Matt Levine’s Article on Derivatives Accounting Explained in Plain English.

Matt Levine of Bloomberg wrote 2500 word article the other day describing, in detail, some new tricks banks are beginning to use to evaluate their derivatives contracts. It’s a great read for someone who’s exposed to that world but indecipherable to a regular. I wanted to translate this article into plain English.

Back in the day, before the crisis, Libor rate was a gold standard for many things: interbank lending, funding, discounting future cashflows of derivatives contracts. Fresh-faced analysts used to plug in that risk-free rate into their Excel spreadsheets valuations models and worry about other things. Well, those days are gone. Matt Levine in his Bloomberg article explains how it is being dealt with today, at least in JP Morgan, although others may follow suit too.

You see, before, doing valuations on your derivatives contracts you used tools called CVA (credit valuation adjustment) and DVA (debit valuation adjustment). But ignore these fancy words for a moment. In plain English CVA means an adjustment for a risk that a counterparty won’t pay you. DVA means an adjustment for a risk that your own credit deteriorates. To describe DVA concept in extreme but understandable terms, imagine that you owe $100K to Russian mobsters, but you die of a heart attack (it’s a metaphor for your credit worsening), so you (or your estate) book a gain on your DVA. Mobsters book a loss on their CVA. Matt Levine is correct for using the word “creepy” to describe DVA: why would you care if your own credit deteriorates, isn’t it the other guy’s problem? Well, it is, but as a bank you have to reflect such deterioration in your books. But CVA and DVA are not offsetting each other, so from what I can discern from the article Jamie Dimon wasn’t too happy about having to explain these counterintuitive discrepancies on earnings calls. In fact it does sound kinda weird: “Our credit deteriorated so we booked a gain, and the next month when our credit spreads improved, we booked a loss.” I know, weird, isn’t it? But that’s how it works in the banking realm.

But what if you didn’t die, but your business has suffered some temporary setbacks? You book a little gain on your books, on the money that you owe the mobsters and go out and find someone who will lend you the money at some interest rate. That’s where the new concept of FVA (Funding valuation adjustment) comes in. You don’t fund yourself with risk-free rate anymore. Libor-shmibor! Everyone knows you’re in some kind of trouble, so they will charge you extra. These days 3-mo Libor is not considered a risk-free rate it once was.

If Libor is not risk-free rate then what do you use? You use some kind of spread over Libor. JPMorgan apparently uses its own 50 bps CDS spread as a funding valuation. That means when they calculate how much it costs them to fund they add 0.5% (50bps) to a 3mo Libor rate. Note that if their credit worsens that 50bps will become, say, 70 or 80 which would make their funding more expensive and will be reflected in the books as a loss, offsetting the accounting gain on a credit deterioration. But this way Jamie Dimon or Marianne Lake won’t have to explain, again and again, how they booked a gain if their credit worsened. Yeah, it’s worsened, but it also became more expensive for us to borrow. FVA in some sense offsets DVA. So it’s a wash. You can be dead or in trouble but your books are perfectly balanced!

Nothing scandalous here, just a neat new concept of accounting tricks explained.

Advertisements

Big Banks should Deleverage or Perish (My follow up in Am. Banker)

Big Banks should deleverage or perish.

But there’s a bright side, albeit with a cruel irony, to such institutional failure. If we’re powerless to break up the banks, then we’re also powerless to bail them out should they fail. There will be no more bailouts, because we’ve simply run out of options.

Follow Up on Jamie Dimon and TBTF.

Perhaps, I overestimated Jamie Dimon’s ability to recognize what the correct play is under certain circumstances. This is a poker term, and for poker players “correct play” carries almost religious connotations. You always have to play correctly, even if you lose that one hand due to chance. This is because in the long run you always win. You don’t always have to demonstrate your strength. It’s ok to fold every now and then. By folding one hand and saving chips you can get a monster hand the next time. I thought that Jamie Dimon understood this in general, and, with the London Whale fiasco he just had that one bad hand from which he could quickly recover. But this issue drags on for more than a year now and the scrutiny is only intensifying. It just won’t go away, especially if met with more resistance from JPM quarters. Entrenched attitude is the worst attitude in these circumstances. That is why I thought embracing reform is the best next move for him. If he did that everyone would immediately forget about London whale trade.

