Weekly Financial Market Update
StrategicPoint of View®
May 14, 2012
Welcome to the StrategicPoint of View® -- a market and economic overview of what occurred last week, what's up for this week, and our commentary on the economy and current market activity in general for "Making Money" listeners.
LAST WEEK
Weekly jobless claims came in at a pleasing 367,000, while job openings
increased to 3.74M. The federal budget showed the biggest surplus in 25
years (don’t get used to it). Producer prices fell, helping to put the
lid on inflationary fears. And consumer confidence vaulted to 77.8
marking the ninth straight month of improvement.
Overseas, the political fallout from the French and Greek elections
continued to roil the markets. New leaders are rejecting austerity
measures designed to reign in runaway spending and debt. Market
sentiment has turned negative as confidence in a political solution to
the euro-zone troubles wanes.
JP Morgan, the largest US bank (as measured by assets) fell 9.3% on
Friday following an announcement that the company had a $2B trading loss
on synthetic debt securities designed to hedge its portfolio risks.
S&P 500: 1,353 (down 1.17% for the week and up 7.64% on the year)
NASDAQ: 2,934 (down 0.74% for the week and up 12.63% on the year)
Dow: 12,821 (down 1.66% for the week and up 4.94% on the year)
US Treasury 10 yr: 1.85% (from 1.89% last week)
Crude Oil (June): $95.57 (from $98.60 last week)
Gold (June): $1,580 (from $1,643 last week)
USD/Euro: $1.2916 (from $1.3085 last week)
THIS WEEK
It is a busy week for economic data. CPI, retail sales, housing starts
and building permits, industrial production, initial job claims and
leading economic indicators will help determine how strong the US
economy is. The Federal Reserve releases its minutes from the April
24-25 FOMC meeting. And Facebook prices its initial public offering
COMMENTARY
Gatekeepers of the Economy
On last Friday JP Morgan Chase demonstrated that banks - deemed too big
to fail - are still taking on risks similar to the ones that propelled
the world into the 2008 crisis. Let’s be clear: what happened at JP
Morgan is not contagious, and the US economy is not in danger because of
it. However, if the best of the banking breed can make a
‘self-inflicted’ egregious ($2B ) blunder, what are all the other less
stellar banking institutions doing with regard to risk management (or
lack thereof)?
We hold our biggest banks to a higher standard than other corporations
for good reason. These banks are the gatekeepers to the global economy;
they help to control the flow of money. When money dries up, so does
economic growth. The big banks are viewed as so important that
governments may choose to prop them up in bad times (2008 in the US and
2012 in Europe). In turn, banks are asked to behave in predictable ways,
lend money in order to grease the economy, protect depositors, and hold
enough capital in reserve to cover any mishaps along the way. To do so
banks must effectively manage a variety of risks.
JP Morgan started out to do the right thing: control the risk in its
proprietary (not client related) portfolio. The bank had more money in
deposits than were needed to fund its lending program. The excess money
was used to buy investment grade corporate bonds. Believing these bonds
were solid investments, the bank sold insurance in the form of
derivatives called credit default swaps on a basket of these corporate
bonds. With the fees the bank made from selling the insurance, it hoped
to cover any unexpected defaults. If there were no defaults, the fees
became profits.
As the economy gained speed last fall and into the first of the year,
the hedge proved to be a major money making venture. So good were the
profits that JP Morgan used the same trade to protect other parts of its
trading portfolio. In the end, JP Morgan sold $100B of its derivative
insurance product – placing an outsized bet on one trade.
The profits were good until economic sentiment turned sour in March. JP
Morgan then found itself trapped with too many obligations. When the
bank started to unwind the play, hedge funds and other institutions
realized the massive position JP Morgan had taken and actively bet
against the bank’s insurance portfolio and the corporate bonds it held.
The result: enormous losses that had to be acknowledged publicly, which
CEO Jamie Dimon did on Thursday.
Jamie Dimon has been a strong advocate against regulations enacted
following the 2008 crisis, especially the “Volker Rule,” which would
impose limits on the kinds of trading risks banks can employ. The goal
of the rule was to limit abuse in risk management. As it stands,
however, the Volker Rule now would exempt derivative trading when it is
used as a hedge, as JP Morgan claimed it to be.
The Federal Reserve and the US Treasury have been in support of flexible
rules with regards to portfolio hedging. The Securities and Exchange
Commission, the Commodities Futures Trading Commission and the Federal
Deposit Insurance Corporation are in favor of tighter restrictions.
Final rules, as part of the Dodd-Frank law, are to be adopted this
summer. In the interim, expect support to grow for more regulatory
oversight, based on the JP Morgan debacle.
JP Morgan seemed to forget its role as gatekeeper of other people’s
money – both their own depositors and the community and nation it
serves. Perhaps too much over-confidence and hubris fed a view of
prowess that cannot fail. Just look at AIG, Bear Stearns and Lehman
Brothers which – to some degree - were all victims of their own success.
It is very unlikely that JP Morgan will falter, but the bank serves as a
reminder that risks to the financial services industry are still very
much with us. As gatekeepers, large institutions either manage their own
risks, or rely on someone else to do it for them. The JP Morgan case,
along with the recent MF Global collapse and the $2B loss at UBS by a
rogue trader, support the view that financial institutions (gatekeepers
or not) continue to need strong oversight. We look forward to a day when
banks and their partners can, for the most part, monitor themselves.
This past week JP Morgan Chase reminded us that they aren’t there yet.
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*Past performance is not indicative of future results. Indices are
unmanaged and you cannot directly invest in them. The Nasdaq Composite
Index measures all NASDAQ U.S. and non-U.S. based common stocks listed
on the Nasdaq Stock Market. The S&P 500 index is based on the
average performance of 500 industrial stocks monitored by Standard and
Poor’s. The data referred to above was taken from sources believed to be
reliable. StrategicPoint Investment Advisors has not verified such data
and no representation or warranty, expressed or implied, is made by
StrategicPoint Investment Advisors.
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