Money Stuff: JPMorgan Had a Good Bad Year

Epistemology JPMorgan Chase & Co. announced its quarterly results this morning and they were … good? Bad? Weird? Awkward? "Too early to say"? Here's Jamie Dimon: Jamie Dimon, Chairman and CEO, commented on the financial results: "JPMorgan Chase reported strong results in the fourth quarter of 2020, concluding a challenging year where we generated record revenue, benefiting from our diversified business model and dedicated employees. While we reported record profits of $12.1 billion, we do not consider the reserve takedown of $2.9 billion to represent core or recurring profits – essentially reserve calculations, while done extremely diligently and carefully, now involve multiple, multi-year hypothetical probability-adjusted scenarios, which may or may not occur and which can be expected to introduce quarterly volatility in our reserves. While positive vaccine and stimulus developments contributed to these reserve releases this quarter, our credit reserves of over $30 billion continue to reflect significant near-term economic uncertainty and will allow us to withstand an economic environment far worse than the current base forecasts by most economists." It is hard to know what to do with "a challenging year where we generated record revenue." You can take it as sort of a boast: This year was hard, but we did better than ever, because we are very good at our jobs. You can take it as a sigh of relief: Boy are we glad 2020 is over, also wow look how rich we are. You can take it as an acknowledgment that, in the midst of a pandemic, it's a little gauche for a big bank to make record profits: We recognize how hard this year was for everyone, and we will collect our enormous winnings in a solemn and dignified fashion. You can, as Dimon suggests, take it as a statement about the unknowability of bank earnings. If you run a lemonade stand, you buy some lemons and squeeze them and sell the resulting lemonade, and your quarterly profits are pretty much how much you got for the lemonade that quarter minus how much you paid for supplies and labor. Your accounting profits have a close relationship to how much money came in and went out each day. Banks aren't like that. If you run a bank, you own some streams of future cash flows, loans and bonds and derivatives and stuff. They provide cash flows each quarter—you collect interest on the bonds and loans, etc.—but that is only part of your income. Another big part is that a lot of those streams of cash flows are marked to market: Each quarter, you ask what will be the likely present value of the future cash flows from each of your bonds and derivatives; for your loan book, you ask each quarter how many of your loans will default in the future. The change in those present values, or in those likely defaults, goes into your income now. Those things can swing around a lot more than any one quarter's interest income. Also those things are basically guesses about the future. "While done extremely diligently and carefully," they "now involve multiple, multi-year hypothetical probability-adjusted scenarios, which may or may not occur and which can be expected to introduce quarterly volatility in our reserves." As your expectations of the future change, your present profits go up and down, but there's no particular reason to believe that any of your expectations are right. So at the end of 2019, JPMorgan had $14.3 billion of "total allowance for credit losses": Out of its trillions of dollars of loans and commitments, it expected to lose $14.3 billion from future defaults, in the sunny times of December 2019. By June 2020, that number was up to $34.3 billion, as a pandemic seemed like it would crush the economy—which means that JPMorgan had to take $20 billion of charges against its income statement in the first and second quarter, not because loans had defaulted, but because it was more pessimistic that they would default in the future. By the end of the fourth quarter, though, things were better, the reserves were down to $30.7 billion, and so it was showing a profit from bringing them down.[1] If 2020 was challenging but you expect 2021-2024 to be great, then, sure, you will book a record profit in 2020, and everyone will feel weird about it.[2] You could also, though, take Dimon's statement as straightforwardly true and almost tautological: It was a challenging year, so we made a lot of money. Banks' trading divisions often do very well in times of crisis, since they are basically in the business of supplying liquidity and liquidity is in high demand. And in fact JPMorgan and other banks had some pretty great trading results during this year's volatility. (It doesn't hurt that since the spring of 2020, the market has pretty consistently gone up.) Also of course governments and central banks reacted to the Covid-19 pandemic by taking extraordinary measures to support the economy, which tend to be especially helpful to banks. We talked a few times last year about the anomaly that the Federal Reserve's stress tests for big banks used a market-crisis scenario that was much less severe than the actual Covid crisis—but that the banks performed much better in that actual crisis than the Fed thought they would have in its imagined crisis. It turns out that in a real crisis banks don't just lose a lot of money and get sad; they also make a lot of money trading derivatives when the crisis happens, and when the Fed fixes it. The