Here’s a good Sonic Charmer post about how JPMorgan could have prevented the London Whale loss by imposing a liquidity provision on the Whale’s desk:
Liquidity provision means: ‘the more illiquid the stuff you’re trading, the more rainy-day buffer we’re going to withhold from your P&L’. And since one way a thing becomes illiquid is ‘you’re dominating the market already’, you inevitably make it nonlinear, like a progressive income tax: No (extra) liquidity provision on the first (say) 100mm you own, half a point on the next (say) 400mm, a point on the next 500mm, 2 points on the next 1000mm, etc etc. (specific #s depend on the product). Problem solved. In fact, it’s genuinely weird and dumb if they didn’t have such a thing.
The London Whale’s problem (one of them) was that he traded so much of a particular thing that he basically became the market in it. That means among other things that even if on paper “The Price” of what he owned was X there would have been no way for him to sell the position for X. A liquidity provision is a rough and dirty way of acknowledging this fact.
This suggestion isn’t a matter of GAAP accounting: JPMorgan wouldn’t report its asset values, or its revenues, net of this liquidity provision. It’s just an internal bookkeeping mechanism: his bosses informing the Whale that, for purposes of calculating his P&L and, thus, his comp, they would take the GAAP value of the things he had and subtract a semi-arbitrary number for their own protection.
It is weird and dumb that they didn’t do this although you can sort of guess why: the Whale portfolio started very small, and by the time it got big the Whale was both profitable and a (mostly imaginary) tail risk hedge, so it would have been hard for a risk manager to take a semi-punitive step to rein in his risk-taking. “Just tell the Whale to take less risk” does in hindsight seem like a sensible suggestion, but I suppose if he’d made $6 billion it wouldn’t.
Something else though. Here you can read about an exchange between the SEC and JPMorgan about the Whale newly released yesterday. Read more »
When is a loss a loss? That is the question. Read more »
This Bloomberg article about accounting differences between the US and Europe for derivative-y things comes down pretty squarely on the side of Europe, which is to be expected: European (well, IFRS) standards tend to gross up the size of bank balance sheets, compared to US GAAP standards. Grossing up bank balance sheets makes for bigger numbers and scarier banks, and “US banks are scarier than they seem” is more newsworthy than “European banks are less scary than they seem.” Also intuitively truer. As Bloomberg puts it:
U.S. accounting rules allow banks to record a smaller portion of their derivatives than European peers and keep most mortgage-linked bonds off their books. That can underestimate the risks firms face and affect how much capital they need.
Or it can overestimate the risk European firms face. Or any estimating of risks based on any measure of balance-sheet size is necessarily indeterminate. Risk happens tomorrow, not yesterday.
Anyway though some of these accounting differences are puzzling insofar as they are not accounting differences. Here is the mortgage bond one: Read more »
Every financial contract is subject to a bunch of risks, and in some sense each of those risks affects its value. There’s some chance that an asteroid will crash into the earth next year, rendering your 30-year interest rate swap considerably less valuable, and if you’re so inclined you can discount its value for that possibility.
One nice thing to imagine is that your financial contract is, like, one contract, and all the risks are spelled out in that contract, and you can figure out the value of the contract based on real or market-implied probabilities of all the risks happening etc., and you add them all up and you conclude “the market value of this contract today is 12!” or whatever and you go on your merry way. But that doesn’t need to be true. Some of your risks live in the contract and are part of the contract; some live in the counterparty and have to do with the counterparty’s riskiness; some live in whatever collateral arrangements you have with the counterparty and have to do with the mechanics of your collateral; some are asteroids.1
Anyway, remember the Deutsche Bank whistleblower story? I said last week that the question of whether DB’s actions constituted accounting fraud was not a particularly interesting question, but that is all relative and you’d be surprised what I find interesting. One thing I find interesting: those Deutsche Bank trades! And umm their accounting.
