During the past week there has been a buzz around the financial world of J.P. Morgan Chase’s astounding loss on its derivatives position. This has prompted more calls from the economic pundits to declare that Wall Street really, really needs a major regulatory overhaul. The first in line to criticize this bad performance was President Obama who wants tighter regulation and more government intervention.
Now, I understand that a great many people have no idea what a derivative is, and why such a big loss. They just plug in two very painful variables in their skulls: Wall Street and losses; They then demand more regulation and more taxes being bore on these reckless Wall Street tycoons. But simply put, how was this loss generated? Well, in this case, J.P. Morgan tried to come on top this financial quarter with a bunch of bets that didn’t pay out.
What they did was go into long and short positions on certain indices, stocks, interest rates etc., and lost. To keep it simple, a firm can enter a derivatives contract by entering a futures contract. Lets say that J.P. Morgan entered a futures contract to buy the NASDAQ 100 May Futures for 1000 dollars. This means that J.P. Morgan is expecting that a rise in the NASDAQ index in May. If the NASDAQ 100 contract on the open market is worth more than 1000 dollars, than J.P.Morgan will receive the difference the difference of 1000 dollars and the market price at that future date. just a remainder: Derivatives are a zero-sum game, especially when concerning cash settlement.
Digression:Farmers enter derivatives contracts to hedge against uncertainty in prices. A farmer may want to sell his crops 5 months from now, but doesn’t know the price of wheat at that period. He then enters a future contract, selling a contract into the future (going short). He then, locks in the price of his crops. If the price collapses in five months, he is still assured that he will sell his crops for the price stipulated in the contract.
To continue, we may suppose that todays price of the NASDAQ 100 is 950 dollars or 3000 dollars (for the sake of argument, lets suppose that these doesn’t matter at the moment). This really has no bearing on the contract. The only thing that matter is whether a loss or gain will be reported at the end of the period.
In May, the NASDAQ 100 is priced at 900 dollars on the open market. (Assuming the contract isn’t closed out before the end of the period). J.P. Morgan is now in a losing position, and because it is a cash settlement, the bank must pay 100 dollars to the side that took the short position. (When entering a derivatives contract, one side takes the long (betting on a rise in price), and the other side takes a short position (expecting the price to fall). And that’s really all that is to it.
The game gets more complex when complex structures are used. Usually these speculative instruments in a chained (using multiple call and put options on interest rates swaps that are reverse floaters etc.) manner, or following correlations between a liquid asset and a thinly traded index. it doesn’t change the sustenance of the game. One speculates a rise, and the other a fall. This of course is NOT HEDGING. A hedge would be to go in a offsetting transaction to the one have already entered. This example was not the case.
Now lets briefly examine what might be the governments role in causing this:
1. Cheap funds that allow banks to gamble freely without any prudence regarding risk
2. The limits to invest or leave certain assets without closing out previous positions
3.The ability to speculate and take margin positions by depositing risk-free securities as collateral (easily available government securities) (a cheap source of leverage)
4. Tax implications and pervasive incentives regarding investments in certain asset classes
5. Making exceptions on positions on one asset class, while allowing it on others
6.Entering a trade because of an explicit government guarantee on a certain asset class (masking the assets true value).
This is just a short list of government meddling. When the monetary authority (central bank) steps in, it gets even more perverse, but you get the general idea.
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