JPMorgan

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.

The London Whale Trade Scapegoats and What It Means for the Industry

If you’re a low-level employee at a financial firm, beware: you will not be spared if your bosses fuck up. In fact, your entire risk/reward is strongly skewed against you: you bonus is still meager (or non-existent), but your chance to be accused of wrongdoing is not commensurate with your compensation. Like that guy Julien Grout – a mere trading assistant who marked Iksil’s books and who is now facing charges on four counts. His bosses tell him how they’d like to see the positions marked and he goes ahead and delivers them the numbers they want to see. Bruno Iksil, his boss and the trader who put on those trades is not being charged. Instead, he’s cooperating with the authorities and ratting out his own boss and his trading assistant. The interesting part is that Grout, a low level employee who merely evaluated the desk’s P&L, devised a plan to get out of the position, before shit hit the fan, which would book about $500 mln in losses, but his bosses told him no thanks. And what are you going to do then? Are you going to do what your bosses tell you or run to the authorities? If answered honestly and with assessing all the upsides and downsides of either move, this question is easy to answer: you will do what your bosses tell you.

The sad part is that SEC might pump its chest and think it’s found its mojo. But the reality is such that if there’s an abundance of willing striving young men, dreaming of a career on Wall street, unable to say no to prospect of quick riches, there will always be room for such abuse.  It is only the lack of willing soldiers lining up to take those ungrateful jobs that will, well, do the job. When there will be no cache of low-level employees willing to take such uneven risks and then being made scapegoats, this is the beginning of the end. This story is a good warning to all those young jocks dreaming of Wall Street: If your boss loses money and it makes headlines, he’s not going the one taking the heat – you will. Perhaps the next generation of Julien Grouts will pause before wishing for that job on the trading desk after all.

And then, what if it is physically impossible to be honest on Wall Street? The whole system is so corrupt that even a fair-minded person will end up contaminated while on the inside.  When you’re a low-level employee you do what you do because you can’t say no to your boss. When you’re a mid-level employee you do what you do because there’s a big reward on the horizon – a promotion or a bonus. When you’re senior management you do what you do because you’re in the spotlight, sometimes sought, sometimes undesired.

None of those stages are welcoming to self-reflection. The pull of the flow, of the tide is so strong that it’s easier to just go with the flow. People have to stop wanting to do what they’re doing in order to bring changes to the entire system. Since neither government, nor legislators, nor regulators, nor public furor could do anything definitive to change the corrupt system, the system itself has to become unsustainable and collapse under its own weight. When I talk to my still surviving former comrades, many of them simply don’t want to do this anymore, they seek to leave the industry altogether. The pay sucks, the bonuses are zero, there’s more work to do with no reward, monetary or personal. When people refuse to be a part of it, not because they’re fair and civic-minded but because continuing to be a part of it goes against their own self-interest, that’s when there’s hope for any reform.

But we’re still far from it: You may hate your job that pays $200-250K base, but there’s nothing else out there that can pay that.

So, to use a zesty Russian expression to perfectly describe the predicament, Wall Street will continue to “fuck and cry”.