When Something Goes Wrong: The Case of JP Morgan Chase

Managing your investments would be easy if you just bought stocks and watched them move higher.

In your dreams!

In the real world, even the best managers must deal with adversity.  Our choices, no matter how carefully chosen, do not perform as expected.  Something goes wrong.

Dealing with adversity is crucial to investment success.  Tonight we have an informative case study in JP Morgan Chase (JPM), a company that I have cited favorably several times and include in my flagship investment program.  My most recent favorable mention was just this week in my discussion of Europe.

While it is more fun to write about triumphs, it is just as important to think about losses.  Despite my overall record, I certainly make choices that do not work out.  I do not endorse "buy-and-hold." I actively manage every program and every position, constantly reviewing the changing prospects for each investment.

Let us take a closer look at how to handle adversity.

What NOT to Do

There are two basic investment mistakes -- mirror images of failure to analyze.

1. Blindly holding the position hoping that it gets back to your original "buy" point.  This is typical for the average investor.  It is about psychology rather than analysis.  It is buyer's remorse, a desire to undo the losing decision.  "If only I had another chance.....,"  the investor thinks.  This is really stupid.  If the investment is a mistake, this mentality can turn a moderate loss into a  big one.  Some of the biggest companies have gone to zero -- or nearly so.  Check out Worldcom, Enron, GM, Lucent, and many others.  Meanwhile, if the stock actually does recover, it is probably wrong to sell it at the original entry point.
2. Selling instantly and without analysis.  This is a trader mentality, which is fine if you are a trader.  We have all heard about cutting losses and letting winners run.  We also know about "buy low and sell high."  It is more difficult than a slogan.  I listened to some traders discussing this stock and they opinions were mixed.

Analysis, not Paralysis

I can summarize what investors should do in one simple statement:

Review your investment process with the new information and decide accordingly.

You cannot go back and sell at yesterday's or last week's prices.  Each day is a new one.  Suppose that you had no position in this stock.  Would you buy it at the current price?  Is the investment thesis intact?

There are many excellent methods for finding great stocks, so the general advice is to review your own conclusions.  In an effort to be more helpful, I am going to review my own process.

Here is a very brief summary of my own method (further details available on request).

Sector Choice

I try to find a sector that is depressed and unloved.  This is where you shop for value.  You must be prepared for a constant bombardment of pundits on why you are wrong.

Stock Choice

I look for a stock that qualifies on four criteria:

1. It must have a great  business, with strong profit potential.
2. There must be strong management.
3. There must be a near-term catalyst, since no one wants to have "dead money."
4. Corporate financials  -- earnings, cash flow, balance sheet, and risk -- must all be strong.

Regular Review

I constantly review every stock in the portfolio, asking if it still meets the tests.  Analysts who set a stock price target and then wait until it is hit are doing a poor job.  I adjust price targets constantly.  This is why I was able to buy Apple (AAPL) at 63 and hold it through the gains (trimming size to balance the portfolio).  There is no substitute for regular review.

Addressing the Bad News

With this in mind, let us go back to  JP Morgan.  If you are a current investor you should focus on whether the stock is attractive at the current price.  I do not yet have a personal conclusion, since I prefer to analyze more data, but I will share my thought process.

1. Is this still the premier financial business?  Do I still want some exposure to the sector?
2. Have I lost confidence in Jamie Dimon?  On his show tonight Cramer (long the stock in his charitable trust) announced that Dimon was "just like all of the others."  This might be a little harsh, but I have relied on his interviews where he assessed overall risk.  Were these misleading?  Mostly they discussed counter-party risk, but I need to look deeper.
3. Has the potential catalyst changed?
4. What about the new financials?  The question is whether this is a one-time hit or something that affects future operating earnings.  In my experience there have been many "one-hit wonders" where stocks decline on bad news that is a one-time charge (Tylenol poisoning, Intel floating point processor).  The market sells first and thinks later.  The overall earnings picture before the news was very good, as we can see from this chart from Chuck Carnevale's invaluable site.

Preliminary Conclusion

I wanted to write a timely story, and that meant doing it tonight.  We'll know much more tomorrow.  Depending on what I see, I might sell or I might add to the position.  I have clearly stated the criteria.

Emaphsizing the main point:  Do not fall in love with a position.

Each day is a new start.  Be cool and analytical.  If you have a proven method, use it!

Comments

[oldprof]

Virginia -- It is worrisome because JPM was generally thought to have good risk control and Dimon was getting regular reports.

We will learn more about the exact trade (which has been covered pretty well at the FT) but it seems to have been a legitimate attempt at hedging that then got too big. Since Dimon did come forward, we are left to assess what "timely" means.

Interesting comparison.

Jeff

[oldprof]

Angel -

First, the current issue has nothing to do with counter-party risk. I am trying to analyze a problem. It is easy to make a laundry list of unrelated bad things and big numbers, but that is no substitute.

Second, if you do want to discuss the counter-party risk, then you should do a fair comparison with 2008. AIG, for example, made no effort to set up loss provisions for the CDS swaps they wrote. I would like to see a clearing structure for such trades - -the only real solution.

Finally, JPM -- like many others -- also nets positions against a single counter-party.

If you look back at the netting price after Lehman, you will see why throwing around the notional amount is misleading.

Jeff

[Virginia Scanlan]

One has to wonder if the activites of these complex institutions have exceeded the ability of top management to monitor risky behavior. During his Congressional testimony, Fuld said that he lacked the matrix he needed to assess risk in a timely manner. I don't think that he was making excuses. That Dimon missed this is what is so worrisome.

