Hi! Would you like to talk about the London Whale? Sure you would. The amount of misunderstanding of our poor beleaguered beluga is staggering, so I figured we could try to embark on a voyage of discovery together. Maybe we’ll figure it out. Along the way we’ll talk a tiny bit about the Volcker Rule. I am going to try to talk very slowly and simplify things so if you are pretty financially sophisticated you could skip this post (I’ve linked to some better things to read at the end), or just get really angry at me in the comments. Also this post is terrifyingly long, sorry!
So. You are JPMorgan. People come to you and give you money, because you are a bank, and they want you to hold on to their money for them. You pay them interest so you need to invest their money to earn interest – ideally you earn more than you pay so you can make money and pay bonuses and stuff. You invest that money, broadly speaking, by lending it to other people who want to do things with it. Some of those people are buying houses, some of them are running businesses. Those are the main ones. (Some are buying cars, or educations; others are running countries, or municipalities. Ignore that.)
Now a tangent, which is long but important. Some of the money that you lend to people running businesses, you actually lend to people running businesses – like, they come to you and ask you for a loan and you give it to them. Some of it you don’t, because you don’t have enough good loans to make – not enough people come to you for loans because they’re not building factories because Obama or whatever, or people do come to you for loans but it’s for terrible things so you say no. So you have “excess deposits,” deposits that you haven’t loaned out, and you invest those. You invest those in securities – that is, loans that someone already made and packaged into bonds to be bought and sold on the market. Since you are by hypothesis JPMorgan, you do this investing of excess deposits through your Chief Investment Office, or CIO, which is staffed by cetaceans. You can tell how much of this investing JPMorgan does because they disclose it on page 33 of their Form 10-Q filed with the SEC yesterday:
Now these investments are absolutely 100% without any doubt whatsoever “proprietary” in the sense that you have bought them with money and hope for them to pay you back with interest, as opposed to hoping to sell them immediately to a customer. And there is a thing called the Volcker Rule intended to prohibit “proprietary” trading. So this portfolio violates the Volcker Rule, right? No, not at all. The Volcker Rule applies to proprietary positions held in the trading book and intended to be sold within 60 days. As a rough cut, it appears that the CIO positions are mostly longer-term, which is what you’d expect from a bank investing its deposits that would otherwise be put in 3-to-7-year corporate loans or 30-year mortgages.*
Okay so now you’re JPMorgan and you’ve got about $375 billion worth of securities in the CIO – alongside some $700 billion of loans (page 87 of the 10-Q), of which $115bn are in your commercial bank (lending to businesses – page 28), $70bn are in your investment bank (lending to bigger businesses – page 16), $240bn are in retail (basically mortgages and stuff – page 18), and $187bn are in card services & auto (credit cards, car loans, student loans – page 25). So you have $185bn of corporate loans, plus whatever chunk of that $375n CIO position is corporate bonds, which seems to be about $60bn (page 92). And you have something called “lending-related commitments,” meaning revolving credit commitments where you have agreed to lend companies money if they ask for it – that number is almost $1 trillion (page 51), presumably almost all corporate. Add to that the fact that your investment bank involves buying and selling lots of corporate bonds as a market-maker, and doing derivatives with corporations where they might owe you money (something like $100bn, page 51 again), and you get the sense that JPMorgan has a lot of exposure to corporate credit. Meaning that if corporations start going bankrupt, JPMorgan will lose a lot of money.
That’s obvious – they’re a bank, that’s what happens to banks, they lend money and if the borrowers don’t pay it back then they are sad. Here if none of their corporate borrowers (leaving aside governments, mortgage borrowers, etc.) pays them back a cent, they lose in round numbers $250 billion on loans, $100 billion on trading receivables, and up to $1 trillion more if those borrowers draw their revolvers before defaulting (as they are wont to do).
THAT WOULD BE TERRIBLE.
But here is another important thing to realize. If instead of defaulting, companies just Became Shakier Credits – that is, if the market decided that all those companies looked less likely to pay their debts – JPMorgan would, to a first approximation, be pretty okay. Because to some rough approximation JPMorgan doesn’t care about the day-to-day swings in creditworthiness of their borrowers; they care about getting paid back at the end. Banks do a thing called “maturity transformation,” meaning that in some loose sense their social function is to lend money to companies and then wait for it to be paid back, instead of just consigning those companies to borrowing afresh every day from fickle liquidity-hungry investors. This is reflected in their accounting: the loans are reflected on an accrual basis; that is, there is some loss reserve against them which can change as they get less likely to be repaid, but JPMorgan doesn’t book a profit or loss every time the market value of those loans goes up or down. Similarly the CIO securities are for the most part “available-for-sale,” meaning again that JPMorgan’s income (for accounting) doesn’t reflect changes in their value, unless and until they’re sold for a profit or loss.
So now we have to get a little bit technical and we can’t avoid it, I am sorry, but here we are, we’ll hold hands and go slow and it will be okay. You want to hedge your risk that things will go horribly pear-shaped and lots of your borrowers don’t pay you back. (You can handle some regular number of them not paying you back – you’re a bank, that’s your job – but if things are worse than expected and a lot of them go belly-up that’s a problem for you.) One thing that you could do is just buy massive quantities of something called CDS, for “credit default swaps,” which function to a first approximation like insurance on corporate debt and pay off if a particular corporation defaults. You could buy CDS on every company you lend to in the amounts that you lend, but (1) this would eat up all your profits and (2) you can’t really, it doesn’t trade for all of them. But you could instead buy CDS on an index – basically a contract that references 125 big companies, and if some of them default it pays off a little and if all of them default it pays off a lot. That won’t exactly match your profile – why would you be lending to those 125 companies and no others? – but the idea here is that if things go horrible, they will go horrible across the board, and your payouts on the index will have some rough match with your losses on your lending. Just a rough match, not perfect.