challenging years are often the best ones. Europcar The crude explanation of credit default swaps is that they are insurance against bonds defaulting. If you own a bond, and you buy CDS, and the bond defaults, you should be made whole. If it's a $100 bond, you should get $100 back, no matter what. A bond plus CDS should be a (credit-)risk-free combination. It is a bit complicated to get this to work in practice. Defaulted bonds are rarely completely worthless. The issuer restructures, in or out of bankruptcy, and the defaulted bonds get paid off in part or exchanged for some new securities. If you get back $20 or $40 or $75 of stuff for your defaulted bonds, CDS would ideally pay off $80 or $60 or $25, so that you end up with $100 for the bond-plus-CDS package. One way to make this work would be: If a bond defaults, the CDS buyer delivers the bond to the CDS writer, and the CDS writer hands the buyer $100. The buyer is made whole—it has exactly $100—and the CDS writer has to deal with figuring out how much the bond is worth. This is called "physical settlement," and it's pretty straightforward—as long as CDS is bought mainly by bond owners as insurance. But of course CDS is used for lots of other purposes too. People will buy CDS on a company not only because they own that company's bonds, but also as a way to speculate on its credit, or as a hedge for other credit exposures to the company (or its stock, etc.), or as a hedge for other credit exposures to different but correlated companies. People will buy index CDS—a pot of CDS on a bunch of bonds, which pays off a bit if any of those bonds default—as a way to hedge or speculate on general credit risk. CDS is in a narrow sense "insurance against bonds defaulting," but in a broader sense it has been, historically, the main liquid way to make all sorts of bets on credit. What this means is that a lot of people own CDS without owning the underlying bonds that they could deliver for physical settlement. Still you could ignore that. You could say "anyone who buys CDS has to deliver the bond to get back $100." Then people who own CDS but not the relevant bonds would have to buy the bonds, after the default, in order to get paid off on their CDS. In some cases, this would drive the price of the bonds way up after default. Before default, everyone says "this company may not pay these bonds back," so they trade at $60. After default, all the CDS owners say "hey we need to get some bonds to get paid off on our CDS," so they go out looking for bonds and bid them up to $70 or $90 or, why not, $99.99. (Probably not $105, because the CDS only pays off $100.) This is not exactly the system that is used in reality, but it's not exactly not that system either. Another way for it to work would be: If a bond defaults, the CDS writer pays a lump of cash to the CDS buyer, and no bonds change hands. This is called "cash settlement." Ideally the cash settlement would be $100 minus exactly what the bond is worth after the default, but how do you measure that?  You could wait until the restructuring is completed, see what bondholders get, and then have the CDS pay off $100 minus that. This is administratively annoying: Restructurings take a long time, lots of bondholders can't or don't want to hold their defaulted bonds all the way through bankruptcy, and if bondholders get back other securities you still have the problem of valuing them. In practice people want CDS to pay out more promptly than "after the bankruptcy is over," so this approach isn't really used. You could have an arbitrary payout. You could have a rule that CDS pays $100 on a default, no matter what the bonds' recovery is. (Or you could have it pay $60 on a default, on the old rule of thumb that recoveries are typically around 40 cents on the dollar.) That would be … fine, really; it might be a good product for people looking to speculate on credit generally. People suggest it a lot, and it does exist ("binary" or "fixed-recovery" CDS), though it is not that common. The problem is that it doesn't work that well for people who do want insurance against default on actual bonds that they own; they would be overpaying for their insurance, buying something that pays out $100 even if their loss is only $60. So the usual intuition is that the cash-settlement payout should be based on the market price of the bonds shortly after the default. If the company defaults, and the bonds trade down to $45, then the CDS should pay out $55. That way if you have a bond and CDS, you get back $100, $45 for your bond and $55 for your CDS. But it's not always easy to measure the market price on a defaulted bond; it may not trade very much, people may have idiosyncratic reasons for holding on to or buying or selling it, and trading prices might not reflect "real" value. So the way normal CDS works is that there is an auction. After a default, ISDA—the International Swaps and Derivatives Association, which administers CDS—declares a default and sets an auction date, and then there is a bond auction that does two things. One, it allows for physical settlement: If you own a bond and CDS, and want to get rid of your bond and get back $100 on your CDS, you can do that (by selling your bonds in the auction); if you wrote CDS and want to pay $100 and get back a bond, you can do that (by buying bonds in the auction). Two, it fixes a price for cash settlement: The auction coordinates liquidity, so that anyone who wants to buy or sell the bond (whether or not they own or wrote CDS) can do so, so you get a good market-clearing price for the bonds, which you can use to set the payoff for CDS cash settlement. If the market-clearing price for the bonds is $45, CDS will cash settle at $55. This is all oversimplified and the actual auction mechanics are kind of complicated, but this is good enough for our purposes. Once you know the basic structure you can think about how to manipulate it. There are two basic ways: You can try to make CDS pay off too much (because you own CDS), or too little (because you wrote CDS). If you want CDS to pay off too much, what you need is for the auction to clear at a very low price. If you are just a CDS owner, this is hard to do on your own; people who own defaulted bonds are going to want to sell them in the auction. But if you can enlist the company to help you, you've got a shot. Basically the method is to have the company issue some new bonds that are deliverable into the CDS auction and that are worth very little money. This will drive down the clearing price of the auction—which usually reflects the cheapest-to-deliver bonds—and thus drive up the CDS payout.  The classic case here is the Hovnanian trade, where Hovnanian Enterprises Inc. struck a deal with a hedge fund to (1) default on some debt for a bit and (2) also issue some new debt with comical terms that would trade at a very low price, lowering the auction price and so increasing the payoff on CDS. The hedge fund owned a lot of CDS, so it would get a large payoff and use some of it to give Hovnanian attractive financing. This was a clever plan, though it was ultimately abandoned because everyone got really mad. If you want CDS to pay off too little, what you need is for the auction to clear at a very high price, ideally $100. If you are a CDS writer, this is not especially hard to do; all you have to do is buy up all the bonds so that no one can put them up for auction. Just corner the market in the bonds. Of course then you have spent a lot of money buying back the bonds for more than they're worth, which defeats the purpose of having CDS pay off too little, so you will probably prefer a subtler approach. For instance, sometimes there's one relatively low-value bond that will set the price of the CDS auction, and other higher-value bonds that will lead to a lower CDS payoff; if you can corner the market in the first bond, perhaps you can save more money on your CDS than you spend on the corner. (This is sort of the Sears Holdings Corp. trade, though there was a lot going on there.) Or sometimes a company will have more CDS outstanding than bonds—perhaps because it is in a lot of credit indexes, but has paid back a lot of debt[3]—so you can corner the bonds relatively cheaply. I say "manipulate," but you can get these weird scenarios without any intentional manipulation. Just by accident a company can have one weird bond that is worth very little and that sets the price of the auction too low, or just by accident its bonds can be scarce and the auction price can be too high.  Anyway. Europcar Mobility Group defaulted on its debt in December, failing to make an interest payment, as part of a negotiated restructuring deal. Its CDS was triggered, and on Wednesday there was a settlement auction. The bonds seem to be worth something in the neighborhood of 70 cents on the dollar; that is, that's roughly the value they expect to get in the restructuring. So you might expect CDS to pay out around 30 cents on the dollar. But! Back in October, as the restructuring was being negotiated (but before the default), it looked like there might be a weird quirk where the CDS paid too much. From Bloomberg: An anomaly in credit insurance on Europcar Mobility Group could prove lucrative for some traders as the French rental-car firm seeks to restructure 1.3 billion euros ($1.5 billion) of debt. … Investors are betting a payout on Europcar would be higher than normal because of an unusual feature -- the contracts reference a loan, as well as the company's bonds. A 50 million-euro loan from Credit Suisse Group AG last year was designed to be deliverable into credit swaps and traders are betting that will have a lower recovery value. "For some people, this will have been a superb trade," said Munich-based Felsenheimer, who saw the package quoted at about 100% of face value a couple of months ago. "It's a very special situation because of the loan being deliverable and cheaper to deliver than the bonds." But it turned out not to be deliverable. And in the event, there turned out to be a weird quirk where the CDS paid too little. Specifically, zero. From the Financial Times yesterday: A technical quirk has rendered derivatives linked to the defaulted debt of a French rental car company worthless, in the latest embarrassing incident to hit the $9tn credit default swaps market. Buyers of credit default swaps (CDS) on Europcar were expecting a payout to compensate them for the company failing to honour its debt. But an auction held on Wednesday to determine the level of award left them with nothing. The farce marks the latest in a string of mishaps that have undermined confidence in CDS — derivatives that are intended to act like insurance against a borrower reneging on its debts. Part of the problem here was that a lot of the relevant bonds were, not cornered exactly, but locked up:  The problem stemmed from the terms of Europcar's restructuring, which meant that most