Wednesday, January 23, 2013 - Never Been To Davos

Never Been To Davos

by Sinclair Noe

DOW + 67 = 13,779
SPX + 2 = 1494
NAS + 10 = 3153
10 YR YLD un = 1.83%
OIL – 1.13 = 95.55
GOLD – 7.00 = 1685.80
SILV + .02 = 32.33

I want to go back to a couple of reports from the past week which I hope will bring us to today's news. First, JPMorgan’s management task force report on the bank’s $6.2 billion in losses from the “London whale” trade. JPMorgan is a huge institution with more than $2 trillion in assets. Banks typically lend their deposits, but for the tens of billions that JPMorgan cannot lend, this remainder is turned over to its chief investment office. This unit is charged with earning returns on this money and also using these billions to hedge the enormous financial institution against bad events. So, the London Whale was gambling with excess deposits. The idea was to earn returns on this money and also use these billions to hedge the enormous financial institution against bad events, but the trading position became so large, more than $50 billion, that the JPMorgan traders couldn’t liquidate it without hundreds of millions of dollars in losses. Instead of liquidation, they doubled down, adding some $30 billion more in bets on bets, hoping this would save them. That trade still didn’t work, and JPMorgan lost an estimated $169 million in the first two months of 2012. It was then that the traders added another $40 billion to the portfolio.

Like sharks smelling blood in the water, hedge funds went on the attack as they took offsetting positions in anticipation that the bank couldn’t hold the trade. The funds were right. JPMorgan lost $412 million on the first trading day after Bloomberg News and The Wall Street Journal reported about the London whale, and the losses started to snowball.

In the middle of the meltdown, JPMorgan traders fudged numbers, ignored orders, tried to bypass regulations and regulators, and in general scrambled to salvage their bets. Management raced to understand what was going on at the subsidiary while markets freaked in ways that no one ever expected or that JPMorgan’s models predicted. After the first-day loss of $412 million, Ina Drew, then the head of the chief investment office, wrote in an e-mail that it was an “eight sigma event.”

There are plenty of questions following a report like that. Where were the regulators back then? And better still, where are the regulators now? Where was management? Why did the traders do what they did?

Financial losses like the London Whale are difficult to spot, especially by regulators who work outside the company. It is somewhat understandable that they couldn't prevent the losses. What is tougher to understand is why they haven't followed-up. And what is even tougher to understand is how Jamie Dimon could not prevent the losses and why he hasn't been called to task. JPMorgan has provided its own self-analysis, and its task force prescribes more risk analysis, better risk models and management as a remedy. Nobody with a whit of understanding or integrity believes this will prevent future losses, but slathers the mess with a fine patina of good intentions.

That brings us to the next report; this one from the Federal Reserves five year old, well seasoned transcripts of their response to the global financial meltdown. The Federal Reserve has now admitted that five years ago, just days before the start of the financial meltdown, Mr. Bernanke and others at the Fed did not have a clue as to the impending financial disaster. The transcripts offer some gems of ignorance; they said things like the economy had a “reasonably good” chance of returning to its growth trend; Countrywide was described as having a “strong franchise”; the “subprime market” was described as a “really small percentage of the total credit markets.”

So, we should realize the regulators don't have the manpower, the resources, or the inclination to regulate complex derivatives trading, especially when a bank like JPMorgan doesn't make an effort at transparency, and especially when they set up their CIO trading unit in London, outside the purview of the Federal Reserve regulators and outside of the controls of listed exchanges.

And that brings us to today and Davos, Switzerland. The World Economic Forum is meeting and trumpeting its commitment to transparency and inclusiveness along with a burgeoning list of initiatives to advance the same. Their motto is: "Committed to Improving the State of the World." Not surprisingly, some of the biggest backers of the World Economic Forum are the bankers, like UBS, which last year was fined $1.5 billion for its schemes to rig global interest rates. The U.S. Commodity Futures Trading Commission cited more than 2,000 instances of illegal acts involving dozens of UBS employees. And that scandal followed a $780 million U.S. settlement in 2009 over charges that the bank had helped U.S. clients avoid taxes.

