By David Schawel, CFA, Economic Musings
I could write a whole post on whether this whole JP Morgan trading loss is being under or overstated but I won't. For the record, I think given that the $2bil loss, which is ~0.5% of JPM's total capital, shows that the magnitude is being a bit overstated. Nevertheless, the concerns of the critics are reasonable. Does Dimon even know what risks JPM is taking? How can the banking industry keep any semblance of credibility when the most conservative of the TBTF's had a massive risk failure? I digress to my main point.
Wealth effect & impact of QE
It is well established that Ben Bernanke is a big proponent of the "wealth effect". That is, if the stock market is higher people "feel wealthier" and thus react accordingly. The mechanism of this is also clear and straight-forward. The Fed has purchased trillions of dollars worth of US Treasuries, Agency Debt, and Agency MBS. How does it work mechanically? The Fed sends newly created reserves to banks and in return receives the securities. So while no new "net financial assets" are created, fewer securities are in the financial system and a whole lot more reserves. This is what many refer to as "printing money".
As I've talked about here and here QE has undeniably pushed up asset prices. We have 30yr current coupon Agency MBS with a yield under 3%, IG spreads at ~200bps, and higher grade non-agency MBS yields pushed down to 4-5% in some cases. Let's not forget covenant lite deals returning in the levered loan space. Mortgage REITs have quintupled in asset size as investors salivate over 15% yields. (Hint: levering up 8x on a 2.75% asset which is hedged using swaptions is no slam dunk. These will blow up at some point). No need to go on any further. As my friend likes to say, this is the "great incredible paper chase".
Amount of excess reserves is NOT caused by lack of lending
As we have gone over so many times, the quantity of bank reserves are determined entirely by the size of the Federal Reserve's policy initiatives and in NO way reflects bank lending. The moral of the story is these reserves will be at SOME bank, only selling securities would "drain" these reserves.
Banks are in a pickle
Are there any negative implications of the QE policies? The quantity of risk free securities is down (Fed owns ~15% of Agency MBS as well as USTs etc). Banks and other institutions can continue to bid up the prices of these "risk free" assets but eventually they can also opt instead to earn IOER of 25bps at the Fed.
Why do banks need to follow suit with this yield chase? The are attempting to save any sort of profitability as measured by ROA and/or NIM. One major reason that NIM (net interest margin) is under pressure is that banks have already lowered the cost of their liabilities as much as possible. You probably realize your bank pays you little/nothing on your deposits. Now that they already pay little on deposits, lowering their cost of funds/liabilities any further is no longer material.
The obvious next step to saving NIM is making it up on the asset side. Assuming growing loans/increasing pricing isn't feasible today, banks are attempting to save margin in their investment portfolio. With the Fed pricing many banks out of the Agency MBS & Treasury market, they are forced to either take on greater duration (interest rate risk) or go down in the credit spectrum (credit risk).
Ben, you had to know this was coming
Some institutions are buying longer bonds, and others are returning to structured products such as non-agency MBS and CMBS. Other banks afraid of taking on credit risk are buying long duration bonds which exposes them to great amounts of interest rate risk in a rising rate environment.
Banks are starving for interest income due to the ZIRP environment. The Fed has fundamentally propped up these markets and forced banks among others to either invest at inflated prices or go chase credit. Guess what Bernanke wanted and guess what is happening?
Bernanke is not responsible for risk failures at JP Morgan or any other TBTF bank. BUT, he certainly has fostered an environment that has encouraged investors (which includes banks) to take on risk due to their meager alternatives. Risk has crept into an area that is typically conservative on many levels.
It is said that the job of a central bank is to pull away the punch bowl before it gets out of hand. While the Fed pays close attention to inflation, it has left the punch bowl out in the chase for risk assets and is contemplating spiking it even further (QE3).
How will this end? Should we expect that revelations such as the JP Morgan trading losses will not occur given such policies? A chase for risk is what the Fed wanted, only the intention was not for it to occur at banks.
This one's on you Ben.
Economic Musings was founded by David Schawel. David is a husband and father of two living in Raleigh/Durham NC. He currently works as a fixed income portfolio manager. He spent time in NYC in both investment banking and equity research. He is a current CFA charterholder.
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Agree. Don’t hate the player. The beards magical powers are fading
Why do people blame Ben for the issues at banks – but as soon as someone mention that seniors living fixed income are also having to choose riskier assets and risk their capital, well those people don’t seem to get the sympathy that poor Dimon does?
@ Whatisgoingon
The Federal Reserves responsibility and purpose is to: Address the problem of banking panics, TO SUPERVISE AND REGULATE BANKING INSTITUTIONS, TO ACHEIVE MAXIMUM EMPLOYMENT, stable prices, maintain the STABILITY of the financial system and CONTAIN SYSTEMIC risk in financial markets.
Can you help me identify 1 thing they are doing correctly.
Further if retirees are living on fixed income then shouldn’t they own instruments that produce fixed income? And because they should own fixed income- and because Ben is lowering rates…where is the rub to move to risk assets? If interest rates are being lowered and your principal is guaranteed what is the easiest set up EVER in the history of Man kind to make money? Yes..not only are you getting the safests investment…but your getting the power of convexity on rates declining from 2%-1.8% that’s a 11% return.
