the Japanese Economy Once Again

But let us rush to clean up our credentials before Dear Readers make a federal case of it.

Okay...on our age. It says we were born in 1959. Must be a typo. We were really born in 1953...okay...'48.

And, it says we attended Harvard University. Well, yes...we certainly did 'attend' Harvard... But through some bureaucratic mix-up our name was never on the official student list and our diploma must have gotten lost in the mail.

As for the Pulitzer Prize, we wouldn't say that we were awarded the prize, not exactly. There again, it seems to be a case of a slight mis-wording. "Pulitzer Prize-winning" describes the quality of our work...as widely recognized, at least in the office here.

And we didn't exactly invent the Post-It note. We just invented something like it, with scotch tape and a piece of paper. Same idea.

And, okay, did we really "win" the Nobel Prize in economics? We probably shouldn't have used the word "win." We were nominated...well, mom thought should have been nominated. She was putting us "in the running"...or something like that.

There, we hope that clears up any misunderstandings.

*** How do you like that? A guy comes from Brazil. He makes billions helping Zuckerberg launch Facebook. And then he leaves the country. You'd think he'd be more grateful. Or at least more sentimentally attached to the land that gave him so much loot.

But no. Edouardo Saverin is pulling out of the USA. Bloomberg reports:

Eduardo Saverin, the billionaire co-founder of Facebook Inc. (FB), renounced his US citizenship before an initial public offering that values the social network at as much as $96 billion, a move that may reduce his tax bill.

Facebook plans to raise as much as $11.8 billion through the IPO, the biggest in history for an Internet company. Saverin's stake is about 4 percent, according to the website whoownsfacebook.com. At the high end of the proposed IPO market capitalization, that would be worth about $3.84 billion. His holdings aren't listed in Facebook's regulatory filings.

Saverin, 30, joins a growing number of people giving up US citizenship ahead of a possible increase in tax rates for top earners. The Brazilian-born resident of Singapore is one of several people who helped Mark Zuckerberg start Facebook in a Harvard University dormitory and stand to reap billions of dollars after the world's largest social network holds its IPO.

But the rich are doing it all over the world.

A report from London tells us that the French are moving to town. France's new president has pledged to raise income taxes on the rich to 75%...and to boost France's wealth tax too. Wealthy French people are buying houses in South Kensington to escape.

As for the rich in Argentina, they've been making tracks for many years. As soon as they get some money they buy an apartment, in Miami!

Here in Baltimore, wealthy people have been getting out of town since the top in real estate in 1927.

And now, the rich are leaving Maryland too. Governor O'Malley says "wealthy people can afford to pay a little more in taxes..."

Well, yes, they can afford it. But that doesn't mean they will like it.

"We're moving to Florida," says an old friend.

"Wait for me," says your editor...

Meanwhile, the Irish and Spaniards are leaving their homelands too. Money is the reason. But smaller amounts of it. There are few jobs in Ireland or Spain, so they're leaving to find work.

Even the Chinese are jumping ship. No kidding. Taxes are low in China.

Regards,

Bill Bonner
for The Daily Reckoning Australia

From the Archives...

Is the Australian Economy... Booming...or Busting?
2012-05-11 – Greg Canavan

The Art of Value Investing: How to Value a Business, Not a Stock
2012-05-10 – Greg Canavan

When Financial Markets Decouple From Reality
2012-05-09 – Dan Denning

Low Interest Rates Are A Dangerous Addiction!
2012-05-08 – Satyajit Das

The Bear Hunters and the Trigger Event for the Aussie Dollar
2012-05-07 – Dan Denning

• Private Sector Debt Burden About to Get More Burdensome
• Barack Obama and His Nobel Peace Prize
• The French are Feeling Pretty Smug
• Investing in Facebook: How to Lose Money the Easy Way
• Naturally the Feds Want to Raise as Much Money as They Can

A US$2 Billion Banana Skin...

The losses indicated are US$2 billion and may be higher. JPM's share price fell around 9% (a loss of US$14 billion in market value) when the news was announced via a hastily arranged news conference. The bank also lost considerably more in reputation and franchise value.

The episode has all the usual trappings of a salacious trading disaster. Competitors have christened Bruno Iksil, one of the traders responsible, 'Lord Voldemort' (after the Harry Potter villain). The position, which has been common knowledge in the market since early 2012 at least, was dubbed 'the London whale'.

After the losses were announced, the usual journalistic liberties have been taken – the whale has 'beached' or 'been harpooned'. A sub-editor gleefully coined the headline 'Dimon is a Whale of a Hedge Fund Manager', in reference to Jamie Dimon, the CEO of JPM.

But the losses raise serious issues. As they do not relate to the usual 'rogue trading' incident which is typically dismissed as impossible to detect or control, the episode provides insights into the problems of modern high finance, bank strategies and regulation of markets.

Details are sketchy. The losses relate to a position taken to 'hedge' a US$300+ billion investment portfolio managed by JPM's Central Investment Office ('CIO') overseen by staff including experienced hedge fund investment managers. The portfolio has increased in size from $76 billion in 2007 to $356 billion in 2011.

The objective of the CIO is hedging JPM's loan portfolio and investing excess funds. During a 13 April 2012, conference call, Jamie Dimon referred to the unit as a 'sophisticated' guardian of the bank's funds.

In its statement, the bank advised investors that,

'Since March 31, 2012, CIO has had significant mark-to-market losses in its synthetic credit portfolio, and this portfolio has proven to be riskier, more volatile and less effective as an economic hedge than the Firm previously believed.'

The large investment portfolio is the result of banks needing to maintain high levels of liquidity, dictated by both volatile market conditions and also regulatory pressures to maintain larger cash buffers against contingencies.

Broader monetary policies, such as quantitative easing, have also increased cash held by banks, which must be deployed profitably. Regulatory moves to prevent banks from trading on their own account – the 'Volcker' rule – has encouraged the migration of trading to other areas of the bank, such as liquidity management and portfolio risk management hedging.

Faced with weak revenues in its core operations and low interest rates on cash or secure short term investment, JPM may have been under pressure to increase returns on this portfolio. The bank appears to have invested in a variety of securities including mortgage-backed securities and corporate debt to generate returns above the firm's cost of capital.

