Clearing The Bull: JP Morgan And Derivatives Derangement Syndrome (DDS) Part III

Some of the attacks on JP Morgan are indicative of the extent to which governments, regulators and the media understand neither risk nor banking. This is the third in a series of articles on the JP Morgan derivatives loss—here are the links for Parts I and Part II.

What is Derivative Derangement Syndrome (DDS)?

It is when the fear of derivatives becomes so irrational that it renders the victim either unwilling or unable (sometimes both) to see derivatives for what they are, or to come to terms with potentially greater threats to the financial system and the economy. It is a dangerous malady.

Politicians, regulators and the media all suffer from this particular malady and it stems from their complete misunderstanding of what constitutes risk. The answer is of course that derivatives are not the only risk—there are other more serious risks that are even now being overlooked. One of those risks is the dangers of overinflated IPOs.

The Facebook IPO, while not yet a disaster, is proving as damaging to the financial markets as JP Morgan’s derivative losses. The total IPO was US$16 billion and already some 15% of that value, or US$2.4 billion has been wiped out—somewhat more than the initial loss at JP Morgan.

The only reason why this loss isn’t more is because according to Forbes the lead underwriters, one of which happens to be JP Morgan, are still holding onto some US$12 billion worth of stock—that’s 75% of the total issue. If the stock price continues to go further south the banks, including JP Morgan, will be nursing some big losses.

In addition, since the Facebook IPO, the NASDAQ has fallen and with it a host of technology stocks. Should we be surprised?

Apple, the greatest technology stock of the era has a price earnings or P/E ratio of 10, which means the price of the stock represents 10 years of earnings. For Facebook the P/E ratio, based on the forecast earnings for 2012 is almost 100—in other words the stock is way overpriced.

Overpriced stocks and IPOs cause great damage to investors, to markets and ultimately economies. We already know this from the dotcom crisis of the turn of the 21st century. Moreover, Facebook is now valued at some US$100 billion and the holders of that stock will use their new-found wealth to acquire and generate price bubbles in other technology stocks—and so on and so forth, creating a mini-bubble of its own. Further, many are even saying that there was a tech stock bubble before the Facebook IPO.

However, nobody is talking about either Congress or the FBI investigating the Facebook IPO. While we are thankful that this is indeed the case, we need to recognize that this asymmetric approach to banking regulation is a direct consequence of DDS.

As we noted in the first article, the biggest and most consistent cause of financial crisis is credit, and the making of ordinary loans and mortgages. In that regard, the US and Europe have had very similar experiences and it is highly instructive.

In the US, the subprime crisis was caused by poor credit controls allied with poor lending. Poor borrowers took on mortgages they could not afford, which led to inflated house prices, which was followed by a collapse in the housing market, which in turn created huge losses in the financial markets.

This sequence of events has been replicated in Europe with a slight twist, most notably in the countries which collectively became known as the PIGS (Portugal, Italy, Greece and Spain). In all instances, the financial crisis was as a result of poor credit and lending.

In Spain and Ireland, huge amounts of lending found its way into the property market resulting in an almost uncontrollable boom. The collapse of those property markets proved to be the most decisive factor in the collapse of those economies. In Greece and Portugal on the other hand, it was the countries themselves, rather than individuals, that were the subprime borrowers, as they took on unmanageable levels of debt.

In the meantime, that has not stopped governments on both sides of the Atlantic from encouraging bankers to lend as much money to businesses as they possibly can in order to get the economy growing again. According to governments, derivatives are risky but lending clearly not. Go figure.

The real problem however is that if because of DDS, governments and regulators only focus on derivatives as the source of risk, they are unlikely to create the right framework and adopt the right policies that might assist us all in avoiding the next disaster.

Those of us who are literate in the ways of banking and the financial markets, and judging from what one sees in the media we are but few, have a solemn duty to educate governments and regulators along with the rest of the world. In doing so we should do our very best to highlight and continually reinforce the following points:

  1. To date, there have been no major derivatives crises
  2. Poor credit decisions, bad lending and the resulting price bubbles in both property and financial assets, have and continue to be the source of major financial crises
  3. The history of the past 40 years of crises, LDC debt, Junk Bonds, Japanese Asset Price Bubble, Dotcoms, Subprime and now European debt, all prove this
  4. While banks have by their very nature and behavior facilitated these crises, and do need to undertake their own human transformation, they have not been their primary drivers
  5. The primary drivers of crises have been the individual and collective failure of governments in addressing national, regional and global economic imbalances
  6. These failures are a direct result of the very nature and structure of government itself e.g. European political disunion, US Congressional gridlock and national election cycles
  7. Unless and until governments come to terms with these issues, they and not bankers, will continue to be the primary drivers of financial crises, and by definition
  8. The regulation of banks and financial markets will continue to prove inadequate

Jonathan Ledwidge is the author of the book Clearing The Bull: The Financial Crisis and Why Banks Need a Human Transformation. Using simple language, the book explains why banks are only partially to blame for the financial crises and how and why they need to change in order to become more economically and competitively sustainable.

Use this link to give your opinion on the performance of banks post the financial crisis.



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