Commodity Trade Mantra

What’s Really Going on Inside a Big Bank

What’s Really Going on Inside a Big Bank

What’s Really Going on Inside a Big Bank

Here’s a bit of inside information for you.

It’s about how things really work on the inside of a Bank.

Any big bank – any big bank with an incentive to make money, which of course would be all of them.

This is one lesson you won’t ever forget…

Banks have “assets,” otherwise less technically defined as “stuff.”

The stuffing in the stuff banks own (meaning they have a position, or are the beneficiaries of a stream of income) is stuff like loans, like real mortgages, like mortgage-backed securities, like derivatives.

Let’s talk about derivatives.

Why? Because they amount to a huge pile of stuff banks own.

Why? Because derivatives aren’t exchange-traded, for one thing. And that’s where I’m going to be going in a second, so stay with me.

Banks can create derivatives to do pretty much anything they want them to do. After a while, all the banks end up copying each other’s good derivatives “product” ideas, so though they are far from standardized, they are close enough to be traded between them all with a mutual level of confidence as to what they are. And they are created to be amped-up proxies for other stuff, like default insurance on corporate bonds or government bonds, and a ton of other things.

The purpose of creating these derivative things is to give banks stuff to bet on, and bet on in a big way.

Derivatives offer “exposure” to some banks, meaning they want risk exposure to, say, the direction of prices of mortgages, or leveraged loans, or government bonds, or sovereign country exposure. Exposure means they want to bet on it. And sometimes banks use derivatives to hedge against other bets they have on when they are exposed to potential losses.

Here’s the thing about that. It’s a lesson you won’t forget. If you take a position in something, anything, for instance, Microsoft stock, and you think it’s going to go against you, you’d probably just sell it and be done with it.

But what if you bought so much Microsoft stock that if you alone were going to sell all your stock, your action alone would force the price down because of how much stock you have to sell?

Instead of selling your stock, you might want to hedge it. A hedge is another position that you take that will make you money at the same time your Microsoft stock position is losing money. The thing is, now you have two “risk” positions on, not one. Kinda wish you were just able to sell the stock and be done with it, right?

That’s what happens with banks.

They have to hedge because the size of the positions they take. The economies of scale they have and all the money they have to play with and all the leverage they can apply to that money (including our money, our deposits are at their disposal) forces them to make giant bets. And of course, when they fear their giant bets are going to go against them, they make a giant hedge, which, if you’re following me, amounts to another giant bet.

Now they have two giant bets.

That’s what happened over at JPMorgan Chase’s London office, the one where “the Whale got harpooned. The bank had huge exposure on a few giant derivatives positions and decided to hedge those positions with some other positions.

Here’s what happened next, and what you’re reading about in the news now, which is that two London traders are being sued criminally for “fraud.” The original bets were so huge that JPMorgan had essentially all the marbles in its vault. Needless to say, other traders knew that, because those other traders were the ones selling JPM their bets, their exposure.

The big trades weren’t going so swimmingly. The problem now was that the positions were so massive (like your giant Microsoft position) they couldn’t just start selling those positions off. The traders on the other side of them, the blokes who sold JPM the positions in the first place, weren’t interested in buying them back.

Why? Duh, because they’re the ones who sold them, but not really. In reality they “shorted” them by selling JPM stuff they didn’t own but made up to sell to JPM. (I told you banks can make up derivatives.)

That’s right; the traders on the other side of JPM’s trades were short. Being short means you want the price of the thing you’re short to drop, so you can buy it back at a much lower price.

Now that it can’t sell, JPM wants to hedge. But the cat is out of the bag. It then starts to put on some hedges, which are trades, and who is taking the other side of JPM’s hedge trades? Why, a lot of the same traders who sold them their big position. They quickly realize JPM is in trouble with their big position, can’t sell it, and is trying to hedge it.

So what do they do? They stop selling them any hedge positions and start trying to knock down the price of JPM’s big positions, to get JPM to cry “Uncle!” and sell their positions, which would crash the price and give the short-sellers a huge profit when they could buy back their positions from JPM at bargain basement prices.

Now, here’s where it all comes together.

Because JPM’s positions were too big to be effectively hedged, and too big to sell, as the price was falling and they were losing money (on paper) on their big exposure, the trading desk couldn’t let on how big the losses were.

One reason, and big one, is that they didn’t want other traders to know how much they were losing.

And just as important, in order to hide their mounting losses from their bosses (who I have to believe knew about them) and not have the losses hit the bank’s P&L (profit and loss statement), which would signal to other traders that losses were mounting at JPM and if they got bad enough the bank’s managers might say, “Sell the position, get out!” And that would be a windfall for the blokes who shorted derivatives to JPM.

Interestingly, and conveniently, derivatives aren’t exchange traded. (I told you I’d get to that.) The prices at which they trade are determined by the people trading them. Sometimes they don’t trade at all.

So, how do you price them? If you have a huge position and you want to know if you’re making or losing money (in JPM’s case it was losing big time) you have to “mark” your positions – you have to price them.

If you’re losing big time and you don’t want anyone to know, not your bosses and not the traders trying to destroy you to enrich themselves, and there are no exchange prices because these things aren’t exchanged traded, you make up the prices yourself.

About the bosses knowing or not knowing… Think about this a second. If you are a boss and you know the score and it’s your bonus and your job on the line too, mightn’t you want to go along with traders marking their positions to not make things look so bad, so maybe you could buy some time and trade out of a lot of the losses? Just throwing that out there.

Anyway, Javier Martin-Artajo and Julien Grout of JPM’s London trading office are being called out for allegedly “fraudulently” mismarking the desk’s huge positions to mask the huge losses ($6.2 billion) they would eventually take.

A lot of talk will be wasted over who was responsible, who knew, how did the book of trades get priced, how were numbers manipulated, by who, for how long, and on and on and on. It’s going to be a good show. But it’s a sideshow.

The only question worth asking is: Why in God’s name would we ever let get banks get so big that they can and have to make such giant bets to make money for their bonus pools?

The marking thing is a problem. It didn’t just happen here in this instance. It happens all the time. It is why banks trade derivatives. Because they can. Because they can manipulate prices to their advantage, which is how they get around capital ratios and measures like those that are supposed to tell us about how safe a banks is.

Oh, it gets better.

On Monday I’m going to tell you how what happened at JPMorgan is happening all over the place and why we all should be scared when the banks say, as Morgan Stanley, for one, just said, they have a 99.9% certainty they know how much they can lose on any given day.

Newsflash! That’s what they all said back in 2008. Only all their value at risk (VaR) models blew up in their faces.

You don’t think that’s still happening? Boy, have I got news for you!


Don't Like Banks?


Courtesy: Shah

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