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Simon Johnson: JP Morgan at Risk if Euro Breaks Up

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I’m surprised it has taken this long for Someone Serious to make the argument set forth in a new article by Simon Johnson at Bloomberg, which in short form says “You are dreaming if you think a European financial crisis stays in Europe.”

Johnson somewhat undercuts the urgency and importance of his article by working from the assumption that the eurozone dissolves back into its earlier configuration of one currency per nation. Economists and analysts have discussed other scenarios, such as a exit by Greece, which has the potential to precipitate contagion in Portugal, Spain, and Italy; an exit by Germany; a split into more economically homogeneous sub-groups (most likely north v. south). And Bloomberg refrains from putting the real sizzler in the headline: Johnson considers JP Morgan to be vulnerable and explains why.

No matter how you look at it, the most important step that needed to be taken to prevent the recurrence of a global financial crisis was to reduce the interconnectedness of the major players. That has not happened to any meaningful degree. There are efforts underway to move more activities to clearinghouses, but nothing is operational, and the industry is working hard to limit the scope of these plans. So despite all the brave talk about how much better capitalized the big banks are, they’ve beaten back, delayed, and weakened efforts to deal with the biggest source of risk.

Johnson flags one major risk: what happens if a country exits and by legislative fiat, redemoninates contracts entered into by its government, and say, by the banks it has chartered, from the euro to a new domestic currency? That question has gotten some attention with regards to Greek bonds, with experts focusing on how many bonds are governed by Greek law, where the government could redenominate them by fiat, versus those governed by UK law (note that Johnson finesses that issue by positing the dissolution of the eurozone, meaning the euro no longer exists). And with the restructurings of Greek debt leading to new, senior borrowings being put in place, the older Greek law bonds are subordinate and less of a source of bargaining leverage than they once were.

Nevertheless, there is a much more basic reason to be worried. If any country were to leave, it would redenominate the currency of deposits held in domestic banks. For any periphery country, the value of the new currency is presumed to be lower than that of the euro. So depositors lose.

This concern has led to deposit flight from Greek banks and slower-motion runs on other periphery country banks. If Greece were to exit, it isn’t hard to imagine an acceleration of deposit departure from banks in periphery countries. The ECB could step in, but Germany officials have repeatedly nixed the idea of deposit guarantees in the absence of a banking union, which is not something you put in place on a crisis timeframe.

Johnson focuses his worries on the biggest source of excessive connectedness, derivatives, and also debunks JP Morgan’s “fortress balance sheet” claim:

For example, in recently released highlights from its so-called living will, JPMorgan Chase & Co. revealed that $50 billion in losses could hypothetically bring down the bank. (All big banks must provide their regulators with a living will to show how they could be shut down in an orderly fashion if near default.)

JPMorgan’s total balance sheet is valued, under U.S. accounting standards, at about $2.3 trillion. But U.S. rules allow a more generous netting of derivatives — offsetting long with short positions between the same counterparties — than European banks are allowed. The problem is that the netting effect can be overstated because derivatives contracts often don’t offset each other precisely. Worse, when traders smell trouble at a bank that has taken on too much risk, they tend to close out their derivatives positions quickly, leaving supposedly netted contracts exposed.
People with experience regulating or analyzing financially distressed institutions greatly prefer to measure potential losses with the European approach, in which netting is allowed only when contracts expressly incorporate settlement on a net basis under all circumstances.

When one bank defaults and its derivatives counterpart does not, the failing bank must pay many contracts at once. The counterpart, however, wouldn’t provide a matching acceleration in its payments, which would be owed under the originally agreed schedule. This discrepancy could cause a “run” on a highly leveraged bank as counterparties attempt to close out positions with suspect banks while they can. The point is that the netting shown on a bank balance sheet can paper over this dynamic. And that means the JPMorgan living will vastly understates the potential danger.

According to my calculations with John Parsons, a senior lecturer at MIT and a derivatives expert, JPMorgan’s balance sheet using the European method isn’t $2.3 trillion but closer to $4 trillion. That would make it the largest bank in the world.

What are the odds that JPMorgan would lose no more than $50 billion on assets of $4 trillion, much of which is complex derivatives, in a euro-area breakup, an event that would easily be the biggest financial crisis in world history?

Note that the issue isn’t the magnitude of exposures to a single counterparty; one defaulting counterparty leaves supposedly netted positions suddenly not netted all across the banking industry. That leads to more defensive behavior, namely, cutting exposures (say by increasing haircuts or closing out positions) with the weakest players. That of course pushes them closer to the brink. In the worst of the crisis, banks weren’t able to repo Treasuries, that’s how extreme the fear of counterparty exposures had become. (For those who want to know more, Lisa Pollack provided a great primer on gross and net CDS exposures; it gives a simplified but useful example).