What has Ben done for savers. He would have given you over 7% per year principal guaranteed. Do you know what the long Govt. bond did last year? Yes..the long bond beat every hedge fund except Dalio(a broad statement unchecked..but good luck beating 30%. I just pulled up Vanguard Long gov. fund and the thing has given retirees everything they ever wanted. 9+% per year the last 5 years.
Don’t hate the players…that goes for retirees who were smart enough to recognize that living off a fixed income you buy fixed income. NOT stocks. What does the future hold? Well the 10 yr just broke a very long trend line and if I was living off fixed income the power of convexity could yield you huge gains here…but I’d rather buy at the bottom of the channel.
NOW what Ben did for fixed income investors is going to come back to roost right? maybe maybe not. I don’t know. But now it’s a terrible situation to be in. Hate on BEN. unless you can tell me one thing of the above duties he’s perforemed. If he was the manager of a sports team he and his mentor would have been fired along time ago.
Good points but I’m asking why vilify Ben to somehow absolve Dimon; they both need to do much better job.
And the political reality is the Fed can’t do much aside from monetary easing. My simplistic view would have been undertake an orderly default of the weak banks and let capitalism run its course. That said, I don’t know if the appetite existed in Washington or the Fed for this.
Re-instate Glass-Steagal.
Banks can be banks, casinos hedge funds can be gamblers, but they should not mix.
How is this so hard to understand?
It is time for another anti trust act that would break up the largest of the financial institutions. Then we need to regulate them to the point where they serve the simple function they were intended for and not be the masters of the universe, and the dictators of our government.
Quite agree. If you want to fix a problem you treat the root of the problem, not just the symptoms. Treating symptoms by itself ( i.e. banks bad behavior) means nothing because somebody else somewhere is bound to do the same thing as long as incentives are there. There is always a cost in tinkering with free markets, and FED should know better but I think they feel it is the lesser of evils.
This article cleverly tries to push the blame onto the Fed but I am not buying it. For one – Dimon is on the NY Fed. For another, my FDIC-insured accounts at JPM get no interest. So it makes no difference to me why JPM has to put more risk on – Fed policy, JPM client demands, JPM shareholder greed, JPM executive bonuses could all play a role. Glass-Steagall, Volcker rule are just ways to keep some distinction between merchant and investment banking so latter’s gambling losses dont get socialized. In addition to such distinction, there must be a way to keep the gambling losses from becoming so huge they become systemic and freeze the credit lines. Unfortunately, the leverage and feedback and opacity in the unregulated financial instruments makes this almost impossible even with so-called stress tests. If 2008-like events recur, the fed/treasury may have to develop a direct conduit to the banking/credit consumer so that there are no too-big-to-fail entities.
It is interesting that Glass-Steagal was championed by head of CHASE bank over JPM back in 1933, and he won. Years later, Chas and JPM are one entity and fighting Glass-Steagal. I’m sure there’ karma in here somewhere, or symmetry, or……….
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By David Schawel, CFA, Economic Musings
I could write a whole post on whether this whole JP Morgan trading loss is being under or overstated but I won't. For the record, I think given that the $2bil loss, which is ~0.5% of JPM's total capital, shows that the magnitude is being a bit overstated. Nevertheless, the concerns of the critics are reasonable. Does Dimon even know what risks JPM is taking? How can the banking industry keep any semblance of credibility when the most conservative of the TBTF's had a massive risk failure? I digress to my main point.
Wealth effect & impact of QE
It is well established that Ben Bernanke is a big proponent of the "wealth effect". That is, if the stock market is higher people "feel wealthier" and thus react accordingly. The mechanism of this is also clear and straight-forward. The Fed has purchased trillions of dollars worth of US Treasuries, Agency Debt, and Agency MBS. How does it work mechanically? The Fed sends newly created reserves to banks and in return receives the securities. So while no new "net financial assets" are created, fewer securities are in the financial system and a whole lot more reserves. This is what many refer to as "printing money".
As I've talked about here and here QE has undeniably pushed up asset prices. We have 30yr current coupon Agency MBS with a yield under 3%, IG spreads at ~200bps, and higher grade non-agency MBS yields pushed down to 4-5% in some cases. Let's not forget covenant lite deals returning in the levered loan space. Mortgage REITs have quintupled in asset size as investors salivate over 15% yields. (Hint: levering up 8x on a 2.75% asset which is hedged using swaptions is no slam dunk. These will blow up at some point). No need to go on any further. As my friend likes to say, this is the "great incredible paper chase".
Amount of excess reserves is NOT caused by lack of lending
As we have gone over so many times, the quantity of bank reserves are determined entirely by the size of the Federal Reserve's policy initiatives and in NO way reflects bank lending. The moral of the story is these reserves will be at SOME bank, only selling securities would "drain" these reserves.
Banks are in a pickle
Are there any negative implications of the QE policies? The quantity of risk free securities is down (Fed owns ~15% of Agency MBS as well as USTs etc). Banks and other institutions can continue to bid up the prices of these "risk free" assets but eventually they can also opt instead to earn IOER of 25bps at the Fed.
Why do banks need to follow suit with this yield chase? The are attempting to save any sort of profitability as measured by ROA and/or NIM. One major reason that NIM (net interest margin) is under pressure is that banks have already lowered the cost of their liabilities as much as possible. You probably realize your bank pays you little/nothing on your deposits. Now that they already pay little on deposits, lowering their cost of funds/liabilities any further is no longer material.
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