JP Morgan (JPM) just gave us the preview of the next financial crisis. A surprise, hidden $2 billion trading loss in esoteric foreign derivatives at on offshore branch by America’s premier bank is exactly what the markets did not want to hear right now. The London whale has beached itself. Although no one has mentioned this, these are exactly the same sort of securities that drove MF Global into bankruptcy only seven months ago. As baseball great, Yogi Berra, said, “It’s déjà vu all over again.”
I doubt that (JPM) will go under on this one, but others may. This is how our financial system works these days. There is never just one cockroach. With the profitability of traditional business lines now pared back to pennies, banks are desperate to reach for marginal income wherever possible to keep from turning into utilities. Bring on the downgrades! Indeed, the loss could well result in a de-rating not just for (JPM), but the entire US banking sector.
As a result, they have all turned into giant, opaque hedge funds. Some genius thinks up a trade that works out great in computer back testing. The Federal Reserve indirectly provides all the capital they need through its zero interest rate policy. It makes good money for a while. Then the word gets out, and everyone starts imitating them.
But the copycat institutions lack the sophistication, the risk control, and the experience to get it right. When too much capital pours into a single trade it ceases to work. Some little market setback gets magnified 100 fold by leverage and the wanabee trader blows up. If (JPM) lost $2 billion, you can bet someone else has lost $20 billion on a smaller capital base and the runs begin. However, we may not hear about this for another nine months, once the annual audits get underway and fail.
The scary thing is that the senior management of JP Morgan may not even know what their true position is. They are relying on sheepish presentations by some mid-level traders using model driven pricing that has utterly failed them.
The problem is that once the market sniffs out a big position gone wrong, it will press it until the holder can take no more pain. That’s how a $2 billion problem becomes a $4 billion, then a $6 billion one. I remember in 1998 when Long Term Capital management was trying to get out of a gigantic short volatility position on the S&P 500 in that they sold all the way down to 9%. Buy the time the last position was unwound, volatility was trading at 40%, and it took a year to get there. Needless to say, the LTCM shareholders were entirely wiped out.
Sure, the industry shills and apologists say this is a one off, an aberration, and will never happen again. But remember how Ben Bernanke said the sub-prime crisis was contained? These things have a tendency of bubbling under the surface for a while before they explode and send investors into a panic. Have we just seen the opening salvo of the crash of 2012?
OK, maybe I’m in a bad mood today, maybe the market has beaten me up too much lately, or perhaps I am getting cynical in my old age. But I have seen this script unfold dozens of times in my 40 year career. Remember the nifty 50 of the early seventies, the first gold and silver bubbles, portfolio insurance, the 1987 crash, the Japanese stock market bubble, the Granite Capital fiasco, the dotcom bubble, the China bubble, Bear Stearns, and Lehman Brothers? I rest my case.
This couldn’t have come at a better time for the bears. Suddenly the glass on equity valuations has gone from half full to half empty. Take a look at the charts below and you can see they are sitting on a knife edge. We are right at terra incognito on the maps between the modest 5.8% correction that we have seen so far and breaking towards the more serious 10% or 15% the market so richly deserves. Suddenly the glass on equity valuations has gone from half full to half empty, making them far more fragile than people realize. JP Morgan and the absolute rout that we have already seen in commodities are the writing on the wall.
JP Morgan may have given the bears the firepower they need to break the current support lines. If successful, down 500 to Dow (INDU) 12,200 is in the cards, as are $75 for the Russell 200 ETF (IWM) and 1,280 for the S&P 500 (SPX).
*Post courtesy fo the Mad Hedge Fund Trader.
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