JPMorgan is a leading player in Credit insurance and prime brokerage. Their “synthetic credit securities” positions are integral to their business operations with hedge funds and the “leveraged speculating community.” Furthermore, derivatives reside at the epicenter of the dysfunctional global “risk on, risk off” market dynamic. And it’s also been my premise that “risk on” has been showing heightened vulnerability.
There were important developments last week in the realm of market risk dynamics, developments that increased the likelihood that problematic de-risking/de-leveraging dynamics have begun to gain a foothold.
Let’s start with Europe. First, the Greek elections have created great uncertainty, hence, market risk. Voters hammered the two establishment parties, the main New Democracy and Pasok parties that were responsible for negotiating the two EU/IMF/ECB Greek bailouts. Fully 70% of the votes were cast for parties committed to abrogating European-imposed austerity measures. The surprise beneficiary was Syriza, the “Party of the Radical Left,” having placed second to New Democracy. Syriza is led by the radical and charismatic Alexis Tsipras, who this week gained additional support with his message that previous agreements are “null and void” and that Greece is well-positioned to call Europe’s bluff (blackmail the blackmailer, some have suggested).
With leaders from the top three parties each individually failing to formulate a coalition government with sufficient seats to hold a majority in the Greek Parliament, it now appears likely that new national elections will be necessary (most-likely in mid-June). Polls lat week showed Syriza building on recent momentum, so it is unlikely a coalition government can be created without Mr. Tsipras taking a leading role. The markets had been somewhat heartened by the prospect that new elections might be avoided. Now markets will likely face six weeks of uncertainty leading up to the next election. And while the Greeks for the most part state their desire to remain in the eurozone, there is little support for implementing austerity measures negotiated by previous governments. It’s very difficult at this point to envisage a favorable market scenario.
And while the majority of party leaders prefer to stick with the euro, it is also clear that a strong political consensus has developed that Greece must at the minimum renegotiate previously made commitments. Various European officials, including German Finance Minister Schaeuble, have made it clear that the Greek government must remain committed to previous agreements. At this point, the Greeks lack credibility, and EU officials’ patience has worn past quite thin. So, a dangerous game of chicken has begun, and contingency planning for a Greek exit from the euro will now command great attention. Such uncertainty supports risk aversion.
Now that a Greek exit appears unavoidable, it has become popular to surmise that this could be done without unmanageable financial and economic dislocation. Yet no one has a grasp of the consequences and ramifications for Greece, the euro, Europe, the markets, international finance and global economic prospects. It is very unfortunate Greece did not exit two years ago.
Friday from Fitch Ratings: “In the event of Greece leaving EMU, either as a result of the current political crisis or at a later date as the economy fails to stabilize, Fitch would likely place the sovereign ratings of all the remaining euro-area member states on rating watch negative as it re-assessed the systemic and country- specific implications of a Greek exit…. A Greek euro exit would ‘break a fundamental tenet’ of the currency union, which was designed to be irrevocable…”
Along the lines of happenings in the periphery country Greece, things are also going from bad to worse at a European core country, Spain. After promising that no additional public money would be used to bailout Spain’s troubled banks, Prime Minister Rajoy was forced to backtrack this week with the nationalization of the fourth largest Spanish bank, Bankia. And today’s widely anticipated announcement of plans for addressing banking system issues was less than confidence inspiring.
Saddled with enormous real estate loan portfolios, confidence in the Spanish banking system is quickly evaporating. Analysts talk of the need for a massive (Irish-style) recapitalization program ($150bn-$200bn), an enormous sum for an already troubled sovereign borrower. Spain’s Credit default swap prices jumped another 36 bps last week to a record 517 bps. Last week provided added confirmation that the European crisis has decisively infiltrated the “core.”
And especially now that a Greek euro exit is on the table, banking system and sovereign debt fragilities take on new urgency. Importantly, markets have returned to a crisis-prone backdrop where I expect capital flows both between euro zone nations and out of the euro to become critical issues. It is today perfectly rational for wealthy holders of euro deposits – along with risk-averse corporate Treasurers managing cash holdings - in periphery banking systems to shift these funds to more stable core institutions (or perhaps even out of the euro altogether). And if Greek and euro troubles further escalate, there will be increased economic impact as corporations move to more aggressively manage business risks in various economies.