In 2011, the CIO portfolio contributed $411 million to JPM's earnings, below its contributions of $1.5 billion in 2008 and $3.7 billion in 2009. JPM's disclosures show that the unit took significant risk. Based on a common measure known as VaR (Value at Risk), the potential statistical loss for a single day was $57 million in 2011, similar to the $58 million of average risk in the bank's larger investment bank and trading business.

The Art of Topiary...

The losses relate to an attempt to hedge the exposure on this portfolio.

As hedging would reduce returns, the strategy adopted appears to have been to buy insurance against default in the short term (to end 2012) and finance the hedge by selling insurance against default in the medium term (to end 2017). The structure took advantage of the difference in pricing of insurance between the two maturities of around 0.60–0.70% per annum. The strategic view was that risk would increase in the near term but abate in the longer term.

The choice of hedge instrument was an older 'off-the-run' credit index – the CDX NA.IG ('North American Investment Grade') Series 9. In all probability, the choice was driven by economic considerations. The constitution of the index may have provided a better match to the exact risk in JPM's books. The pricing of the index may have been more favourable than a more recent 'on-the-run' index. The relative liquidity of alternative hedging instruments would have been a factor.

The choice may also have been motivated by the desire to mask the bank's trading activities from other market participants, to allow the position to be established without moving market prices. The particular contract, originally issued in 2007, was extensively used in a variety of structured products. This meant that trades could be disguised as hedging existing products or client positions rather than on JPM's own account.

It is possible that the hedge could have been 'juiced up', that is, leveraged, by trading in different instruments such as the tranched version of the index to increase sensitivity to changes in market credit spreads.

With the benefit of hindsight, the trades seem to be no more than what Lord Voldemort might view as 'school-boy spells you have up your sleeve!'

Imperfect Hedges...

In the conference call announcing the loss, Mr. Dimon explained that the CIO portfolio was a hedge for the bank's balance-sheet risk. He stated:

'It actually did quite well. It was there to deliver a positive result in a credit-stressed environment. And we feel we can do that and make some net income.'

It is questionable whether the CIO portfolio or the problematic positions could be regarded as a true hedge. It is complex and relies on the correlation between the bank's underlying positions and trades. The effectiveness of the hedge also relies on the changes in credit pricing for different maturities. The simplest way to reduce risk would have been to sell off existing positions or offset the positions exactly.

The bank's assertion that the entire set of transactions was both a hedge and a source of earnings is confusing. The bank should have heeded the warning of the seventeenth-century French author François de La Rochefoucauld:

'We are so accustomed to disguise ourselves to others that in the end we become disguised to ourselves.'

Given JPM's vaunted risk management credentials and boasts of a 'fortress like' balance sheet, it is surprising that the problems of the hedge were not identified earlier. In general, most banks stress test hedges to ensure their efficacy prior to implementation and monitor them closely.

While the US$2 billion loss is grievous, the bank's restatement of its VaR risk from $67 million to $129 million (an increase of 93%) and reinstatement of an older risk model is also significant, suggesting a failure of risk modelling.

During the conference call, Mr. Dimon conceded that the trades were 'flawed, complex, volatile, poorly reviewed and poorly monitored...there are many errors, sloppiness and bad judgment.'

The episode also points to failures on the part of parties other than JPM.

Banks are now obliged to report positions and trades, especially certain credit derivatives. This information is available to regulators in considerable detail. Given that the hedge appears to have been large in size (estimates range from ten to hundreds of billions), regulators should have been aware of the positions. It is not clear whether they knew and what discussions, if any, ensued with the bank.

External auditors and equity analysts who cover the bank also did not pick up the potential problems. Like regulators, they perhaps relied on assurances from the bank's management, without performing the required independent analysis.

Encouraging Pundits...

The losses are complicated by Mr. Dimon's vocal opposition to some aspects of the re-regulation of financial institutions, especially the Volcker Rule which seeks to restrict proprietary trading of banks. Given the fact that JPM survived the financial crisis relatively well and Mr. Dimon's personal high standing within President Obama's administration (he was considered a potential Treasury Secretary), he has held the moral high ground in arguing for less stringent regulations.

In the bank's annual report, Mr. Dimon wrote:

'If the intent of the Volcker Rule was to eliminate pure proprietary trading and to ensure that market making is done in a way that won't jeopardize a financial institution, we agree... We, however, do disagree with some of the proposed specifics because we think they could have huge negative unintended consequences for American competitiveness and economic growth.'

Banks have sought a weaker version of the Volcker Rule with broad remit to undertake 'portfolio hedging'. This would allow banks to view an investment portfolio in its entirety and enter transaction to offset the risks of the entire portfolio, without the necessity of hedging securities or positions on an individual basis as would be required by a narrow definition of hedging. Banks argued that this exemption is essential to allow flexibility in managing risk within a large financial institution.

The JPM episode has helped re-open the debate. During his conference call, Mr. Dimon ruefully observed that the bank's US$2 billion loss 'plays right into the hands of a bunch of pundits out there'.

Legislators and regulators now argue that the rules for portfolio hedging are too wide and effectively impossible to police effectively. In addition, the statutory basis may not support the rule. The legislative intent was intended only to exempt risk-mitigating hedging activity, specifically hedging positions that reduce a bank's risk.

Interestingly, drafters of the portfolio hedging exemption recognized the potential problems, seeking comment on whether portfolio hedging created 'the potential for abuse of the hedging exemption' or made it difficult to distinguish between hedging or prohibited trading.

In a recent Congressional hearing, Former Fed Chairman Paul Volcker, who helped shape the eponymous provision, questioned whether the volume of derivatives traded was 'all directed toward some explicit protection against some explicit risk'.

The pundits have been quick to suggest that the losses point to the need for more stringent regulations. But it is not clear that a prohibition on proprietary trading would have prevented the losses.

In practice, without deep and intimate knowledge of the institution and it activities it is difficult to differentiate between legitimate investment and trading of a firm's surplus cash resources or investment capital.

It is also difficult sometimes to distinguish between hedging and speculation. The JPM positions which caused the problems were predicated on certain market movements – a flattening of the credit margin term structure – which did not occur.

