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Derivatives Debacle?

-- Posted Monday, 5 November 2007 | Digg This ArticleDigg It! | Source:

By: Rob Kirby


Last week I penned a quip highlighting data contained in the latest Quarterly Derivatives Report from the Office of the Comptroller of the Currency.  Specifically, I wanted to draw attention to the new growth [10 Trillion in Q2/07] being reported in outstanding notionals in J.P. Morgan Chase’s derivatives book:



                      [Source: table 2 on page 23 of pdf doc – Quarterly Derivatives Report]


I was somewhat surprised by some of the comments and feedback I heard and read regarding this issue.  One informed market watcher chimed in with this observation:

“When I first started buying gold and gold stocks it was early 2002. The worry back then was two-fold. There was all the talk about the massive short derivative position in gold and the eventual insolvency of JP Morgan.”

This got me thinking: could such a thing possibly happen?



So, I decided to phone very good friend of mine used to be a bond trader at J.P. Morgan. He subsequently went on to trade the 10 year bond at one of the very largest N.Y. Dealers for 10 years.

He and I had not spoken for about 4 years.

When I telephoned and spoke with him last week, I asked him if he had any comments about the size of J.P. Morgan’s derivatives book.

He told me “no”, and asked, “why should I?”

I told him their book grew [new business] by 10 Trillion in the second quarter of 2007, which works out to roughly 151 Billion in new business every business day for an entire quarter.

His reply, “That’s impossible”.

Coming from a guy who single handedly traded 20 – 25 billion worth of U.S. government bonds in a big day – he knows what he’s talking about.

In fact, he was so bewildered by what I had told him – he questioned the veracity of my numbers. I actually had to show him the numbers on the web site for the Office of the Comptroller of the Currency before he would accept them.

This gave me cause for concern, especially considering I previously reported on this which became public knowledge in early 2006:

Of course then again, maybe J.P. Morgan’s blow out quarter where they conducted 5.5 Trillion [old number from 06 – latest quarter, Q2/07 is 10 Trillion] new notional in derivatives had nothing to do with the precipitous drop in the price of natural gas at all. Maybe, it’s just like authorities say, that storage facilities [that no one can practically see or measure] really are full. Maybe J.P. Morgan conducted all that trade to benefit shareholders. But I’ve got a sinking feeling that we’d never be told the difference if things didn’t work out that way. That became abundantly clear when Dawn Kopecki reported in BusinessWeek Online in a piece titled, Intelligence Czar Can Waive SEC Rules,

“President George W. Bush has bestowed on his intelligence czar, John Negroponte, broad authority, in the name of national security, to excuse publicly traded companies from their usual accounting and securities-disclosure obligations. Notice of the development came in a brief entry in the Federal Register, dated May 5, 2006, that was opaque to the untrained eye.”

So ask yourself; could J.P. Morgan ever be insolvent?

Having received a great deal of feedback on this topic, one fellow African financial scribe I communicate with from-time-to-time [writes a weekly technical market column for an Afrikaans daily] contacted and recounted this to me:


“Some years ago I wrote a column on the very large notional value of derivatives at that time and -there was some major change in the markets - that top management at some firms, notably JPM, may not be sleeping as well as before.


Big flare up - calls from local JPM and also from UK JPM - big flap and the business news editor is shaken to the core on threats of legal action etc etc etc unless front page retraction etc etc. Eventually calmed down, but he and I get invited to local JPM for lunch. Excellent wine, so either we rated some attention or they were doing very well!!


Over lunch they explained something - they told us that when JPM mediates a derivative deal between two parties, say A and B, the contract is not written between A-B, but the two legs of the transaction gets completed as A-JPM and JPM-B, with JPM having one long position and an equivalent short. That means they are risk-neutral.


So, even though they have a really large position on their books, practically all of it is risk neutral.


I was instructed beforehand not to be difficult, but listen and not say much. Definitely not to stir up trouble - people in SA are scared of litigation!!


So we all smiled and enjoyed the wine and I even had a good brandy with the coffee. By then I just had to ask a question: "Let's assume that there is a particular derivatives market in which JPM has a really large position - risk neutral of course, but still very large in notional terms. Let's further assume that some discontinuity happens in that market, a discontinuity so large that a good number of the parties on the wrong side of that position gets wiped out and default on their contracts.


JPM would then lose the profitable leg of the split position, but be stuck with the losing leg. Would that not imply massive potential risk for JPM - should something go really wrong?"


The local CEO and his three assistants all looked at each other for quite a few moments, then the CEO said: "We are not concerned. We are most careful in our analysis of market trends and we have a very tight risk policy to ensure that we will be safely position should something go wrong - which we do not expect to happen."

I had to point out to my South African friend that the scenario described above outlining risk neutral positions implicitly assumes that there are real end users of these derivatives products that J.P. Morgan is amassing.  But look, according to data collected by the Office of the Comptroller of the Currency by data submitted [in call reports] by the banks themselves - this is categorically not the case:  

                                         [Source:  Graph 1 on page 9 of 33 pdf doc]


This should raise serious questions as to what J.P. Morgan along with the rest of their banking brethren and their cronies over at the Federal Reserve are really doing?


The sheer enormity and volumes of transactions being recorded is begging for answers.


The fact that none are forthcoming and the mainstream financial media refuses to acknowledge that anything is even amiss should scare us all.



Rob Kirby
Kirby Analytics Newsletter
Toronto, Ontario, Canada

-- Posted Monday, 5 November 2007 | Digg This Article | Source:


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