Apparently, the issue of “Target2” (Trans-European Automated Real-time Gross Settlement Express Transfer System) balances now garners considerable attention in the German media. Recall that “Target 2” refers to the eurozone’s inter-central bank payment system used for settling cross-border trade and financial flows. This system has not functioned as designed (trades have not fully settled) since the eruption of the financial crisis back in 2007. Instead of private financial flows counterbalancing trade imbalances (the settlement of cross-border obligations), these days trade imbalances and financial outflows from the periphery combine to create enormous and mounting IOUs from periphery central banks to the German Bundesbank. With euro stability now a serious issue and capital flight out of even “core” banking systems a definite possibility, the Target2 drama is poised to create only greater intrigue.
And I could be off-track on this. But I just don’t believe it is mere coincidence that JPMorgan dropped its bombshell $2bn loss announcement in the middle of market worries regarding Greece, Spain, the euro and European bank stability. And I know that in the grand scheme of JPMorgan’s business, balance sheet, capital levels and EPS, $2bn is indeed a “rounding error.” This news will certainly intensify the Volcker rule debate and there are, of course, very important longer-term issues to contemplate. But I think much of what I’ve been reading and hearing misses a key point with immediate market ramifications.
JPMorgan is a leading player in Credit insurance and prime brokerage. Their “synthetic credit securities” positions are integral to their business operations with hedge funds and the “leveraged speculating community.” Furthermore, derivatives reside at the epicenter of the dysfunctional global “risk on, risk off” market dynamic. And it’s also been my premise that “risk on” has been showing heightened vulnerability.
I’ll assume that JPMorgan’s enormous derivative portfolio was constructed with a particular market/risk environment in mind. It would make sense to me that JPMorgan has been comfortable building massive risk exposures throughout various markets, anticipating a relatively sanguine “risk on” landscape. Management was comfortable with the view that global policymakers had things under control – and were confident that global markets would remain abundantly liquid. They likely viewed the hedge fund community as relatively stable and likely to successfully work through recent challenges. And I will further presume that developments in Europe, throughout global markets and with the global leveraged players had recently made them much less confident in previous assumptions. It would make sense if they’ve decided to start hunkering down.
I’ll guess that top JPMorgan management was forced to respond to recent changes both in the marketplace and in prospects for the market risk/liquidity backdrop more generally. Recent developments and the abrupt return of de-risking/de-leveraging dynamics significantly changed the risk-profile of their positions and market insurance products more generally. They bet big on “risk on” but now must work to position for the likelihood of “risk off.”
In discussing Credit insurance and derivative markets over the years, I’ve invoked an analogy of writing flood insurance during a drought. It’s a truly wonderful business – that is until torrential rains arrive and the complacent community of highly-speculative (and thinly-capitalized) insurers flood the insurance market as they desperately attempt to offload (“reinsure”) the risk they accumulated during the profitable drought-period boom. Those seeking long-term survival (as opposed to the crowd trying to make a quick buck) better have a superior ability to discern weather patterns.
If I were JPMorgan top management, I’d surely be moving today to reduce the company’s risk profile – especially with respect to myriad global market risks. The clouds are darkening and much better to move before the heavy downpours commence (and buyers, along with their liquidity, run for the hills). While I will give no Credit for their self-serving self-flagellation, they are a savvy group that has demonstrated their ability to manage through crises. Certainly, writing Credit and market risk insurance has, again, become a risky proposition. And I’ll assume that JPMorgan’s market-making operations will be reined in throughout various risk insurance markets – and I’ll assume a similar change in tack will be afoot by the cadre of major derivatives operators. Importantly, this equates to less liquidity and more expensive market insurance. A less favorable insurance market equates to more restraint in risk-taking and an attendant tightening of financial conditions. As such, I would not be surprised if this week proves a major inflection point for global risk markets - and a major coup for “risk off.”
Source: Prudent Bear