And the $2.3, or per Johnson and Parsons, $4 trillion of JP Morgan “balance sheet” exposures don’t tell the whole story. Banking expert Chris Whalen has described JP Morgan as a $2 trillion banks attached to a $75 trillion derivatives clearing operation. Why do you think, when Lehman and MF Global got wobbly, that JP Morgan became more and more difficult to deal with? Because their role as clearer made them particularly exposed.

Now you might say, “didn’t JP Morgan submit a preliminary plan for an orderly wind down? Surely we can manage this sort of thing now.” Don’t hold your breath. Top bankruptcy lawyer Harvey Miller objected to the decision to put Lehman into bankruptcy in haste, warning that the failure of a mid-sized broker/dealer (and Lehman was clearly bigger that) disrupted markets. JP Morgan’s outline assumes (and the FDIC has taken up this line) that in a worst case scenario, the authorities can wind down the holding company, wiping out equity holders and cramming down bondholders as needed, and keep the operating subs going. The problem is that neither the FDIC speech on this topic nor the JP Morgan presentation deal with derivatives, collateral, or repo. Derivatives contracts are not at the holding company level but are booked in the depositary. I’m told foreign counterparties would seek to terminate these agreements, and sources guesstimate that 30% to 50% of JP Morgan’s derivatives agreements are subject to UK law. Thus it is not hard to imagine that distress at the holding company will prove difficult to contain. In other words, there is likely to be a considerable difference between how the Orderly Liquidation Authority works in theory versus in practice.

Johnson’s warning is clear: a eurozone crisis is not likely to be contained, and the biggest US banks are exposed. And it is looking more and more likely that we’ll find out whether the regulators can, as they insist, manage a big bank failure without engaging in massive bailouts.

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28 comments

  1. tulsatime

    There can’t be any doubt that, sooner or later, the Central’s will not be able to save everyone. That is when the cascade begins, and Mr market finds out how much worthless paper makes up those trillions of balance sheets. None of the TBTF will survive if that slide starts, so they will break the Fed before they let it happen. Maybe they can peel off BOA this time for sacrifice and delay the total collapse for another cycle?

  2. psychohistorian

    So when this house of private cards falls down will anyone question the global inherited rich about our society that is their ongoing creation?

    Or will we continue on like F Beard, complain about the bankers and money, quote scripture and take our Shock Doctrine austerity like good complacent faith breathers?

    1. Mansoor H. Khan

      “complain about the bankers and money”

      Complaining is not enough. The public has to understand money and banking and rethink it. God helps those who help themselves. We need to do our part and make a serious effort to understand our situation.

      We need to continue to teach each other the truth (how modern banking really works) and the resolution will follow via consensus.

      Here is how the bankers’ game works:

      http://aquinums-razor.blogspot.com/2011/11/here-is-how-bankers-game-works.html

      mansoor h. khan

      1. Warren Celli

        Mansoor H. Khan said; “We need to do our part and make a serious effort to understand our situation.”

        Situation analysis: The aberrant diseased Xtrevilist rich people are screwing the poor people. Over time they have gained control of global governments and their respective institutions through use of the Noble Lie and their self centered secessionist traitorous corporations. They are exploiting us and killing us physically with their combined military might and psychologically and emotionally with their combined media might.

        Understanding; how banking works, the ins and outs of how the bogus EU was crammed down the people’s throats, gps drone navigation systems, the idiosyncrasies of Mikuni downdraft carburetors, or the science of gunpowder, etc., will not get you jack sh!t.

        All you really have to know is that the fat sick parasitic pigs have taken far more than a fair share of life’s pie, have a gun to your head, and you need to devise strategies to get it back outside the frame work of their non responsive to the will of the people repressive systems.

        Deception is the strongest political force on the planet.

        1. Mansoor H. Khan

          Warren Celli,

          Do you have any practical/actionable suggestions for how to improve our situation?

          mansoor khan

    2. F. Beard

      I don’t so much complain as brain-storm how money should be implemented.

      Bankers aren’t the problem, banking is.

    1. DP

      If you think the “analysis” of the self promoting clown Reggie Middleton is all you need, why don’t you stick with Zero Hedge?

      1. Tinky

        An ad hominem attack is all that you muster? I’m not a particular fan of Middleton, but if you believe that Zero Hedge doesn’t have significant value, then you should take your own advice and spend a bit more time there.

