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JP Morgan Trade 101

05/14/2012

Although all the details are not known yet and likely won’t be known for a very long time, I have seen the basic idea of their horrible trade-gone-wild, and it simply reinforces why I’ve been so bearish on financial stocks.

As a large commercial bank, they have a large portfolio of loans they have made.  As the economy gets stronger, the risk of those loans defaulting decreases and, therefore, the quality of those loans increases, which increases the value of those loans, just like bonds increase in value when the quality increases.  After all, wouldn’t you pay more to buy a good bond or loan than you would pay to buy a bad bond or loan?

The loans that banks make are carried as assets on their balance sheets.  Like any company, banks want to protect the value of those assets.  JP Morgan believed the U.S. economy was improving nicely, which means the value of their loans-made or assets would also be improving nicely.  However, what if they are wrong?

To protect themselves from the downside risk of being wrong, they hedged their bet.  To do this, they bought credit default swaps (CDS) on a popular index of commercial loans. Think of CDS as repayment insurance.  The bank paid a fee to some third-party to insure the index would not lose value.  If the economy got worse and the value of loans made went down, the value of the index would go down, which means the third-party would have to make the bank whole.  They hedged their bet.

Up to this point, it is a normal hedging procedure.  In case JP Morgan was wrong that the economy was improving nicely, they bought some protection, which is prudent.

Apparently, they bought so much of the available CDS, the value rose and prices to buy CDS rose.  They had “moved the market.”  JP Morgan was finding the cost of buying the protection was increasing.  At some point, they decided to start selling CDS or protection for the easy fees.  Since they believed the economy was improving nicely, why shouldn’t they accept fees for insuring against something they didn’t think would happen anyway?

While there is a high probability that there are facts I don’t know yet, it was at this point, when they started selling insurance, that I believe JP Morgan jumped the rails.  When the economy stumbled recently, the value of the CDS which they had sold lost billions in value, because they would have to make others whole on losses in the index.

In other words, when they stopped paying out fees to be insured and started receiving fees to insure others, I think they crossed the line of investing their own money and starting gambling with taxpayer-guaranteed-money.

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