Well, Jamie Dimon read my article, which was a surprise. I have accomplished getting my point across to the very person it was intended for, and that’s all that matters. He disagreed that embracing breakdown of TBTF is a smart thing to do, because he thinks size gives him the advantage. He’s competing with European banks that are even bigger. A valid concern for a person whose obligation is to shareholders and bondholders. But also a surprisingly short-sighted view. Perhaps, he’s mistaken by attributing the JPM success (stockwise) to the size of the firm. Maybe it’s due to the cheap financing that banks enjoy and other industries (or smaller banks) don’t. Even assuming that JPMorgan doesn’t use the Fed’s window to borrow at 25bps (hard to believe that someone would forgo free cash), the supposed profitability of other banks like his could be directly tied to that window. If we recall, JD did not want to take that cash in 2008 because he thought it would stigmatize him and he had valid reason – JPM was in the better shape (relatively) compared to all other (Citi, BofA). So, it’s likely that he’s misattributing stock performance to his managerial style.

Also, it’s safe to assume that Jamie Dimon spent the last year surrounded by lawyers and consultants and have mastered the art of defending his position in either platitudes or legalese. Defending it to such an extend that he began to believe his own spin. And this is the most unfortunate part of this whole thing. In his daily routines he’s surrounded by sycophants, people who take orders and people who’re paid to tell him what he wants to hear. When everyone around  you tells you that you’re doing the right thing you begin to believe it yourself. It’s as if they have their own “unskewed polls”. It’s one thing for politicians or for talking heads or for consultants to fall under such spell. But in a supposedly Darwinian world of business, a world where Dimon has excelled for decades, to lose such perspective is a deadly sin. Losing touch with the outside world is the worst transgression. We did have a short telephone conversation (he spoke mostly) and that is the impression that I got. He had a prepared speech that he has delivered a hunderd times before to hundreds of other people.

Dimon lost perspective. Oh, well. At least I tried.

Jamie Dimon Should Embrace TBTF reform (My new article in the American Banker)

Here’s my new take on TBTF problem.

To summarize, to embrace the TBTF reform is a winning issue for Jamie Dimon. It has a limited downside/unlimited upside an has a potential to repair his tarnished reputation and turn him into  the industry leader. He holds a winning hand and doesn’t know it.

Jamie Dimon wins this round.

After listening to Jamie Dimon’s testimony before Congress the other day I became less enthusiastic about Volcker Rule. No, I didn’t suddenly turn into a laissez faire supply-sider, I simply became more convinced that if such matter is entrusted into the hands of regulators we would have to be dependent on these regulators struggling with definitions, like what a hedge is. That would be too painful to watch.

I have to admit that, perhaps, capital requirements and other Basel III rules   can be more effective than outright ban on certain kinds of trades.

My comrades on the left might disagree. But think about it: banning something outright will simply ban it on paper but in reality such ban will not prevent smart and resourceful Street guys from finding ways around it. Even potheads could for years find ways around the drug laws. Moreover, a sweeping ban will make a great excuse for the ever-complacent or complicit regulators to fall asleep again while giving the public the illusion of things being under control. Besides, show me any ban that has prevented people from obtaining/providing the illegal goods or services. What would prevent various exceptions and exemptions from being forced quietly into the legislation that renders the entire brick wall between deposits and trading desks useless?

Jamie Dimon and many others on Wall Street want regulations to be simple and effective. So do I. And so do regulators, I suspect, who are helpless in the face of complexity. Having capital requirements will be hard not to enforce simply because it’s quantifiable. All they have to do is build a spreadsheet where column B is needed capital and column C is actual capital, subtract one from the other and voila, there’s the list of those who meet the criteria and those who don’t. I’m being slightly facetious and simplistic, but you get the idea. Much easier than wrestle over definitions of what is a “directional trade” or a “macro hedge” with those who made a career out of twisting the terminology. Arguing over a definition of a “hedge” is a battle that the regulators, in their current state, can’t win.

