Opinion on  JPMorgan Chase & Co (JPM)     Sector: Financial  >  Industry: Money Center Banks
Bearish on JPM ...

JPM has the world's largest exposure to credit default swaps (CDS) with notional exposure of $8.0 trillion (yes trillion not billion!) and BSC is the second largest with notional exposure to CDS of $2.7 trillion.  JPM’s largest counterparty exposure in CDS could reasonably be expected to be on BSC. I suspect that the notional exposure would have accounted for circa 5% of BSC’s book leaving JPM with an exposure of $135 billion.

 

However this direct exposure would have been subject to various netting arrangements which would have reduced the net exposure to a much lower amount.  It is impossible to estimate what this direct counterparty exposure would have been but it would have been large.  Of greater concern to JPM would be that if BSC had gone bankrupt this would have brought JPM to bankruptcy itself as the largest player in the CDS sector as BSC defaulted on all its numerous counterparty exposures.

So, does the acquisition of BSC make JPM a better bank than before BSC threatened bankruptcy?  Before I attempt to answer this note the following:

1.      JPM is spending a paltry sum of circa $1.6bn to acquire BSC which represents 1% of its own market cap of $162bn
2.      for this JPM is getting $370bn of assets (excluding the $29bn guaranteed by the Fed)
3.      However, what hasn’t been publicised is that JPM is getting additional notional CDS exposure of $2.7 trillion bringing JPM’s total exposure to $10.7 trillion!

Managing this very significant exposure has two significant risks. The first is counterparty risk, the second is successfully managing the extremely large CDS position in a volatile and now highly correlated market.  Both of these risks if not managed well could easily make a significant dent in JPM’s book value of circa $126bn. I suspect that this No1 (plus No2) position would not be countenanced by Jack Welch!

One must not forget that JPM is no gem and has the following problems:

1.      It has a whopping $94bn of Home Equity loans which are experiencing unprecedented delinquency rates
2.      It has the world’s second largest credit card exposure of $148bn
3.      It has direct exposure to $24bn to sub prime mortgages
4.      and direct exposure to $26bn of leveraged loans
5.      JPM had one of the top private mortgage originators

In addition to the above, JPM faces considerable risk under Basle 2 where the estimate of JPM’s Economic Capital (eCap) to its present Tier 1 capital is of the order of 4.8 standard deviations greater than the average for large US banks (HABC is 2nd with 3.91x and Citi is 3rd at 3.88).  This means that under a Basle 2 eCap environment JPM would need to raise significant Tier 1 capital to achieve robust capital ratios.

Coming back to the initial question; I believe that the acquisition of BSC was JPM protecting itself from bankruptcy via contagion.  The transaction has been dressed up to look cheap and defensible on the basis that BSC provides the prime brokerage JPM has always coveted.

The acquisition has saved JPM for the short term; however the real test will be if JPM can carefully manage its much larger CDS position.  The key risk here is if another reasonably large participant in the CDS market were to go under this would reintroduce the counterparty contagion risk (threatened by the failure of BSC). JPM is now even more exposed to this risk than before – so let’s hope that there are no other BSCs out there !  The other catalyst would be a downgrade of either Ambac or MBIA – so hold onto your hats as this has just occurred and its impact will quietly gather momentum.

JPM has the world's largest exposure to credit default swaps (CDS) with notional exposure of $8.0 trillion (yes trillion not billion!) and BSC is the second largest with notional exposure to CDS of $2.7 trillion.  JPM’s largest counterparty exposure in CDS could reasonably be expected to be on BSC. I suspect that the notional exposure would have accounted for circa 5% of BSC’s book leaving JPM with an exposure of $135 billion.

 

However this direct exposure would have been subject to various netting arrangements which would have reduced the net exposure to a much lower amount.  It is impossible to estimate what this direct counterparty exposure would have been but it would have been large.  Of greater concern to JPM would be that if BSC had gone bankrupt this would have brought JPM to bankruptcy itself as the largest player in the CDS sector as BSC defaulted on all its numerous counterparty exposures.

So, does the acquisition of BSC make JPM a better bank than before BSC threatened bankruptcy?  Before I attempt to answer this note the following:

1.      JPM is spending a paltry sum of circa $1.6bn to acquire BSC which represents 1% of its own market cap of $162bn
2.      for this JPM is getting $370bn of assets (excluding the $29bn guaranteed by the Fed)
3.      However, what hasn’t been publicised is that JPM is getting additional notional CDS exposure of $2.7 trillion bringing JPM’s total exposure to $10.7 trillion!

Managing this very significant exposure has two significant risks. The first is counterparty risk, the second is successfully managing the extremely large CDS position in a volatile and now highly correlated market.  Both of these risks if not managed well could easily make a significant dent in JPM’s book value of circa $126bn. I suspect that this No1 (plus No2) position would not be countenanced by Jack Welch!

One must not forget that JPM is no gem and has the following problems:

1.      It has a whopping $94bn of Home Equity loans which are experiencing unprecedented delinquency rates
2.      It has the world’s second largest credit card exposure of $148bn
3.      It has direct exposure to $24bn to sub prime mortgages
4.      and direct exposure to $26bn of leveraged loans
5.      JPM had one of the top private mortgage originators

In addition to the above, JPM faces considerable risk under Basle 2 where the estimate of JPM’s Economic Capital (eCap) to its present Tier 1 capital is of the order of 4.8 standard deviations greater than the average for large US banks (HABC is 2nd with 3.91x and Citi is 3rd at 3.88).  This means that under a Basle 2 eCap environment JPM would need to raise significant Tier 1 capital to achieve robust capital ratios.

Coming back to the initial question; I believe that the acquisition of BSC was JPM protecting itself from bankruptcy via contagion.  The transaction has been dressed up to look cheap and defensible on the basis that BSC provides the prime brokerage JPM has always coveted.

The acquisition has saved JPM for the short term; however the real test will be if JPM can carefully manage its much larger CDS position.  The key risk here is if another reasonably large participant in the CDS market were to go under this would reintroduce the counterparty contagion risk (threatened by the failure of BSC). JPM is now even more exposed to this risk than before – so let’s hope that there are no other BSCs out there !  The other catalyst would be a downgrade of either Ambac or MBIA – so hold onto your hats as this has just occurred and its impact will quietly gather momentum.