Research Watch

JPMorgan's "unbelievably ineffective" hedge. End times for the euro? French socialists may be good for stocks. On video: the Warren Buffett diet.

PORTFOLIO POINT: This is a sampling of the week's best research notes. In a world of too much information, we hope our selection helps you spot the market's key signals.

Cue every whale pun you’ve ever heard, as JPMorgan’s self-described “unbelievably ineffective” $2 billion hedge loss makes cetacean waves. CEO Jamie Dimon’s conference call after first-quarter results revealed problems with the firm’s already-controversial Chief Investment Office hedging desk is fast becoming the stuff of legend. On top of this, there is some serious scepticism about whether what the 'synthetic credit portfolio’ in question was doing could be described as hedging at all, and all the Volcker-related implications of that. Meanwhile, France's left turn could prove to be the right turn for stocks, and Goldman Sachs identifies a clear winner in the long-term, risk-adjusted battle between global equities and property. The investment bank has also sided with Pimco's Bill Gross in forecasting a third round of quantitative easing in the months ahead, although another commentator argues that central banks are creating the wrong kind of money. Also this week, find out how the big investment houses are 'sub-priming' commodities, just how taxing Australia really is, and where to locate Europe’s austerity. On video, the Warren Buffett diet.

Dimon in the rough'¦ From the conference call:
“'¦Errors, sloppiness, and bad judgement.”
“Bad strategy, badly executed and poorly monitored”
“It could get worse. This could go on for a little bit.”
“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” - Jamie Dimon
It was a pre-tax $2bn trading loss offset by a $1bn securities gain in reducing credit exposure. Net income hit of $800m. Jamie pointing to $8bn of unrealised gains in an available-for-sale portfolio. No change to share buybacks etc. “'¦general counsel is sitting right here and would kick me if that wasn’t true.”
Quite some details on how the risk was modelled: Dimon says that new VaR models introduced over the first quarter were withdrawn and the old ones plugged back in. Some really tough questioning of Jamie on modelling by Mike Mayo of CLSA in particular'¦
Further update (2232 UK time) – '¦And the most excruciating bank conference call we’ve ever heard, ends. Something of a Volcker Rule flavour towards the end, but Jamie stuck to his guns on arguing this was a hedge. An “unbelievably ineffective” hedge. (Jospeh Cotterill via FT Alphaville, May 11)

Voldemort’s curse'¦ A month ago we warned that JPM's CIO office is nothing short of the world's largest prop trading desk. Not only were we right, but what just transpired is just shy of our worst possible prediction. At the end of the day, the real question is why did JPM put in so much money at risk in a prop trade because we can dispense with the bullshit that this was a hedge, right? Simple: because it knew with 100% certainty that if things turn out very, very badly, that the taxpayer, via the Fed, would come to its rescue. Luckily, things turned out only 80% bad. Although it is not over yet: if credit spreads soar, assuming at $200 million DV01, and a 100 bps move, JPM could suffer a $20 billion loss when all is said and done. But hey: at least "net" is not "gross" and we know, just know, that the SEC will get involved and make sure something like this never happens again.
'¦But hey, just as Goldman named its frontrunning service the "Asymmetric Service Initiative" thereby magically not making it a frontrunning service, naming the world's largest prop desk the "Chief Investment Office" makes it no longer be the world's largest prop desk.
'¦ Some of [Achilles] Macris’s bets are now so large that JPMorgan probably can’t unwind them without losing money or roiling financial markets, the former executives said.
'¦ [Bruno] Iksil’s positions in credit-derivatives have become so large that some market participants dubbed him “Voldemort,” after the villain of the Harry Potter series who’s so powerful he can’t be called by name. “What Bernanke is to the Treasury market, Iksil is to the derivatives market,” Bonnie Baha, head of the global developed credit group at DoubleLine Capital LP in Los Angeles, where she helps oversee $32 billion, said in a telephone interview. (Zero Hedge, May 11)

The euro as we know it is doomed...

“JP Morgan analyst Michael Cembalest calculates that the major countries on the euro are more different from each other than basically every random grab bag of nations there is, including: the make-believe reconstituted Ottoman Empire; all the English speaking Eastern and Southern African countries; and all countries on Earth at the 5th parallel north. '¦ If you find yourself wondering, as I did, how the 50 states within the US would compare across this measure of dispersion, remember that the nice thing about the United States is that baked into the first word of its name is not only a monetary union, but also a fiscal union. '¦ [The graph below] shows fiscal transfers between the rich California-Connecticut-Illinois-New Jersey-New York quintuple and poorer states like Tennessee. If similar, seamless transfers existed in the EU, the rich north would have to send to Portugal and Greece at least an additional 30 cents for every dollar they paid in taxes, year after year after year. '¦ The Germans call this sort of thing 'a permanent bailout.' We just call it 'Missouri.'”