So, some background. As far as I can tell, DB sold a bunch of credit protection in sort of normal ways, CDX and stuff. And it bought a bunch of protection in leveraged super senior tranches. A super senior tranche, classically, is:
- You have a pool of reference assets,
- You pay some spread to a protection writer,
- If defaults wipe out more than some unlikely-seeming percentage – 15%, say – of those assets, then the protection writer gives you money, more or less 1% of notional for every 1% of losses over that threshold,
- So for instance if there are 40% losses you get paid 25%.
- The protection writer is like a big bank or monoline or whatever and, in 2005, is either AAA/AA or is posting mark-to-market collateral or both.
So there’s your trade. A leveraged super senior is the same thing, except replace that last bullet point with:
- The protection writer posts a bunch of collateral – 10% of max exposure, say – day one.
- The protection writer is a Canadian asset-backed commercial paper conduit or some other non-credit party.2
- If certain bad things happen that make you worry that you don’t have enough collateral, you can ask the protection writer to post more collateral, but (1) they don’t have to, (2) they don’t want to, and (3) they can’t.3
Read more »
Oh man, what is going on in this FT article? Here is the bottom line:
In a series of complaints to US regulators, two risk managers and one trader have told officials that Deutsche had in effect hidden billions of dollars of losses.
“By doing so, the bank was able to maintain its carefully crafted image that it was weathering the crisis better than its competitors, many of which required government bailouts and experienced significant deterioration in their stock prices,” says Jordan Thomas, a former US Securities and Exchange Commission enforcement lawyer, who represents Eric Ben-Artzi, one of the complainants.
The “in effect” does a lot of work there; Deutsche Bank “in effect” hid billions of dollars of losses because there were no losses. Other than that!
Here’s a synopsis of what seems to have been going on:
- Starting in 2005, Deutsche did some credit trades where they bought protection from some Canadian pension funds and sold protection to hedge funds, etc.
- The bought and sold protection were not identical, with various technical bits of non-overlap that you can read about at your leisure down below.1
- A credit crisis occurred, changing the risks involved in those non-overlapping bits from silly, abstract, purely theoretical risks into significantly more alarming and more-likely-to-occur but still purely theoretical risks.2
- Deutsche’s people sort of ran around dopily trying to figure out what to do about it. Here’s a condensed version of the running around they did about the main risk, the “gap option” that DB was short in its leveraged super senior trades:
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Have you given up on this week yet? Of course you have. Libor Libor Libor Libor, we get it, mistakes were made. Next week though we get the start of bank earnings season, which will at least kick off with a whaling expedition, so that’s something.
One thing that we’ve had to look forward to in recent earnings seasons is getting to talk very seriously about how banks “make money” by becoming worse credits, or less amusingly “lose money” by becoming better credits. This is more or less referred to as “DVA,” for “debit valuation adjustment,” and stems from accounting rules that allow and/or require banks to reflect changes in the fair value of certain of their liabilities – including changes in fair value due to their own deteriorating or improving credit – in their accounting net income. The counterintuitive result is that the worse the bank looks, the better its earnings look. This provides cheap irony, which is a valuable social function because earnings reports are often pretty boring and what else are we going to talk about; it also provides countercyclical bank confidence-boosting (though not countercyclical actual capital), which is also a valuable social function especially if you take away other countercyclical confidence-boosters like lying about your unsecured borrowing costs. (Libor Libor Libor.)
The effect should be particularly interesting this quarter as there’ll be dueling credit effects on earnings. On the one hand, bank credit is broadly wider – I see JPM 5y CDS +44bps for Q2, C +50, BAC +38, GS +46, MS +45 (from Bloomberg CMA) – and when I last did any math on it 1bp of CDS spread seemed to translate into anywhere from ~$2mm (for GS) to ~$22mm (for JPM) of DVA earnings. So there’s potentially $2bn in imaginary earnings in those numbers. Read more »
When the London Whale thing came out, JPMorgan made one sort of clever attempt to minimize it by saying this:
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 losses in CIO’s synthetic credit portfolio have been partially offset by realized gains from sales, predominantly of credit-related positions, in CIO’s AFS [available-for-sale] securities portfolio. As of March 31, 2012, the value of CIO’s total AFS securities portfolio exceeded its cost by approximately $8 billion. Since then, this portfolio (inclusive of the realized gains in the second quarter to date) has appreciated in value.