Hedging individual positions is impractical and would be expensive. It would push up the cost of credit to borrowers significantly. All hedging also entail risks. At a minimum, it assumes that the counterparty performs on its hedge. But inability to legitimately hedge also escalates risk of financial institutions. Ultimately no hedging is perfect or, as author Frank Partnoy told Bloomberg, 'The only perfect hedge is in a Japanese garden.'

Additional regulation assumes that the appropriate rules can be drafted and policed. Experience suggests that it will not prevent future problems.

Bankers and regulators have always been seduced by an elegant vision of a scientific and mathematically precise vision of risk. As the English author G.K. Chesterton wrote,

'The real trouble with this world [is that]... It looks just a little more mathematical and regular than it is; its exactitude is obvious but its inexactitude is hidden; its wildness lies in wait.'

Human Sacrifices...

JPM indicated that it is trying to unwind its positions. Given the size, the level of losses may increase as markets may move against the bank as it tries to liquidate its position.

But JPM should survive this loss. The bank was quick to point out that the US$2 billion loss was offset by profits in other parts of the portfolio. According to the bank:

'As of March 31, 2012, the value of CIO's total [available for sale] securities portfolio exceeded its cost by approximately $8 billion.

The fate of specific actors is more difficult to predict. Mr. Dimon's language in describing the losses was expressive:

'... Errors, sloppiness, and bad judgment... Badly executed, badly monitored. I'm not going to repeat it 800 times...I know it was done with the intention to hedge tail risk... it was unbelievably ineffective...'

He seemed to be trying to distance himself and the bank's Board of Directors from the failures, praising the expertise of the individuals involved. 'We added different types of people, talented people and stuff like that.' He was at pains to point out that the CIO had been very successful, until recently.

But human sacrifices will be needed. The question is whether it reaches the executive suite or can be limited to foot soldiers. Mr. Dimon has admitted his credibility is at stake, though not necessarily his job.

What complicates Mr. Dimon's position is that as recently as 13 April 2012, he indicated that the CIO positions were not problematic, dismissing the issue as 'a complete tempest in a teapot'. After the losses were announced, Mr. Dimon admitted on US television that he was 'dead wrong' to have dismissed questions about the issue.

Just Watch This Space...

The episode raises deeper concerns, beyond the issues at JPM.

How many other such problems, in other firms, remain undiscovered? JPM is a major player in credit derivatives and by no means the worst managed or the most aggressive in risk taking. If it curtails its activities then the loss of liquidity may affect other players and result in unrelated losses.

How has earnings pressure in banks affected their risk taking? Clearly, the large cash holdings of banks and the need to generate adequate returns for shareholders is encouraging risk taking.

How do regulatory initiatives and monetary policy action affect bank risk taking? Central bank policies are adding to the problem of banks in terms of large cash balances which must be then invested at a profit. The implementation of the Volcker rule may have had unintended consequences. It encouraged moving risk taking activities from trading desks where the apparatus of risk management may be marginally better established to other parts of banks where there is less scrutiny.

The most important question remains whether any specific action short of banning specific instruments and activities can prevent such episodes in the future. It seems that, as Lord Voldemort observed in Harry Potter and the Deathly Hallows Part 2, 'They never learn. Such a pity'.

Regards,

Satyajit Das
for The Daily Reckoning Australia

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011)

From the Archives...

Is the Australian Economy... Booming...or Busting?
2012-05-11 – Greg Canavan

The Art of Value Investing: How to Value a Business, Not a Stock
2012-05-10 – Greg Canavan

When Financial Markets Decouple From Reality
2012-05-09 – Dan Denning

Low Interest Rates Are A Dangerous Addiction!
2012-05-08 – Satyajit Das

The Bear Hunters and the Trigger Event for the Aussie Dollar
2012-05-07 – Dan Denning

• The Shadow Darkens Over Investment Bank JP Morgan
• A Big Oops at JP Morgan!
• Investors Rushed to Bid Up the Shares of WFC
• How I generate ‘slipstream’ trades
• How to Setup a Stop Loss for Your Trade

How soon could Greece exit the euro? Well, it may not be that easy. Remember, back in February we made the argument that Europe's powers that be had to prevent a Greek bond default. They couldn't allow a precedent to be set.

If it was okay for Greece to default, then why not Spain? Why not Italy? Confidence in Europe's entire government bond market would be blown to smithereens, taking the banking system (capitalised by government debt) with it. The European Central Bank (ECB) would be collateral damage.

Mind you, no one in Europe's establishment likes to mention Iceland. There's probably a reason for that. It might give the Greeks ideas. In 2008, Iceland's three largest banks owed foreign creditors more money combined than the size of Iceland's economy. The government couldn't guarantee the banks debts. So it didn't.

The government DID assume the banks' domestic obligations. But it told the foreign creditors to get lost. It defaulted. The currency fell by about 80% against the euro. The default and devaluation put Iceland back in a trade surplus a few years later and earlier this year ratings agency Fitch upgraded the credit rating on Icelandic government debt.

Now, you may be thinking that stiffing your creditor is a less-than-honourable decision. But it was done democratically. Iceland put the question of default to its people and 90% of the people chose default. They put the credit risk right back on the lender, which seems appropriate considering the borrowers were not the people but the banks. The people refused to accept the debt burden taken on by the banks. And the creditors? Too bad for them.

Greece has taken the other path. The politicians thus far have rejected what the people want. Greek politicians are taking their marching orders from Brussels, Berlin, and Paris. The debts of the private sector are now the debts of the people. Maybe this explains why the Greeks are currently unable to form a government. According to some sources, that government may have less than €2 billion cash.

Of course the main difference between Iceland and Greece is that Iceland had its own currency. The default was coupled by the devaluation. That's what made the debt go away. It caused a short, sharp, painful recession. And in GDP terms, the economy is much smaller today than it was in 2008. But the debt was liquidated. That's the important part. It hasn't been preserved as a perpetual burden on taxpayers in order to satisfy creditors (the private banks).

The Greeks can't devalue until they exit the euro, and the Europeans don't want the Greeks to exit just yet. If the Greeks repudiate their foreign creditors, it means they repudiate the debts they owe to French, German, and other European banks. There's no telling what would happen then.