It was almost comical to see senators asking Jamie Dimon his opinion on how to regulate the financial system. Here’s Jamie Dimon’s idea of sensible regulations: Proper capital requirements, proper liquidity, proper risk management and risk controls. It does not sound unreasonable at all. I could almost sense the slight disappointment among some (mostly Republican) Senators as they haven’t received anything less of “let the market take care of it”. The whole Senate testimony was worthy of a Monty Python’s skit in its absurdity, as the only voice of reason was coming from a Master of the Universe (Tom Wolfe accurately described this dynamic almost 25 years ago in his Bonfire of the Vanities). I wonder what was going on in Jamie Dimon’s mind at that point, but if I had to speculate I’d say disbelief, amusement mixed with a breathtaking realization that he’s the sole de-facto arbiter of a system that affects millions of people and trillions of dollars.

Meanwhile, capital requirements under current Basel III rules would have prevented Goldman from buying CDS contracts from AIG, for example. Or at least they would require Goldman to post higher capital in these kinds of trades to account for the risk of AIG becoming insolvent. While we can’t be sure such a trade would not have been done, we can be sure it would have been much smaller in size.

If OTC derivatives have been cleared through the exchange, there would be no high-stakes “who has what” poker game going on between the biggest financial institutions, trying to figure out who has what in ‘Assets available for Sale’ section of the balance sheet or other hard to decipher nicknames given to toxic assets. These holdings would have been more transparent. Thus, as Jamie Dimon rightly pointed out in his testimony, JP Morgan would not have been asked to take the bailout package, as everyone would see their minimal exposure to the crappy assets, compared to other firms. Thus, it is quite possible, that the bailout could have been smaller and more targeted (to Citi and BofA) and not sweeping and imposing.

Look, I’d love to have regulators who are smart and capable of doing their job, but the truth is, they will always be at least one step behind, because they don’t have the capacity and the wits to anticipate what is the next product to be invented on the Street. Regulators are a reactive force, not proactive. Lawmakers proved to be no better at understanding the complexities of the current financial system and dealing with the repercussions. Good intentions are a poor excuse. What we care for are the results.

We also would like to offer some advice to Jamie Dimon and other Wall Street alpha dogs – be a mensch, stop being offended at being called names. It’s not Obama’s job to become friends with Wall Street. He plays his game – you play yours. At this point of their careers neither Jamie Dimon, nor Lloyd Blankfein nor many of others on top of the Wall Street hierarchy care about money – they care about their legacy. Right now none of them look like socially conscious tycoons of the 1900s, no strangers to consolidation and market manipulation, sure, but who nonetheless understood the long-term dynamics of the society and came to rescue the system with their own money when the circumstances called for it. And yet, the bar has been set so low, and in part by our own public servants, that even Jamie Dimon, a fox guarding the hen house, looks as having more integrity than the subservient watchdogs. As evidenced by ingratiating senators who are on Wall Street’s payroll, asking Dimon for advice on how to run things, all Wall Street’s powerful men’s grievances about unfair treatment look nothing more than a simple disingenuous posturing. Guys, let me break it to you: You run the freaking game! You don’t have to have a TV show (like Ace Rothstein in the Casino), or bring attention to yourself by verbal sparring with various politicians; you have to have the whole thing to be quiet. Please, no more displays of victimhood and defensive language. And I’d like to conclude by posing a question to Mr. Dimon to ponder: imagine a less sharp and more reckless man inheriting your job one day. Wouldn’t it be a fitting legacy for a man in your position to help build a system that is less dependent on someone having both superhuman qualities and spotless integrity and more dependent on built-in levers of control that work regardless of someone’s pedigree and ambitions?