[Angel Martin]

Jeff, the big banks have the following approx notionals for deriatives: 80% interest rate swaps, 10% foreign exchange, 7%cds, and the other 2-3% equity and commodity derivatives. http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq411.pdf (p11).

Now the ISDA says that over 99% of notional is cleared, netted etc.
http://www.risk.net/risk-magazine/news/2074319/half-rate-swaps-cleared-isda

So we are all safe? Lets take interest rate swaps, since they are by far the biggest. As i understand the netting process, for fixed to floating swaps, if JPM has a swap where they pay LIBOR and receive a fixed payment, they also have an equivalent swap where they are paid LIBOR in exchange for fixed payments.

Ok, suppose the counterparty paying LIBOR to JPM defaults. In a financial crisis like that, LIBOR is going to go thru the roof. In 2008 the swap spreads increased by about 1%.

In this scenario, JPM can lose 1% of notional for the duration of the swap (minus posted collateral) on all swaps where the counterparty defaults.

In a scenario with only a single digit swap default rate, JPM loses tens of billions of dollars per year. Given that JPM and the whale managed to lose 2 bil in a calm market environment i don't have confidence that they can survive an environment where swap counterparties start defaulting. And the bigger the derivative notionals, the bigger the problem...

[oldprof]

Isotopes -- The statement that Fed QE instantly goes to bank assets (because the Fed has paid them for the bonds) and is then invested in commodities or stocks is incorrect. The Fed buys from primary dealers. Those dealers had to buy the bonds that they are selling to the Fed.

So the basic story is false.

It is true that some banks have unused cash assets available for investment. Most do not engage in stock purchases and none will be able to do so when the Volcker Rule is implemented. Meanwhile, there is some proprietary trading. There is little evidence that this is unhedged buying of stocks, but also no way to prove the contrary.

This makes it a field day for those who want to claim that Fed purchases are directly propping up stocks.

Someday maybe I can do more, but that is the best possible with the current evidence.

Jeff

[oldprof]

Andrew -- You might be right. There are a number of great journalists working on this, and I learn more each hour.

You are especially correct in noting that when others know the position, it can work against you.

Thanks and more later.

Jeff

[oldprof]

Proteus -- I agree. We are all balancing risk and reward. This was unexpected risk. We need to consider what it says about JPM, and also about other financial institutions.

I have been underweight financials, sticking with only the best, but even that has been too much -- at least so far.

You are correct in noting that we should all re-evaluate the risks and rewards.

Jeff

[oldprof]

Angel -- One of the reasons for this article was to explain why it is usually wrong for investors to shoot first and think later.

You assume that the other aspects of the derivative portfolio were more complicated than this. I suspect the contrary.

On European CDS swaps, for example -- these are relatively plain vanilla trades using the ISDA master agreement and standard term sheets. You can do many of them with different prices, but it is the same trade.

Would we prefer to see all of this on an exchange, with complete transparency? Sure.

Meanwhile, to pretend that it is some big mystery is just another way of scaring investors, who could use some returns.

To summarize -- there is no reason to believe that the rest of the JPM derivative book is more complicated than this trade, and plenty of reason to think that this was the toughest to evaluate. But I am still collecting information.

Jeff

[Isotopes]

Jeff,

I have a question for you. I was reading Harry Dent's latest commentary (I'm not a big fan of him by the way) and he implied that JPM and other bank are using the Fed's expanded balance sheet to invest directly in the equity market.

I thought that's not how the QEs worked and what he describes is not possible or perhaps even legal.

Are banks able to do this?

[Andrew]

Risks are based on probability and they are always present. You can understand the market completely now, and still lose in the future. If you only lose 30% of the time you're doing very well.
My take: I assume it was a theoretically fantastic, cost-efficient hedge using locked-in contracts. But the newspaper stories about Bruno's trading made other funds take positions against the hedge, and those positions revalued the market. JPM took losses to break the contracts and adjust the hedge.

[Angel Martin]

Jeff, if JPM couldn't understand the risks in their credit quality hedge portfolio (or whatever the "whale" was doing), how much confidence can you have that they are properly netting/hedging their derivatives portfolio, which is much larger and more complicated?

[Proteus]

I own JPM, and have always considered them to have top-notch management. I still do. That said, I am rethinking my financial holdings. I now have to consider the possibility (hopefully a small possibility) that the financial investing landscape has become so complex or difficult that even good management is increasingly likely to make large mistakes.

[oldprof]

Angel -- I am analyzing this openly and honestly.

The $70 trillion notional comment is really beneath you -- unlike your typical analysis.

We both know that there is a netting process and analysis of counter-parties. Dimon has been pretty open about analyzing that aspect, and that was not called into question today.

So let us keep a grip on reality, and be fair in our analysis.

If you want to join those who reject all information, then go ahead. I prefer to evaluate all sources.

Jeff

[Angel Martin]

Jeff, in our previous posting, you asked the question (paraphrasing): "is there systematic risk of a credit lockup like 2008?"

Who knows?... but these big banks like JPM specialize in hidden risks. Dimon was claiming that the "whale's" position were hedges.

Since the risks of the big banks are hidden they can only be guessed at. But one metric is total debt outstanding. The more debt, the more hidden risks and the greater the fragility of the system to a shock.

The big banks and bank holding co's have not delevered, they have more debt than 2008...

http://federalreserve.gov/releases/z1/Current/z1r-4.pdf

oh, and what about JPM's 70 trillion notional derivatives contracts ?

http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq411.pdf

not to worry, Jamie Dimon assures us that they are hedged...