Some people are already speculating that a massive ECB money-printing binge - on the order of hundreds of billions of Euros - would ensue. The intent would be to insulate the rest of Europe from a Greek euro exit. But an unintended consequence would be a devaluation of the euro...back to parity with the US dollar!

Now that would be a shocker. But then, we are in a kind of race to the bottom when it comes to currency values. Every country wants a cheap currency to boost exports. Exports lead to growth. Growth is better than austerity. But obviously, not everyone can have the cheapest currency. If Europe devalues...you can expect QE3 from the Fed soon. Heck, maybe even the Chinese will devalue as well. And the RBA may cut rates again sooner than anyone expected.

You can see the absurdity of the current monetary system in this series of tit-for-tat monetary expansions. The 'race to the bottom' in the competitive currency devaluation has lowered global interest rates. In the early stages, lower rates led to more borrowing - the credit boom. The biggest beneficiaries have probably been countries like Australia and Brazil. You got combined commodity inflation and demand for 'risk' assets like commodity currencies and resource stocks.

Around the middle of the race, you saw the expansion of government deficits. You can thank the Federal Reserve for this. The best example of this is the decline in 10-year US Treasury yields since 2007. You can see below the 10-year yield is once again near all-time lows. This has been a boon for US mortgage rates and, of course, for the US government, whose borrowing costs have gone down as its deficits have blown out.

But here in the late stages of the race we have JP Morgan losing $2 billion in the hunt for yield. And why is JP Morgan hunting for yield and losing money? Because ultra-low interest rates (negative in real terms) force you to speculate and take bigger risks to earn a real return. It's not just mums and dads. Its investment banks too. It's everybody. We are all Jamie Dimon!

Bill Gross, the manager of the world's largest bond fund, reckons we are reaching the end of the race. 'Major changes to our global monetary system lie on a visible horizon,' Gross writes in a Financial Times article. Gross reckons the diffusion of low-interest rate sovereign bonds from the developed world has brought us to a tipping point which may lead to an entirely new monetary order.

He elaborates:

'Now, with dollar reserves widely dispersed in China, Japan, Brazil and other surplus nations, it is fair to assume that there will come a point where 2 per cent negative real interest rates fail to compensate for the advantages heretofore gained in buying sovereign bonds.

'There is the potential for both public and private market creditors to effect a change in how credit is funded and dispersed - our global monetary system. What that will look like is a conjecture, but it is likely to be more hard money as opposed to fiat-based, or if still fiat centric, less oriented to a dollar-based reserve currency.

'The developing credit cancer may be metastasised, and the global monetary system fatally flawed by increasingly risky and unacceptably low yields, produced by the debt crisis and policy responses to it. The great white whale lies on the horizon. Investors should sail carefully.'

Investors definitely should sail carefully, especially since the monetary policy response seems to be 'three sheets to the wind'. The old sailing phrase describes the ropes that hold a sail in place, the ropes being sheets. When the ropes are loose, the sails flap and the ship cavorts around on the sea like a drunken sailor (mixed metaphor alert!).

The Fed, the ECB, the Bank of Japan, and the Bank of England are drunken sailors. The world's monetary policy is three sheets to the wind. Insert your favourite nautical disaster metaphor here. Are there any lifeboats on this Love Boat?

Toscafund chief economist Savvas Savouri tells the Australian today that as the US dollar loses its reserve currency status, the Aussie dollar will climb to $1.70 against the greenback! 'China needs to gorge on US Treasury securities at the moment to keep its exchange rate stable, but come 2014 that policy will likely change.'

We're not sure what Dr Savouri is on about. Could it be the IMF's reweighting of its special drawing rights in 2015? In the event, he's not worried about China at all. Yesterday we expressed doubts that China can make the seamless transition from export-driven growth to domestic consumption. It's going to be bumpy.

Dr Savouri disagrees. 'People are naive if they think there'll be any 'landing' in China...On practically every measure, such as bank reserve requirements or interest rates, monetary policy is much tighter in China than in the West.' This reflects the belief that economic growth is just a matter of having the right policy settings.

Ahem.

Savouri says it's all happening now. Or next year. 'Next year will provide more economic fireworks than 2008...If, for instance, Russia or Norway announced that they would only part with their oil in return for a basket of currencies - rather than US dollars alone - many other countries would probably follow suit.'

Is he right? Well, there's no doubt the dollar standard is near the end of its monetary journey. But there's no land in sight. A lot of investors have chosen to maroon themselves on the island of US Treasury bonds. Is there a survival strategy you can use or are we all going down on the same ship?

Regards,

Dan Denning
for The Daily Reckoning Australia

From the Archives...

Is the Australian Economy... Booming...or Busting?
2012-05-11 - Greg Canavan

The Art of Value Investing: How to Value a Business, Not a Stock
2012-05-10 - Greg Canavan

When Financial Markets Decouple From Reality
2012-05-09 - Dan Denning

Low Interest Rates Are A Dangerous Addiction!
2012-05-08 - Satyajit Das

The Bear Hunters and the Trigger Event for the Aussie Dollar
2012-05-07 - Dan Denning

• Why Greece Can’t Afford to Stay in the Euro
• Don’t Invest in Europe’s Debt
• China’s Monetary Policy
• Price of Gold Communicates U.S. Monetary and Fiscal Policy is Lousy
• China Using Holdings of U.S. Treasury Bonds as Cudgel to Bludgeon United States

Societies become more complex as they age. Each challenge...or opportunity...is met with a new rig of some sort. A tax. A regulation. An organizational fix.

As time goes by, these fixes act like friction...they slow the machine. They make it hard to move...inflexible and unresponsive. And over time, more people gain access to a fix - each lobbying group and special interest, each with his own bailout or subsidy...and each desperate to hold onto it.

Output is thus shifted to unproductive activities. The real producers are punished - with taxes and regulations - while unproductive activities are rewarded, with bailouts, handouts and sweetheart deals.

The financial industry was 2.5% of the economy when WWII ended. Now, it is 8.5%. How did it get so big? What does it do for all the money?