        1. Yves Smith Post author

          Most hedge fund managers I know quit reading ZH a long time ago. They are wrong more often than they are right, particularly on macroeconomics and the credit markets.

          1. DP

            Worse than being wrong, they are fast and loose with the facts and “Tyler Durden” and his Amen Chorus will go after anybody who points out factual errors like a pack of wild profane dogs.

          2. Tinky

            I consider ZH to be primarily an aggregator. There is no doubt that some of what it posted is poor quality, but some is quite the opposite.

            I do agree that the quality of comments, broadly speaking, leaves quite a bit to be desired. But if one is willing to ignore the noise, there is plenty of information of value to be found.

          3. Tinky

            Yves,

            Coincidentally, ZH has just penned a post on the “Shadow Banking” system. I can follow the broad strokes, but ultimately it is too technical for me, and I would be interested in your take.

            Thanks.

        1. DP

          If somebody could actually read one of Middleton’s self congratulatory rambling poorly written pieces that is full of links to other self congratulatory rambling poorly written pieces and and actually say what the heck he is trying to say I’d appreciate it.

  3. vlade

    I believe it would be relatively simple to revert the flow of the funds from PGS to Germany – say for Germany to enact a law that deposits for domicile that leaves EUR will be automatically redenominated to the new currency.

    Since technically the country leaving EUR would be leaving EU as well (or close enough, if they did it unilaterally), it would not be breaking EU law on intra-EU capital controls (until break it doesn’t, after break the leaver is not in EU so the same).

    All of sudden German banks would not be so safe for periphery depositors, who could then choose either to flee to UK/US (which is not costless, especially with the current FX volatility), or stay at home.

  4. Conscience of a Conservative

    There are lots of reasons to say JP Morgan is too big and should be broken up, but talking about its exposure to Europe is non-sense. If Europe falls apart we’ll have much bigger problems to deal with than JP Morgan.

  5. Norman

    So, isn’t it the law of averages that the top gun (JPMorganChase) goes down, considering all the players involved?

  6. Susan the other

    So now I’m more confused than ever. It is good to have an interpreter for Simon Johnson, however. Thanks Yves. I’m lost on every sentence. And wondering what the FDIC can do if it is left to restructure a big bank holding a mountain of unsettled derivatives? Does the FDIC have a living will? What is the rationale behind putting the derivative contracts to be paid in the depositary? And Lisa Pollack’s article was a good primer, but not easy to understand by any stretch of the imagination. I’m so lost I can’t tell a joke from a fact like when she asks “So why does such a small amount (freak out) the political world?” Is the political world turning this into a huge distraction? Why all the talk about 1.4 quadrillion in notional derivatives, etc? If it’s no big deal why is Germany so adamant about protecting the Euro (i.e. Germany itself) and refusing to allow funding directly to various banks unless those governments co-sign or until there is a fiscal union? One of my assumptions was that Germany was protecting itself from a mountain of CDSs. I’m too dumb to jump into this and try to understand it. We need a tutorial for dummies please.

    1. charles sereno

      I’m also a dummy. One of my first questions would be: Since everyone has been talking about Eurozone problems forever, even laying odds on exits and break-ups, why haven’t bank depositors in, say, Greece or Spain not panicked as we did in the US bank runs of ’32 and ’33? I understand that there has been some drainage, but that’s not a sufficient explanation. Any help?

  7. pebird

    I think that by definition you can’t have an orderly wind down of a TBTF institution. It’s putting lipstick on a slice of ham.

    Financial globalization sure plays havoc with national governments, money is more fungible than public policy. Don’t like a law or regulation? Move the exposure to another domicile and play the shell game.

  8. proximity1

    “Simon Johnson: JP Morgan at Risk (n?, v?) if Euro Breaks Up”

    “So despite all the brave talk about how much better capitalized the big banks are, they’ve beaten back, delayed, and weakened efforts to deal with the biggest source of risk (n).”

    “Johnson flags one major risk (n):”

    “when traders smell trouble at a bank that has taken on too much risk (n), they tend to close out”

    Question: Are economists clear about when the term “risk” denotes a verb and when it denotes a noun?

    Does “risk management” concern the noun, the verb or both?

    Don’t some uses of “risk” actually refer to “liklihood” or “probability”? And, in those cases, isn’t it usually in not always the case that in fact, that “risk” is simply impossible to measure, quantify, evaluate—though their usage implies that they are doing just that, measuring “risk”, as probability of some peril, danger– the damage or loss of “X”, as in the liklihood that “X” is lost, apart from the actual consequences of the loss of “X”?

