According to the Financial Times, as of last week, JPMorgan Chase sold up to 70% of its position in the CDX.NA.IG.9 index, where the Fail Whale trades originated. I assume they are working on the remaining 30%, though CEO Jamie Dimon has said that the trades would “not be an issue by the end of the year,” suggesting there are several months to go. But the bleeding will be eventually stanched from this trade, and sometime in July, when they announce their earnings, we’ll find out just how much JPMC lost on the deal – the speculation has been anywhere from $2 billion to $7 billion.
None of this should suggest that JPMorgan Chase, or any major US bank, has insulated themselves from risk around the world. In fact, that risk is gradually growing. Simon Johnson notes today at Bloomberg that US banks have no real buffer to protect themselves from a crisis in the Eurozone:
As a warm-up, consider first a simple contract. Let’s say you have lent 1 million euros to a German bank, payable three months from now. If the euro suddenly ceases to exist and all countries revert to their original currencies, then you would probably receive payment in deutsche marks. You might be fine with this — and congratulate yourself on not lending to an Italian bank, which is now paying off in lira.
But what would the exchange rate be between new deutsche marks and euros? How would this affect the purchasing power of the loan repayment? More worrisome, what if Germany has gone back on the deutsche mark but the euro still exists — issued by more inflation-inclined countries? Presumably you would be offered payment in the rapidly depreciating euro. If you contested such a repayment, the litigation could drag on for years […]
Personally, I’m most worried about the balance sheets of the really big banks. For example, in recently released highlights from its so-called living will, JPMorgan Chase & Co. revealed that $50 billion in losses could hypothetically bring down the bank. (All big banks must provide their regulators with a living will to show how they could be shut down in an orderly fashion if near default.)
JPMorgan’s total balance sheet is valued, under U.S. accounting standards, at about $2.3 trillion. But U.S. rules allow a more generous netting of derivatives — offsetting long with short positions between the same counterparties — than European banks are allowed. The problem is that the netting effect can be overstated because derivatives contracts often don’t offset each other precisely. Worse, when traders smell trouble at a bank that has taken on too much risk, they tend to close out their derivatives positions quickly, leaving supposedly netted contracts exposed.
That’s almost exactly what happened in the Fail Whale trades, and Johnson suggested that this would occur at a much larger scale if the euro dissolves. Now, it’s true that the euro may not actually dissolve in this way. But it really may not have to – just a couple incidences of countries shifting their currencies could create this outcome. And when you have the thin margins like a JPMorgan Chase, it may only take that much to create chaos.
As Johnson explains, JPMorgan Chase and other big banks, especially the ones heavily invested in the derivatives market, stand at significant risk if several counter-parties ask for their contracts at the same time. That’s what a credit event like the dissolution of a currency could create. Under European accounting standards, JPMC has assets of $4 trillion, so a $50 billion loss, which their own living will says would bring down the bank, isn’t out of the realm of possibility. Especially when so much of it is tied up in derivatives.
If anything, the Fail Whale trades showed the potential consequences of this in miniature. JPMC may have gotten away with the Fail Whale without any major consequences, thanks to their purchase of Washington. But Washington won’t be able to help them in the event of a euro crisis. As Yves Smith writes, “a eurozone crisis is not likely to be contained, and the biggest US banks are exposed.”