The answer to the first question is that it grew as the economy became 'financialised.' More and more laws were passed granting more and more special favours and protections to the financial industry. Just read the tax code.

Go ahead, we dare you! You will find special allowances and deals for the insurance industry on almost every page. And there are rules and regulations for pension funds. And pensions themselves. ERISA. 401k. 501C3. SEC. FDIC. Dodd-Frank. CFPB. Everything is regulated...controlled...protected...

And all of this happened on the back of the biggest expansion of financial instruments in world history. The feds transformed the economy from one that made things...at a profit...to one that just made money.

The money supply in the US increased by 1,300% in the 40 years after Richard Nixon 'shut the gold window' at the Treasury. That 'wealth' did not take the form of new factories in New England or new tractors in the Old South. It went mostly into money instruments...funneled through the financial industry to the rich people who owned financial assets.

Every potential new competitor had to comply with such a mountain of rules and regulations that he quickly gave up. Even if approved, he could not hope to provide a new product. Instead, he could only provide the same approved services and products that the big, entrenched players already had in stock.

John Kay, writing in The Financial Times, explains what would have happened had the computer industry been tied in the same knots.

"If you needed a licence to enter the US computer business, you can imagine the Computer Regulation Agency interviewing Bill Gates and Steve Jobs in the 1970s. What dutiful regulator would allow someone who had not even completed his Harvard degree to sell software to the public?"

Protected. Coddled. The financial industry went rogue. It was supposed to match investors with worthy investments, helping to bring genuine growth and prosperity to the US. Instead, it matched up most of the new money with itself.

The typical American was impoverished. Forty years after America's money went rogue, he has not a dime's more earning power per hour. And 4.5 times more debt, adjusted for inflation.

Regards,

Bill Bonner
for The Daily Reckoning Australia

From the Archives...

Is the Australian Economy... Booming...or Busting?
2012-05-11 - Greg Canavan

The Art of Value Investing: How to Value a Business, Not a Stock
2012-05-10 - Greg Canavan

When Financial Markets Decouple From Reality
2012-05-09 - Dan Denning

Low Interest Rates Are A Dangerous Addiction!
2012-05-08 - Satyajit Das

The Bear Hunters and the Trigger Event for the Aussie Dollar
2012-05-07 - Dan Denning

Similar Posts:
• State Managed Capitalism
• Care for a Poor Bill of Health?
• The War On Rogues
• Bear Raids in the Economic Battlespace
• How The US Military Is Sucking The Empire Dry

]]> http://www.dailyreckoning.com.au/when-the-financial-industry-went-rogue/2012/05/15/feed/ 2 http://www.dailyreckoning.com.au/when-the-financial-industry-went-rogue/2012/05/15/ http://feedproxy.google.com/~r/dailyreckoningaus/~3/c-K5mgYn9h4/ http://www.dailyreckoning.com.au/when-cash-is-king-investing-with-risk-on-the-downside/2012/05/15/#comments Tue, 15 May 2012 07:22:53 +0000 dr@dailyreckoning.com.au (The Daily Reckoning) http://www.dailyreckoning.com.au/?p=18477 cash!]]> Reckoning today from Baltimore, Maryland...

China is falling apart.

Bond yields are falling.

Copper is sinking.

Oil is sliding.

US stocks, too, slipped all last week.

Even gold...that old stalwart friend...turned its back on us last week, closing the week at $1,585.

Oh, dear, dear reader...everything is giving way. What can we hold fast to?

Can we count on the lumpen, dear reader?

As you know, when it comes to investing or politics, the humble masses are our North Star...our guiding light. We can depend on them to be almost always wrong. They fall for jingoes and jackasses every time.

"Stocks for the long run," was a popular appeal back at the end of the '90s...just before the stock market produced its worst returns in 60 years.

"The War on Terror" was another popular flimflam; it helped separate the public from $4 trillion or so of its money.

And don't forget "Change," from the man who changed nothing.

We had given up on stocks. They were too expensive. Besides, as we put it, the stock market had never completed its historic rendezvous with the bottom. Investors hadn't given up. P/E ratios were still over 12 or 15. Dividend yields were below 3%.

We wanted a P/E below 8...and then we'd start to consider them. Or, give us a dividend yield over 5%.

Most important, we'll wait until the public is fed up with stocks...convinced that they are a loser's game.

Well, that day may not be far ahead. USA Today reports:

NEW YORK - On Main Street these days, investing in the stock market is about as popular as watching a scary movie on a 12-inch black- and-white TV.

Wall Street's long-running story about how stocks are the best way to build wealth seems tired, dated and less believable to many individual investors. Playing the market isn't as sexy as it used to be. Since the 2008-09 financial crisis, the buy-now mentality has been replaced by a get-me-out, wait-and-see, bonds-are-safer line of thinking.

Stocks remain out of fashion even though the stock market has risen more than 100% since the bear market ended three years ago. It's up 25% since October and 9% this year.

Retail investors have yanked more than $260 billion out of mutual funds that invest in US stocks since the end of 2008, says the Investment Company Institute, a fund trade group. In contrast, they have funneled more than $800 billion into funds that invest in less- volatile bonds.

Investors' chronic mistrust of stocks is reigniting fears that an entire generation is unlikely to stash large chunks of cash in the increasingly unpredictable market as they did in the past.

"Investors have suffered a traumatic shock that has caused severe psychological damage and made them more risk-averse," says Carmine Grigoli, chief investment strategist at Mizuho Securities USA. Current worries, such as the USA's swelling deficit, Europe's unresolved debt crisis and slowing growth in China, have done little to ease their anxiety, he adds.

Investors are choosing 'safe' bond funds. Hmmm... Is it time to dump bonds and buy stocks? Or dump them both?

We faced this question a few days ago. We got a cheque - the payout on a deal we did long ago and since forgotten about.

What do to with it? Cash? Bonds? Gold? Stocks? Real Estate?

We chose cash!

Our guess is that we'll be on our present path...lagging growth...dragging unemployment...sagging yields...for a while longer. How much longer? Damned if we know...

But Treasury yields are already near or at all-time lows. How much lower can they go? Houses are already down to their most affordable level ever...how much cheaper can they get?