    I gather that sometimes “risk” is a verb and then it often means something similar to “wager,” “venture” (v) or “bet” (v).

    Other times “risk” is a noun, but it isn’t always clear to me when that term means “peril”, “at peril”, or “probability,” or “liklihood”–as in “the risk of failure is immense,” and when it means a quantity, as in “we risk much (or little) by this course.”

    When “risk” refers to probability of some event “X” occurring, then, with regard to market-behavior, I’d argue that those using it to suggest that their (or some other’s) “risk(s)” are “managed”–i.e. “covered”, “insured” against lost, simply don’t know what they are talking about, are kidding themselves and whomever they’re talking to, as well.

    In the case of Europe’s (and the world’s) danger of some, many, most or even all of European nations falling into default, or their banking system as a whole, both the “risk” as quantity and the “risk” as probability is simply beyond anyone’s means to measure, to calculate, to predict.

    And even if the risk of partial or total failure, default, that is, the liklihood, is nearly immeasurably small, the “risks” (consequences) of that failure are beyond our means to measure in either their probabilities or their magnitudes.

    I think we need better, clearer terms and a sounder practice in their use.

  9. emptyfull

    I’m thinking that Simon Johnson will be considered “Not Serious” in 5, 4, 3 …

    Actually, I’m shocked he’s been allowed to take part in any official deliberations whatsoever. He’s been very persistent in naming the TBTFs as the greatest threat to our economy. Doesn’t seem bought off in the slightest.

    1. Capo Regime

      Just wait–they will dig up a skeleton in his closet or set him up with a hotel maid.

  10. sunny129

    JPM has 2.3T in assets and almost 2.1T in liabilities with net assets= 200B!

    Derivatives exposure with re Euro/int rate swaps W-T-F knows!

  11. Fiver

    Can’t agree. Several comments:

    First and foremost, I’d hazard it is the EZ banks and sovereigns that need to fear JPM, not the other way around. JPM is essentially fused with the Fed/Treasury and mediates that relationship with other CB’s and peers (DB etc.) – as noted in the piece, most deeply with the Bank of England via its Wall Street/London hall of mirrors multiverse of derivatives. Its solidity (and those of the other giant US banking entities) are considered of vital US “national security” importance, meaning the outcome of any real contest of wills re EZ entities is a foregone conclusion. The idea that Germany (or anyone else) has “leverage” on the US is as implausible as that Greece (or any other EZ/EU country) had/has “leverage” on Germany via “If we go down we’re taking you with us…” thinking. That is in my estimation the same sort of perverse logic that drives hysterical fear that Iran, if it ever did get a nuke, would invite suicide by hitting Israel, because Iran’s leadership is “irrational”.

    The framework, therefore, that ex-IMFer Mr. Johnson and so many other milquetoast “reformers” argue within is in my mind the opposite of truly serious. The simple fact is that an authentic seriousness in the face of the imminent prospect of “Financial Armageddon” would generate SERIOUS responses. We have at no point seen that sort of response, rather, what we’ve witnessed is a massive effort to keep thinking and policy as close to the centre of the inside the box as possible.

    It is a “given” that precisely those instruments that made financial systems’ transnational interconnectedness so dangerous in the first place are those about which nothing can really be done, digital, globalized derivatives/hedging being at the core. How does one limit wider damage from failure of TBTF banks if 1 large entity can be split into 5 smaller ones, but the degree and types of interconnectedness in toto remain the same, and the same criminal class runs them all?

    Seriousness would mean treating this situation at any point since roughly mid-2007 as if a lethal global pandemic was underway and The Scientist says it’s game over inside of 3 days if we don’t take decisive action immediately. We’ve seen nothing remotely resembling that.

    Close “markets”? Unthinkable. Capital controls? Certain Death. Void CDS? God will smote you and flush your remains.

    We’ll know it’s getting truly serious when our best minds are actually directed by elite leadership itself towards supplanting this vicious system of endless looting and public pain for the majority, not perpetuating it, because they actually fear consequences. They do not.

    For now, there are far more imaginary balance sheets and other ingenious toys in the bag of joke solutions than there are honest fingers to pluck them.

    TPTB have consistently been a great deal smarter than we are. I wouldn’t be expecting anything so dramatic (and lucrative) as a Lehman just yet. A scare? Sure. Because it pays off big time for insiders who do not care about the public interest and as noted is an exercise in power. But the real crunch is at least a couple years out. I can only hope (anyone got a better word? that one’s ruined) the politically aware portion of the public is better prepared to respond than last time around – they certainly aren’t up for it now.

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