(The Atlantic, May 7)

Sacrifice Greece'¦ “It will be very difficult [for Greece] to form a viable coalition and to implement the measures required in the MoU. Particularly, the identification of the 7% GDP of budget savings for 2013 and 2014 by the end of June looks very unlikely to us. '¦ If Greece does not make progress... the Troika is likely to stop the [bailout] programme. If that happens, the Greek sovereign and its banking sector would run out of funding. As a consequence, we expect that Greece would be forced to leave the euro area. With the outcome of the election, to us the probability of a Greek exit is now larger than our previous estimate of 50%, and rises to between 50-75%. However, even after the elections in Greece, France and Germany, we regard the probability of a broad-based break up of the monetary union as very low. We continue to expect that in reaction to Greece leaving the euro area, more far-reaching measures from governments and the ECB would be put in place.” (Guillaume Menuet and Jurgen Michels of Citigroup, May 7)

Before you complain about the budget'¦
(The Australia Institute, May 7)

The sub-priming of commodities... “It’s always been common practice for commodity inventory to be financed by banks by being pledged as security for the loans in question. The problem comes if such enterprises, instead of using the inventory for general business purposes, are encouraged to stockpile for the sole purpose of liquidity provision and the opportunity to punt on the underlying commodities themselves. It’s a process which arguably artificially pumps up demand for the underlying inventory. Bundle all those loans together, meanwhile '” ideally into a product that can be sold to buyside investors seeking exposure to commodities '” and suddenly you’ve got a direct source of funding for an ever-more speculative game. '¦ This process is virtually impossible to quantify. We know that’s a disappointment to equity investors who are used to dealing with voluminous information, but that’s the nature of structured finance. Many structured finance deals are private in nature. '¦ But over the last year we’ve heard more and more anecdotal evidence of Wall Street increasingly structuring commodity deals, such as structured notes and swaps and even using commodities as collateral. '¦ In the case of a downdraft, it leaves people with unwanted long positions in a declining market, prompting even more sales. This has happened to gold a few times in the last year and anecdotally we get the sense that there such support in the $95 and $80 dollar areas for oil. A breaking of those areas might prompt further sales from structured finance participants.” (Brian Reynolds of Rosenblatt Securities via FT Alphaville, May 8)

Socialism versus stocks... “In 1981 France elected a president with far deeper left-wing credentials: Francois Mitterand. He brought the Communist party in his coalition. He planned a program of nationalization, higher taxes and more power for trade unions. It was far-left stuff. And there was no euro and France controlled its money supply as well. In US dollar terms the French stock market quickly plummeted about 30%. And Mitterand's early moves seemed to confirm the panic. He tried to reflate the economy: While the rest of the western world was going through Volcker-style austerity, he nationalized some of France's big companies. But Francois Mitterand was president of France for 14 years, from 1981 to 1995. Over that period investors in the French stock market made a total profit of 750% -- in U.S. dollar terms. Yes, it was a bull market. But over that period the gross returns on French stocks actually beat those on US stocks by a 20% margin. '¦ Hollande is much more moderate '¦ [and] has far less room to maneuver: The euro, and France's existing national debts, are checks on policy. And '¦ Hollande's friends include the chief executives of major French companies including Axa and Vivendi. '¦ What European stock investors need today, many smart people argue, is looser monetary policy. With Hollande at the Elysee Palace and Mario Draghi running the European Central Bank they may now get it.” (Smart Money, May 7)

Berkshire or bullion?... “Warren Buffett's view, which was outlined in this year's annual letter, is that no matter how far out you go, one ounce of gold today will always be an ounce of gold. He goes on to say that 'you can fondle the cube, but it will not respond.' Buffett certainly has a point. An ounce of gold 12 years ago is still an ounce of gold today. But isn't the same thing true of stock in Berkshire Hathaway (BRK/A)? Given the fact that BRK/A does not pay a dividend, no matter how much a holder 'fondles' or looks at their holdings, one share of BRK/A stock purchased twelve years ago is still one share today. Sure, you can sell it for more now than you bought it then, but the same is true of gold. In fact, your gain on gold is considerably more than your gain would be on BRK/A. Looking at the performance of the two assets since the start of 2000 shows that the value of gold has increased considerably more than the value of Berkshire Hathaway. In fact, with a gain of 466% since the start of 2000, gold's gain has been nearly four times the return of BKR/A (466% vs 120%).”

(Bespoke Investment Group, May 8)

QE3 is coming... “Pacific Investment Management Co’s Bill Gross and Jan Hatzius at Goldman Sachs say investors should prepare for additional bond purchases by the Federal Reserve to combat a slowing U.S. economy. A decision to buy more debt is “getting closer,” Gross, who runs Pimco's Total Return Fund, the world’s largest mutual fund, wrote on Twitter yesterday. Hatzius, the chief economist at New York-based Goldman Sachs, predicted in a report the same day that the Fed will announce additional monetary easing when it meets in June. '¦ 'In such an uncertain environment, taking out a bit more insurance still looks like the sensible choice for US monetary policy makers,' Hatzius wrote. 'We have stuck with our forecast of some additional monetary easing' at the Fed’s policy meeting June 19 to June 20. '¦ 'Risk markets need more ammo if they are to stay up,” Gross, who is based in Newport Beach, California, wrote on Twitter.” (Bloomberg, May 9)

Where's the austerity?...
(Marginal Revolution, May 8)

Oh, there it is...

“The supposed absence of austerity... is mostly a product of a reliance on nominal, absolute figures. If we instead turn to data from the International Monetary Fund's WEO database we see, first and foremost, that budget balances are in the process of improving dramatically.” (The Economist, May 8)

Video of the Week: Eat like a billionaire... Find out what's on the menu in the Buffett household. Can you believe the legendary investor doesn't drink water?

(Bloomberg, May 2)

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