As for stocks, our bet is that they can get a lot cheaper. Mr. Market, should he care to undertake such a mission, could drive the Dow from 12,000 down to 6,000...or even lower. And, if he cared to, he could hold prices at that level for years.

So could he push the 10-year Treasury yield all the way to 1% (now about 1.8%) if he wanted to.

Yes, dear reader, there's still room on the downside. A lot of it.

One of the nice things about being a long-term investor is that you can wait a long time before you make your move. As Warren Buffett says, you don't have to swing at every pitch. And there's no penalty, except missed opportunities, for just waiting for the perfect ball to cross the plate.

That's what's so nice about cash. It's a bat. It's in your hands.

And we wouldn't be at all surprised to see Mr. Market toss us a powder puff pitch before too long.

Regards,

Bill Bonner
for The Daily Reckoning Australia

From the Archives...

Is the Australian Economy... Booming...or Busting?
2012-05-11 - Greg Canavan

The Art of Value Investing: How to Value a Business, Not a Stock
2012-05-10 - Greg Canavan

When Financial Markets Decouple From Reality
2012-05-09 - Dan Denning

Low Interest Rates Are A Dangerous Addiction!
2012-05-08 - Satyajit Das

The Bear Hunters and the Trigger Event for the Aussie Dollar
2012-05-07 - Dan Denning

Similar Posts:
• “I” is Lonely…
• Investors Better Off Investing in Anything but Stocks
• One Year Treasury Bills to be Reissued by Bush Administration
• Are You an Investing Mannequin?
• Your Average Australian Super Fund

]]> http://www.dailyreckoning.com.au/when-cash-is-king-investing-with-risk-on-the-downside/2012/05/15/feed/ 0 http://www.dailyreckoning.com.au/when-cash-is-king-investing-with-risk-on-the-downside/2012/05/15/ http://feedproxy.google.com/~r/dailyreckoningaus/~3/-OvyI0CwexM/ http://www.dailyreckoning.com.au/a-big-oops-at-jp-morgan/2012/05/15/#comments Tue, 15 May 2012 07:21:54 +0000 dr@dailyreckoning.com.au (The Daily Reckoning) http://www.dailyreckoning.com.au/?p=18487 JPMorgan made headlines late last week for a $2 billion trading loss that's likely to grow over time. Today, the bank's CIO fell on his sword for the trading gaffe.]]> Congratulations, Federal Reserve! Your zero interest rate policy tempted the world's most-sophisticated bank to create its own toxic blend of interest income in the derivatives markets.

JPMorgan made headlines late last week for a $2 billion trading loss that's likely to grow over time. Today, the bank's CIO fell on her sword for the trading gaffe. Ina Drew, a 30-year veteran of the firm decided today was a good day to "retire" from her trading desk.

JP Morgan's costly error was the result of "reaching for yield," just like retirees all over the US are doing. When traditional fixed income securities like Treasuries and CDs provide almost no yield whatsoever, the only remaining option is to reach in to riskier markets to try to find some yield. Reaching for yield - overpaying for income-producing securities in a low-rate environment - usually leads to a painful tumble off the proverbial ladder.

As part of the banking crisis fallout, the Federal Reserve pushed interest rates down close to zero, and is telling investors to expect zero rates until 2014. Savers will have gone six years without interest income, all so the Fed can implement its grand experiment to rebalance portfolios away from cash and US Treasuries.

"We'll buy the Treasuries," the Fed implicitly says to investors, "so you can push up the stock market to create a wealth effect for the economy." This begs the question: What happens if the Fed decides to unwind its gigantic Treasury portfolio? Wouldn't that reverse the stock market wealth effect at warp speed?

The answer is yes, but here's the dirty secret: The Fed is never going to unwind its portfolio. It's going to be forced by investors (and Congress) to keep the reserves it has injected into the banking system intact, so it can keep rates low on the US national debt. That's why we've been looking for short ideas that would suffer in an environment of rising commodity costs.

It's inevitable and unfortunate that retirees starved for yield are overpaying for risky assets like REITs, junk bonds and even financial products that create "synthetic" yield. A synthetic yield means a yield created by derivatives, rather than the underlying security.

These derivatives often cap upside returns in exchange for higher current income. As such, these structured products are essentially a slow return of capital masquerading as income. Some annuity products sold to retirees fit this description.

Back to JPMorgan, and the specifics of its $2 billion trading mishap. This is important, because it's a consequence of our still-broken financial system...

JPMorgan warned in its 10-Q that it's going to take an earnings hit in the second quarter from trades in its Chief Investment Office (CIO). CEO Jamie Dimon felt the need to schedule an impromptu conference call explaining the impending losses from CIO's hedging activities.

JPMorgan's Treasury and CIO department is tasked with investing the bank's excess cash, while hedging the credit risk that exists on the rest of the bank's $2.3 trillion balance sheet. Most people forget that banks are among the biggest fixed-income investors, and are suffering in a low-interest rate environment along with retirees. It's hard to shed a tear, I know.

So JPM decided it was a good idea to play along with the Fed's encouragement to exit low-yielding securities and move out along the risk spectrum to invest its excess cash to enhance shareholder returns.

JPM's $1.1 trillion in deposits exceed its loan portfolio by $407 billion, so it has lots of excess cash looking for a return. At March 31, CIO managed a $374 billion portfolio of securities - presumably in a manner that hedges JPM's credit risk. There is derivative exposure too, as we discover in the 10-Q.

The CIO can create synthetic credit risk by shorting credit default swaps, in which it would collect insurance premiums from underwriting the default risk on a specific entity. The result is synthetic interest income if everything is peachy and default doesn't occur; if not, the result is repeated margin calls and a complete blowup if the reference entity defaults. Think a mini version of AIG in 2008.

Jamie Dimon refused to provide any detail about the derivative trades on the conference call, but we can guess. Here is my guess: JPM owns a boatload of credit risk. Therefore, if CIO were trying to offset this risk, it would probably sell short credit default swap insurance (CDS). Some of the biggest rises in CDS spreads since March 31 were in European banks.

