But wait, why are these contracts called "Credit Default Swaps," and not "Bond Put Options" or "Bond Failure Insurance?" Because in securities law, writers of put options are required to put up initial margin and increase that margin if the markets move against the options. The collateral requirements for anyone writing "insurance" are even more stringent (which is why no insurance companies failed during the financial crisis.) JP Morgan sidestepped the whole issue of collateral by coining "Credit Default Swap" as the name of the new product.
CDS are custom, illiquid, non-transparent and uncollateralized. In 2003, Warren Buffett wrote that these and other derivatives were "financial weapons of mass destruction" that could harm not only their buyers and sellers, but the whole economic system. "Nonsense," said Alan Greenspan, who was head of the US Federal Reserve system at the time, and who blocked regulation of the new industry (he changed his mind in 2008.)
How did JP Morgan lose $3 billion
JP Morgan invented the CDS market in the 1990's and remained the dominant player through 2010. Unlike AIG, which lost $180 billion on nominal exposure of $3 trillion in CDS exposure, JP
Morgan skated through the 2008-9 financial crisis relatively unscathed, and still controls about 30% of the CDS market. The problem for JP Morgan is that the other 70% of the market is now filled with ex-Morgan employees who know how the models work and have taken those models to new employment in hedge funds.
We still don't understand exactly what a single trader nicknamed "the London whale" was trying to do, but he sold notional exposure of about $100 billion against the default of investment grade corporate bonds with an average maturity of 2017. Hedge funds ganged up on the other side of the trade. As the Morgan position sank into the red, the trader doubled and redoubled his position, but was finally forced to admit a loss of $2 billion in May. When the trades are closed out, the final cost is likely to be $3 billion. Not the end of the world for JP Morgan, which earned $5.6 billion in Q1 2012. But a black eye for JP Morgan head Jamie Dimon, who had been aggressively lobbying against the new regulations coming out of the 2010 Dodd-Frank legislation. If nothing else, we now have a test case as to whether JP Morgan violated the "Volcker rule" provisions of Dodd-Frank prohibiting "proprietary" trading (as opposed to trading "necessary to accommodate normal market making operations.")
What happened with the FaceBook IPO?
We generally avoid IPO's for two reasons:
We invest almost exclusively in "seasoned" companies with at least three years of financials as publically traded companies.
For every Google (which tripled in the first year as a public company) there are a hundred Vonage's (which peaked on the first day of trading and is now down 90% from that day.)
It was already a tough year for Web 2.0 IPO's (GroupOn down 51%, ,Zynga down 43%). When we heard that Morgan Stanley had "magnanimously" agreed to increase the allocation of stock to retail investors, we knew this one would be a stinker - institutional investors were shying away. And indeed it was, down 40% from the high on 5/18 and down 32% from the IPO price of $38.
Average retail investors don't understand any of this. Hundreds of thousands put in orders for $1,000-$25,000 of stock and immediately lost a bundle. Worse, technology problems at NASDAQ caused many investors to receive MORE shares than they thought they ordered, compounding their losses. Straightening that out will cost $40-100 million. Time and again, average Americans have been "hosed" in their dealings with Wall Street. Absolutely no-one in Washington, not at the SEC, not at the White House, not in Congress, seems to have any interest in bringing Wall Street to account.
Does anyone wonder why average Americans have pulled $400 billion out of stock mutual funds over the last 5 years?
What about your "Obama wins in 2012" forecast?
Last month we described 5 circumstances where Romney might win. The most important:
"Unemployment surges. If average Americans can see their lot improving even if current conditions are poor, Obama wins. If the economy turns down over the summer, Obama loses. On that basis, we see Congress doing absolutely nothing to boost the economy over the next 6 months."
A few more months of jobs reports like the one we got last Friday, and it's "game over" for the Obama administration. And no, Congress refuses to do anything that would boost jobs growth.
Shouldn't we give up on stocks and only buy bonds
Of the hundreds of billions pulled from stock funds in the last 5 years, many billions have gone into bond funds, which have maintained or even increased values as the Fed pushed interest rates to near record lows (only lower during the Great Depression.) In 2014, or perhaps now in 2015, the Fed will allow rates to rises. Medium or long dated bond funds are going to get killed. For long term capital needs such as retirement, the 3-4% current yield available from bond funds simply isn't enough to grow the pot. Also, if inflation ever returns, that 3-4% nominal yield might only be 0-2% real return.
Our strategy remains: Stock and commodity investments for cash needs at least 5 years out. Bond investments for cash needs 1-5 years out. Money markets for cash needs of less than a year.
Why should we be optimistic? Everything we read implies "the end of the world."