What did this mean? Well, I think it roughly meant what it said, which is that as if March 31, JPMorgan’s Chief Investment Office had about $375bn worth of bonds for which it had paid about $367bn, and that after March 31 (1) that portfolio of bonds increased in value to at least $375,000,000,001 and (2) JPMorgan had sold at least some of those bonds at a profit. But one nice thing about it is that, if you squinted, you could read it as “our hedge decreased in value, yes (and by $2bn), but that’s because the underlying portfolio increased in value (by $8bn), so net-net we’re way ahead, and it was a hedge, and whaddarya gonna do, hedges go down when things-hedged go up, that’s life.” That turned out to be an entirely wrong reading but hey they tried!
Reuters moved that story forward a bit with this kind of interesting parsing of Jamie Dimon’s words, including particularly the statement that JPMorgan had realized $1bn of gains on the CIO portfolio of available-for-sale securities between the end of the first quarter and the beginning of that super-awkward whale-confession conference call. Read more »
When exactly did this “blame the test” game start? At what point exactly was it when the fact that Jr. can’t add three plus three became “well, of course not. The test is unfair.”? What level of absurdity have we reached when it is the accounting rules that force the reporting of “dismal results,” and are therefore to blame in large part of the financial disaster we are coping with?
The audit watchdog agency is considering issuing additional guidance on fair value accounting, which banks have blamed for forcing them to report dismal results, chairman Mark Olson told Reuters on Monday.
Olson, who leads the Public Company Accounting Oversight Board (PCAOB), said U.S. accounting regulators need to keep examining consequences of the standard, but lawmakers should not get involved.
Audit watchdog weighs more fair value guidance [Reuters]
The debate over mark-to-market accounting rages on.
The accounting standard known as FAS157 has been criticized by some bankers, notably Blackstone Group chief Steve Schwarzman, for needlessly causing big write-downs and encouraging financial panic. It’s defenders include Goldman Sachs, which pointedly left the Institute for International Finance in June, a banking lobby group, over the IIF’s anti-mark-to-market stance. Last week Treasury Secretary Hank Paulson defended mark-to-market during a talk he gave at the New York Public Library (which, ironically, is now officially called The Stephen A. Schwarzman Library.)
“I believe in fair value accounting,” Paulson said.
Over at the Deal, Robert Teitelman cries foul, accusing Paulson of restating the debate in question-begging terms.
Now “fair-value accounting” has been around for awhile, but increasingly its patrons are using it to nudge aside the far clearer and more precise term “mark-to-market.” “Fair value” contains a kind of moral imperative. Mark-to-market lays its weary head on the markets. Fair value, is, of course, by definition, fair. Who can argue with that?
Paulson and the triumph of fair-value accounting [TheDeal]
Earlier this morning we discussed how changes in the way accounting rules treated auction-rate securities helped drive corporate investors out of the market. (For a rousing debate of exactly which accounting changes stamped out demand, click here.) Credit market concerns and the changes in the way auction-rate securities are treated on cash flow statements contributed to the rush out of the securities by bringing additional scrutiny to the once obscure financial instruments. At the end of 2007, many companies made the decision to shift assets out of auction rate securities as these changes were implemented for the new fiscal year.
The Apollo Group owned as much as $365 million in ARS at the end of 2007, according to a recent filing. But by February 19, 2008, all but $107 million of the ARS investments had been liquidated and not reinvested in the ARS market. Apollo says this well-timed exit was part of a plan to intentionally reduce its exposure to the auction rate securities, although they do not reveal what prompted the exit. The timing wasn’t perfect, however, and Apollo found itself unable to liquidate approximately $79 million in ARS due to auction failures.
Despite not completely exiting the ARS market, we’ll count Apollo a winner. So who’s still holding the securities? After the jump, we reveal two companies trapped by the auction failures.
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