If CIO was short a basket of CDS on European credit indexes that included European banks, then its hedging activities could wind up inflicting large losses. If so, the CIO would have had to post more and more margin with its counterparty as the trade went against it. At some point, Dimon was informed of this unpleasant reality and decided to unwind the losing trade and break the news in the 10-Q.

JPM's conference call was a stark reminder that investing in large derivatives-trading banks (the "Too Big to Fails") is investing in a volatile cocktail of credit risk. Executives manage this credit risk with minimal disclosure about what types of risk they're taking. "Just trust us," is what they say. "We have sophisticated 'Value at Risk' models managed by rocket scientists," they say. As you recall from the financial crisis, this was a formula that blew up spectacularly.

Jamie Dimon was very defensive and combative in response to questions on the call. He couldn't provide specifics about the mark-to-market loss lurking in the CIO trading books - for obvious reasons: Other traders on Wall Street, like sharks smelling the scent of blood, would make JPMorgan's exit from these underwater derivatives positions an even-more painful experience, while pocketing derivatives trading profits.

We won't know any more detail until JPM reports its second quarter, when Dimon promised to provide more detail - presumably after unwinding the losing trades. This episode is one of many flashing signs that the global banking system is more fragile than advertised.

JPM has built a reputation as one of the better risk managers among the world's largest banks. If JPM had this surprise, what derivatives accidents lie in wait at other banks? With the eurozone on the verge of heightened drama and bank restructurings, I don't think stock market bulls want to find out.

Finally, I'd be remiss to not mention our wonderful financial system regulators. Using the logic of the idiots (Dodd and Frank) that supposedly "reformed" Wall Street after the financial crisis, what we need now is another new regulatory agency. Dodd-Frank was a thin coat of paint over a cracked and broken banking system; since it failed to accurately diagnose the causes of the financial crisis, it was a dud and a nuisance from day one.

More legal complexity, more wasted money and red tape and more lack of regulator accountability is what we got, when in reality, a big part of the problem was regulators not policing activities at the Too Big to Fail banks. Here's an idea - one that banking history expert Jim Grant has been pushing for years: It's called "capitalism."

Take away the subsidies and bailouts for banks, along with the regulatory red tape. If they want to blow themselves up, fine - but losses would fall on the risk managers making those decisions and bank shareholders, not taxpayers or depositors. Push to return the investment banking business back to the partnership model that worked much better. Then, with the senior partners' capital on the line, we'll see how many derivatives blowups occur.

Regards,

Dan Amoss
for The Daily Reckoning Australia

From the Archives...

Is the Australian Economy... Booming...or Busting?
2012-05-11 - Greg Canavan

The Art of Value Investing: How to Value a Business, Not a Stock
2012-05-10 - Greg Canavan

When Financial Markets Decouple From Reality
2012-05-09 - Dan Denning

Low Interest Rates Are A Dangerous Addiction!
2012-05-08 - Satyajit Das

The Bear Hunters and the Trigger Event for the Aussie Dollar
2012-05-07 - Dan Denning

Similar Posts:
• The Shadow Darkens Over Investment Bank JP Morgan
• Topiary Lessons – JP Morgan’s US$2 billion Loss
• Stocks Better than Bonds When Inflation is a Big Threat
• Citi Reports $4.69 Billion in Fixed Income Trading
• The Problem With a Well-Diversified Portfolio

]]> http://www.dailyreckoning.com.au/a-big-oops-at-jp-morgan/2012/05/15/feed/ 0 CDSCIOhttp://www.dailyreckoning.com.au/a-big-oops-at-jp-morgan/2012/05/15/ http://feedproxy.google.com/~r/dailyreckoningaus/~3/-bInHhc0oTw/ http://www.dailyreckoning.com.au/preparing-for-chinas-growth-slowdown-with-the-energy-hub-portfolio/2012/05/14/#comments Mon, 14 May 2012 06:15:51 +0000 dr@dailyreckoning.com.au (The Daily Reckoning) http://www.dailyreckoning.com.au/?p=18430 Economic activity in China is slowing down. The slowdown touches all parts of the economy, too. If you haven't yet prepared your portfolio for a world with a lot less economic growth, there's still time. But maybe not as much as you think.]]> If you haven't yet prepared your portfolio for a world with a lot less economic growth, there's still time. But maybe not as much as you think. The transition from a world led by American consumption to one led by Chinese consumption isn't going to be seamless. And it probably includes an extended stop-over at Deleveragingville, during which time not all stocks will be treated equally.

The good news out of China - the news that the bulls will seize on this morning - is that the People's Bank of China cut reserve requirements at banks and injected $63 billion into the economy over the weekend. The Bank is trying to free up liquidity, lower interest rates and generate economic activity. Which brings us to the bad news.

Economic activity in China is slowing down. The slowdown touches all parts of the economy, too. For example, April industrial production (IP) was 9.3% higher year-over-year. But that was the weakest reading for industrial production in three years. It was also lower than the 11.9% rate in March.

Now, an industrial production of 9.3% doesn't seem like a disaster. It seems pretty solid. It's certainly not the kind of disastrous figure that precedes a big crash. But you do have to wonder how much you can trust any official government numbers these days.

It's not so much that the statistics themselves lie. It's that the people providing the statistics may be lying. They do so in order to inflate their growth numbers to the party higher-ups. High growth is the currency with which you can purchase political advancement. And in any case, the lower IP number had plenty of company in the last week.

April imports in China were up just 0.3% year-over-year. Analysts expected 11% growth. That expectation was based on an average monthly growth rate of 25% in 2011. That string of strong export figures fully supported the idea that China was seamlessly switching from export-led growth to more domestic consumption. Last week's data challenges the narrative.

Last week's retail sales figures also showed slower growth, and so did the fixed asset investment figures. That's the very definition of a statistical double whammy! Both figures represent different growth models.

Retail sales should rise as China's per capita incomes rise and consumption increases in the economy. Fixed asset investment - the resource-intensive building of roads, houses, bridges, and infrastructure - should gradually decline, at least as a portion of over-all GDP. Less investment, more spending. That's the simple explanation of what everyone expects to see in China.

But instead you see this: less investing, less spending, less building, less importing, less exporting, and less lending, despite cheaper credit. What kind of a world is that? That's a world that's not growing as fast, or is even contracting.