Other strategic partners include Bank of America which has just agreed to pay Fannie Mae $10 billion to settle allegations that it had improperly handled mortgages; Barclays Plc, which also paid nearly a half-billion dollars in a settlement over manipulating interest rates and faces record fines for trying to fiddle energy markets; Citigroup, which last year settled a lawsuit over sub-prime mortgages for $590 million; Credit Suisse, out more than a half-billion dollars for money laundering. The rogues' gallery is filled out with the likes of HSBC, Goldman Sachs, Standard Chartered, and of course, JPMorgan. The interests they represent are corporate; no more, no less. "Improving the state of the world," comes behind networking and dealmaking.

Just today, we learn Morgan Stanley is being sued by a Chinese bank over $500 million in subprime collateralized debt obligations which Morgan Stanley knew to be trash. The traders even sent emails calling the CDOs: S---Bag, Nuclear Holocaust, Subprime Meltdown, and other catchy names. It's becoming depressingly familiar: Bankers joke openly in emails about a toxic investment they're creating. Bankers sell said toxic investment to clients while betting against it. Everybody loses money, nobody goes to jail. Rinse, repeat, crash the economy.

So, what is the response from all the bright minds gathered in Davos? Nowhere in the forum's printed program do the words “financial crisis” appear. Two different panels will discuss systemic risk issues which may or may not be relate to financial institutions.

Jamie Dimon appeared on a panel this morning and he stressed the key role of banks in making the economy work, and insisted many of the bad practices of the recent past were being phased out. Regulators, he said, were "trying to do too much, too fast." The bankers, he said were “doing the right thing.”

Banks have spent much of the past few years in a bunker, getting on with shoring up their tarnished finances – and that's spelled difficulties for many in need to get their hands on money they need. Given its importance to the global economy, many reforms have been called for to make them work better for society as a whole. One solution being espoused around the world is to siphon off risky trading activities from traditional banking such as taking deposits and granting loans. In other words, if Jamie Dimon and the London Whale want to go to England and gamble, fine – just don't gamble with FDIC insured depositors' funds.

Part of the forum in Davos was to try and re-direct blame to regulators and the need for better regulations, but not necessarily more regulations, and not necessarily more regulators, and not necessarily requiring banks be transparent with regulators.

Axel Weber, a former central banker and current chairman of Swiss-based bank UBS, acknowledged what he called the "excesses" of the past but said it was pointless to debate breaking up banks. The excesses of UBS and other bankers are also known as felonies, and there has been no accounting as of yet. There is an elderly, 78-year old widow in Florida who followed the advise of UBS employees. She tried to evade taxes. She now faces 5 years in prison. No jail time for the UBS guys.

"Where does the financial sector start or stop?" Weber asked. "It's so intricately linked that we shouldn't throw out the baby with the bathwater .... We all provide valuable social functions."

In other words, the cancer has grown so large, it would be painful to cut it out, so don't even try.

The rise of the bankers has coincided with a decline in the middle class, and a surge in debt. A stunning 35% to 40% of everything we buy goes to interest. This interest goes to bankers, financiers, and bondholders, who take a 35% to 40% cut of our GDP. That helps explain how wealth is systematically transferred from Main Street to Wall Street. The rich get progressively richer at the expense of the poor, not just because of “Wall Street greed” but because of the inexorable mathematics of our private banking system.

This hidden tribute to the banks will come as a surprise to most people, who think that if they pay their credit card bills on time and don’t take out loans, they aren’t paying interest. Not true. Tradesmen, suppliers, wholesalers and retailers all along the chain of production rely on credit to pay their bills. They must pay for labor and materials before they have a product to sell and before the end buyer pays for the product 90 days later. Each supplier in the chain adds interest to its production costs, which are passed on to the ultimate consumer. The financial sector compose a whopping 40% of US business profits; that's five times the 7% made by the banking sector in 1980.  Bank assets, financial profits, interest, and debt have all been growing exponentially. Exponential growth in financial sector profits has occurred at the expense of the non-financial sectors, where incomes have at best grown linearly, or not at all.

 If we had a financial system that returned the interest collected from the public directly to the public, 35% could be lopped off the price of everything we buy. That means we could buy three items for the current price of two, and that our paychecks could go 50% farther than they go today. Last year, the federal government paid $454 billion in interest on the federal debt—nearly one-third the total $1.1 trillion paid in personal income taxes that year. Sure, let's talk about government deficits and the debt ceiling and let's talk about cutting spending, but let's also realize where we are spending the money before we start the cutting.

Maybe Jamie Dimon is correct when he says bankers are doing the right thing, but my question is: for whom? And at what price?