In the light of JP Morgan’s stunning losses on derivatives with
the full scope of total potential losses still not yet clear. But the
real losers in this turn of event are not limited to J P Morgan and its board
but it covers many more.
1) CDS as an instrument: It has revitalized critics who have started
talking against credit default swaps as unmanageable and its effectiveness as
hedge instrument. Critics are panning
CDS down as an instrument but they are forgetting that, it was stupidity of
position takers not the instrument itself which resulted into this loss. Taking
such a big position on illiquid vintage CDX 9 series (current one is CDX 18) is
recipe of disaster. Once market knows that you have such a huge concentrated
position it will make exit troublesome. It
was excess of credit which brought financial crisis not access to credit, same
way the use to leverage their balance
sheet by financials like Lehman and AIG created
problem not CDS since CDS is still an effective hedge instrument which diversify
risk to broader set of investors.
2) Regulators: In the
spring, JP Morgan passed the Federal reserve test with flying colors. The Fed agreed to
let JP Morgan increase its dividend and buy back shares. There was no hint in
the stress tests that JP Morgan could be facing these kinds of potential
losses. Since regulators mostly rely on model used by banks, which is
generally designed by so called “Quants”.
There may be call to have a deeper look at those internal models,
rightly so !
3) Regulation: There is a very thin demarcation line between hedge
and prop trading, prima facie it looks like the huge position taken by CIO
office was atleast bordering on the prop trading. Such activity will be illegal
under Dodd Frank act (Volcker rule), and this incidence will reinvigorate the
demand for more stringent regulation. However, in the aftermath of financial
crisis we need smart regulation not more regulations. Heavy regulation will curb credit which is
required for economy to grow. So we need more prudent regulations and regulators.
4) More bad news to follow: Even though James Damien said
"just because we were stupid does not other are also is not true" may
be a very optimistic assessment of his peers and there might be a few more bad news
to follow. Since in OTC market, it’s the herd mentality which rules.
5) Rating of Financials: Rating
agency "once bitten twice shy" may consider to take action on
individual name or financials as a whole. Not a good omen for banking.
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