Maybe this is all just a gradual moderation in China's growth rate. You can grow your economy at double digit rates when you're coming off a low base, but as GDP creeps up, sustaining that infernal pace becomes impossible. Developing economies grow at double digits. Developed economies don't.

For Aussie investors, this means be on your guard. The Aussie share market is, by definition, a growth-oriented market. China's fixed asset investment binge of the last two decades almost single-handedly accounted for the windfall profits from rising iron ore and coal prices.

That's all changing now. We think it means a shift in the leadership of the commodity sector in Australia. Read that shift correctly and you should be okay. Read it incorrectly and you probably won't be okay.

Even the New York Times is on to the story, reporting that,

'China has been the largest single contributor to global economic growth in recent years, and a sustained slowdown in its economy could pose problems for many other countries. Particularly exposed are countries that export commodities like iron ore and oil and rely on demand from China's steel mills and ever-growing ranks of car owners.'

Hmm. Which 'particularly exposed countries' could the Times possibly mean?

Slipstream Trader Murray Dawes is already trading the 'negative growth' story. He's been sending us versions of the Bloomberg chart below for weeks now. It shows the price of iron ore imports in China. The price has been in a steady distribution since late last year, but now it's turned down.


Source: Bloomberg


Murray's especially interested in this price because he has several short trades on with iron ore producers. One is already in stage-two profit. The others are trending nicely. From a 'big picture' perspective, it's basically a 'negative growth' trade. It's one way to hedge your overall portfolio risk by at least making a little money as things fall apart.

But you don't need to be excessively negative either. We mentioned that we think leadership in the Aussie resource sector is changing. From whom to whom? From the bulk materials producers to the energy miners, that's whom and whom!

On the case is our own Dr Alex Cowie. He's travelled to Adelaide for the annual conference of the Australian Petroleum Production and Exploration Association (APPEA). He's writing notes this week for our sister publication Money Morning. You can see his posts this week at www.moneymorning.com.au

The conference starts today but it's already in the news. 'The head of the world's fifth-largest oil company wants to turn Australia into a global energy hub on a par with the Middle East, Canada and Russia, after a 20-year absence from the local market,' reports Angela Macdonald-Smith in an exclusive interview at the Australian Financial Review.

Hey, that sounds familiar. We told a similar story last year in Revolution in the Desert. We wrote about the new 'energy superhighway' between China and Saudi Arabia and its direct impact on natural gas, both conventional and unconventional. We told our Australian Wealth Gameplan readers about three companies operating in Australia's Cooper Basin that would benefit most from this big global energy shift. It's worked out pretty well so far.

And it could get even better. Christophe de Margerie, the CEO of French oil giant Total, says the company will invest at least $16 billion in Australia over the next five years. Total is already invested in the Santos LNG project in Gladstone and the $34 billion Icthys LNG venture led by Inpex in Darwin. But Christophe de Margerie is ready for more.

'We think it is the right time to see if, on top of those two projects and all the acreage we have off the north-west coast, we can do more with local companies, and to start, with Santos...We have said it already to Santos, we will meet with them and see what we can do from there - and not only be definition on LNG coming from those coal-bed-methane fields. I come with a totally open mind.'

Hmm. That sounds to us like Total might have an interest in shale gas assets in Australia. Despite BHP's cost blowouts on its US ventures, Total is thinking long-term, as a major integrated oil company must. New reserves must replace annual production on a constant basis. That means planning years ahead, so that exploration can yield actual resources that enter into production when you need them (or when your customers need them, to be more accurate).

This is probably the bright spot in an awkward moment in the Aussie share market. The China growth story is evolving. The next ten years on the Aussie market aren't going to look anything like the last ten years. You can't afford to invest as if nothing will change. But what CAN you do?

Well, we'd expect more de-leveraging. JP Morgan's $2 billion trading loss reported last week - admittedly a pittance relative to the size of the company's balance sheet - is more evidence that the world's financial markets are highly leveraged. You have trillions in assets sitting on top of a very small sliver of equity. In fact, the leverage is probably higher and more dangerous than in 2007, when the global financial crisis began.

The world's financial markets are more fragile and interconnected now than they were five years ago. That means commodities, resource stocks, and the Aussie dollar are all in danger of big falls if the 'risk off' mentality leads to more deleveraging in the financial world. You saw what happened in 2008. Now imagine that was just a preview. And it's not something that could happen far off in the future. It's something that could happen now, in 2012.

It's hard to reconcile that gloomy forecast with a bullish forecast on energy, but if you're looking 20-30 years out like Total, it's not as hard. It means a falling Aussie dollar is the perfect opportunity to buy Aussie energy assets on the cheap. You then have a tangible asset that's at the centre of the Asian growth story for the next 30-years - natural gas.

Of course most investors are not investing for the next 30 years. Most investors can't afford another bad three years, or another three years of average returns. So if we're right about the commodity shift AND the deleveraging in the markets, what's the best position to take? More on that tomorrow.

Regards,

Dan Denning
for The Daily Reckoning Australia

From the Archives...

Is the Australian Economy... Booming...or Busting?
2012-05-11 - Greg Canavan

The Art of Value Investing: How to Value a Business, Not a Stock
2012-05-10 - Greg Canavan

When Financial Markets Decouple From Reality
2012-05-09 - Dan Denning

Low Interest Rates Are A Dangerous Addiction!
2012-05-08 - Satyajit Das

The Bear Hunters and the Trigger Event for the Aussie Dollar
2012-04-07 - Dan Denning

Similar Posts:
• Australia Presents Investors With Great Portfolio of Energy Choices
• As the Commodity Bull Slows
• Why BHP Should Be Bracing Itself For a China Slowdown
• China as a Nuclear Power Play
• The Geopolitics of Energy

]]> http://www.dailyreckoning.com.au/preparing-for-chinas-growth-slowdown-with-the-energy-hub-portfolio/2012/05/14/feed/ 1 APPEAIPhttp://www.dailyreckoning.com.au/preparing-for-chinas-growth-slowdown-with-the-energy-hub-portfolio/2012/05/14/ Copyright - Daily Reckoning AustraliaThe Daily Reckoningnonadult