holders of its €1bn bonds were restricted from trading, preventing the debt from being included in the crucial auction that determined the swap payout. If nobody who owns the bonds can sell them—because they've agreed not to, as part of their deal to get a recovery in the restructuring—then there won't be any bonds available at auction, so the auction price will be 100,[4] so the CDS will pay zero. (Which is unfortunate for some bondholders who agreed not to sell the bonds, but who had CDS that they hoped would compensate for their losses.) But that isn't quite the whole story; there were actually enough bonds available outside of the lockups. The problem is that … investors … forgot? A JPMorgan Europe Credit Research note yesterday noted that "even accounting for the lock-ups, the deliverable pool was seemingly large enough to cover potential net interest in the Auction," and pointed out: The outcome is a missed opportunity for market participants given that anybody can participate in the second of round of the auction (regardless of whether they had a CDS position or not) and submit (through a participating dealer) as many limit orders in the direction of the open interest as they wish. … Given that the company is seemingly offering investors a package valued somewhere in the high 60s, any market participant could have offered the bond into the auction at an elevated price (even significantly above par). ... If you owned one of these bonds, worth about $70, you could have put in a limit order to sell it in the CDS auction for $99.99, or $120 for that matter. What would it hurt? But not enough people did. The consensus seems to be that there was nothing nefarious; they just assumed that the CDS auction would clear at a normal price—the preliminary indicative price in the initial round of the auction was $73—and didn't bother submitting their bonds. From the FT again: While there was still more than enough debt outstanding to settle the swaps properly, not enough holders ultimately sold their bonds into the auction. "This is an inherent threat in the auction that we always reminded people of," said Athanassios Diplas, of Diplas Advisors, a former banker regarded as one of the architects of the modern CDS market. "You cannot rely on someone else to provide liquidity in the auction." I don't know what to tell you. A lot of finance is built around sort of no-arbitrage assumptions: "If X happened, then people could make a risk-free profit, so they'd flock to the opportunity until X did not happen." In liquid continuous markets those assumptions often more or less work. But sometimes people just forget to take their risk-free profits, and the system breaks down a bit. An IPO On Wednesday, Poshmark Inc.'s initial public offering priced at $42 per share. Yesterday morning, Poshmark opened for trading on the Nasdaq, with an opening price of $97.50, 132% above the IPO price. The stock closed at $101.50, 142% above the IPO price. I have nothing particular to say about this. We talked about it yesterday. Well, yesterday we talked about Affirm Holdings Inc., not Poshmark, but same basic story. "The way the IPO pop works is that, whatever the IPO price is, the stock doubles the next day," I wrote, because I am very good at explaining finance.[5] Still true today. Eventually it will not be! Historically, sometimes stocks even go down after their IPOs. Right now they double. Bitcoin mining Here is a story, from November 2013, about a guy who mined 7,500 Bitcoins in 2009, put the private key on a hard drive, and then in 2013 accidentally threw away the hard drive. By then the Bitcoins were worth about $4 million, so he tried to get the hard drive back. It was in a landfill. Still: He even went down to the landfill site itself. "I had a word with one of the guys down there, explained the situation. And he actually took me out in his truck to where the landfill site is, the current ditch they're working on. It's about the size of a football field, and he said something from three or four months ago would be about three or four feet down." He gave up and went home, though he did "set up a Bitcoin wallet for donations aimed at recovering the hard drive." A spokeswoman from Newport council emphasised that any treasure hunters turning up to the landfill site wouldn't be allowed in, but "obviously, if it was easily retrieved, we'd return it." There are tons of these stories, all darkly amusing; we talked about them the other day. Supposedly 20% of all Bitcoins in existence have been lost like this: If you lose your private key, your Bitcoins are gone forever, with no bank to appeal to to get them back. That was 2013. Bitcoin has gone up a bit since then. At today's price that's about a $290 million hard drive. He's having another try. From yesterday: A computer engineer who claims he accidentally threw away a hard drive containing a virtual currency worth tens of millions of pounds has promised to give a local council a quarter of the fortune if they help him dig it out of a rubbish tip. James Howells, 35, says the hard drive of his old laptop contains bitcoins worth about £200m but is languishing in a landfill site in Newport, south Wales. Howells says both he and the council will benefit if they allow him to dig for it but the local authority is refusing, claiming an excavation would break licensing regulations and cause environmental damage. "The attitude of the council does not compute, it just does not make sense," said Howells. Every sentence is incredible: He believes that even after all this time the hard drive would still be in good enough working order. "The outside case might be rusted. But the inside disk, where the data is stored – there should be a good chance that it still works." Howells said he had financial backing from a hedge fund to pay for the search so the council would not be out of pocket. And he has a plan. "The way the landfill operated in 2013 was when a general waste bin was full, it was given a serial number, it was dragged off to the open pit and it was buried. It was also given a grid reference number. "So if I could access the landfill records I could identify the week that I threw the hard drive away, I could identify the serial number of the bin that it was in, and then I could identify where the grid reference is located." Financial backing from a hedge fund! Imagine those pitch meetings, wandering around Mayfair trying to get hedge funds to agree to sift through acres of garbage to find some Bitcoins. "You'll want our special situations team." If anyone has a copy of his pitch deck for this trade, I need it desperately.[6] I assume it would lay out the plan for digging up the garbage, and the sources and uses of funds. There'd be a financial model showing that, even accounting for paying off the local council and discounting for the possibility that the hard drive has rotted away, you'll make at least a 30% expected return on your investment. There'd be a page on the capital structure and payment waterfall. You'd need a deep dive into the landfill's record-keeping system, with aerial maps showing the grid and schematic diagrams of the cross-section. Then a technical section on how you put a rusted garbage-covered hard drive into a computer to get the Bitcoins off of it. At the back of the deck you'd have a page on "The Team," with little pictures and bios of the guys who are going to dig up the garbage. If no one sends me this pitch book I might have to make it myself. It should be taught in business schools. If you took a class on "Blockchain and Crypto for Finance" and there was no case study on digging up landfills for hard drives, you should demand your tuition back. I assume the disk will eventually disintegrate under its blanket of garbage, but you never know. In another decade, when Bitcoin has become the world's main store of value and 90% of it has been misplaced, this will be a trillion-dollar rubbish dump and Wales's main industry will be combing through it looking for that hard drive. Elon Musk's Boring Company will open a factory in Wales and design special drilling equipment to mine (the rubbish dump) for Bitcoins (on that hard drive). The future of finance is amazing. Things happen GameStop Stock Soars and Social-Media Traders Claim Victory. The Fed Wakes Up to Race. U.S. Targets Xiaomi, Cnooc in Trump's Late Anti-China Push. People are worried about duration. A Raven Queen Vanishes, and Britain Checks a Prophecy. Someone Wants to Pay $7,777 for Elon Musk's Dogecoin Tweet.  If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks! [1] The reserves were $33.6 billion at the end of the third quarter, and $30.7 billion at the end of the fourth; the difference is the $2.9 billion reserve takedown that Dimon references. [2] Also, more to the point, if by the second quarter of 2020 you expected the fourth quarter of 2020 to be terrible, but by the fourth quarter of 2020 things are pretty good and the future looks even better, then you will have a huge profit in the fourth quarter, because you'll be reversing the reserves you took earlier. [3] Or because it has partially "orphaned" its CDS by moving its debt to a new entity, leaving very little debt at the old entity that still has lots of CDS outstanding. Perhaps, if you are a CDS writer, you can convince the company to do that orphaning, by giving it a cut of your profits. This is roughly the  McClatchy Co. trade. [4] Technically what happened is that  there weren't enough bonds on offer to meet the physical settlement requests, so the auction didn't clear and produced a sort of default price of 100. Here are the auction results, showing that there were limit orders to sell 35.9 million euro of bonds, but 43.3 million euro of buy physical settlement requests, an imbalance of about 7 million euro. [5] I also noted that part of the reason for the pop is that a lot *fewer* shares get sold in the opening auction on the stock exchange than in the IPO. That's even more true here: Poshmark sold 7,590,000 shares in its $42 IPO, including the greenshoe (see page 9 of the prospectus, and footnote 1 in yesterday's column); 797,151 shares traded in the $97.50 Nasdaq opening cross. The price to sell 7.6 million shares is lower than the price to sell 800,000 shares. [6] I suppose it's more likely that a hedge fund called him. The special situations team was sitting around brainstorming, someone thought to Google "lost Bitcoins" and found that 2013 article, they put together a quick financial model and called him up. "Hi, you don't know us, but we represent certain financial interests, and we think we could help you dig up a landfill." If you have the hedge fund's investment memo I would also very much like to see that. Follow Us Get the newsletter You received this message because you are subscribed to Bloomberg's Money Stuff newsletter. Unsubscribe | Bloomberg.com | Contact Us Bloomberg L.P. 731 Lexington, New York, NY, 10022