The $24 Trillion Derivatives Monster

This is a story that bears repeating. J. P. Morgan Chase & Co. (JPM-NYSE) is one of the biggest banks in the world with assets of approaching US$ 700 billion, capital of about US$ 41 billion and a market cap of US$ 71 billion. By comparison Canada's largest bank the Royal Bank of Canada (RY-TSE, NYSE has assets of about US$ 235 billion, equity of about US$ 12 billion and a market cap of about US$ 26 billion. J.P. Morgan Chase is roughly three times the size of Canada's largest bank.

But there is an area where J.P. Morgan Chase dwarfs the Royal Bank. Indeed J.P. Morgan Chase dwarfs everyone in this business. The business is derivatives. In the USA J. P. Morgan Chase is over 50% of the derivatives market. According to figures from the Office of the Comptroller of the Currency (OCC) as at December 31, 2001 JPM had notional amounts of derivative contracts outstanding of US$ 23,520 billion or US$ 23.5 trillion. That was out of total derivatives of reporting banks of US$ 45.4 trillion. The aforementioned Royal Bank of Canada had at the end of their second quarter a notional amount outstanding of approximately US$ 1.2 trillion.

Despite the huge notional outstandings at the end of 2001 JPM was actually down from their peak that was seen at the end of the second quarter 2001. At that time notional amounts outstanding approached US$ 30 trillion. Since then they have fallen an amazing US$ 7 trillion in only roughly six months.

Part of it relates to the merger of the two firms J.P. Morgan and Chase Manhattan that took place in 2001 as the US$ 30 trillion related to the combined firms pre merger. We would surmise that part of it was due to netting and probably derivatives transactions between the two banking institutions. Still the outstanding figure is astounding. By comparison the US GDP totals roughly US$ 10 trillion and total outstanding debt of all sectors totals just over US$ 19 trillion.

The comparison of course is somewhat unfair as the outstanding derivatives is notional amounts. Actual exposure is measured by the net credit equivalent exposure. As at December 31, 2001 the credit exposure for JPM according to their annual report was US$ 51 billion. Again by comparison the credit exposure for the Royal Bank of Canada was roughly US$ 13 billion at the end of their second quarter April 30, 2002. These figures are allocations according to credit formulas. In the event of a catastrophic unpredictable event the exposure may be considerably larger. Derivative portfolios are subject to a constant barrage of stress tests.

Derivatives are securities whose value depends on the values of other basic underlying securities. Derivatives have exploded in use over the past two decades. The include such well known instruments as futures and options which are actively traded on numerous exchanges and as well numerous over-the-counter instruments such as interest rate swaps, forward contracts in foreign exchange and interest rates, and various commodity and equity derivatives. The worldwide market is huge with an estimated size in excess of US$ 100 trillion. Everyone from the large financial institutions, governments, corporations, mutual and pension funds, to hedge funds, and large and small speculators, use derivatives. Many individual investors may also use them even if all they are doing is using them to write covered calls against their investments on the advice of their stockbroker.

The huge derivatives exposure at JPM has been the subject of a number of articles over the past few months. First its sheer size is enough to catch anyone's attention and secondly when one puts it beside the number of collapses over the past several months it seemed that every time one occurred JPM was at or near the top of the list of credit holders. Enron, Global Crossing, Kmart, Argentina were all amongst JPM's holdings that went down. JPM have said that so far all of the high profile collapses are only about 1% of its total portfolio. Still it is a concern.

But when it comes to derivatives it brings up visions of Long Term Capital Management (LTCM) the hedge fund that collapsed in 1998 and that required a bail out from the Federal Reserve and a cadre of banks including JPM; and, Nick Leeson, the derivatives trader that brought down Barings Bank PLC in 1995; and, the Orange County, California collapse in 1994. Indeed derivative collapses have been behind numerous stories over the past decade. The most recent was the collapse of Enron where the energy giant was hiding transactions in subsidiaries using derivatives. As well stories have come to light about significant manipulations in energy derivatives by Enron that had a negative impact on energy prices during the California energy blackouts.

But JPM as a subject of articles has put it in the category of "too big to fail" (Is J.P. Morgan Chase too big to fail? John Crudele, New York Post, February 7, 2002). Jim Grant's Interest Rate Observer termed JPM's derivative position as so huge it looks like a typographical error. The next largest exposure is with Bank of America at US$ 9.3 trillion outstanding. So the almost US$ 24 trillion at JPM does look like a monster.

One of the more curious exposures is gold derivatives. JPM has been the subject of considerable scrutiny by the Gold Anti-Trust Committee (GATA) as one of the chief culprits behind the alleged gold manipulation. JPM certainly does have large outstandings in gold derivatives. According to figures from OCC JPM had over US$ 41 billion of gold derivatives as at December 31, 2001. This represented almost 65% of all the gold derivatives held by US banks. It also represents the equivalent of 149 million ounces of gold assuming the closing price of gold on December 31, 2001 at US$ 279. Of course what we don't know is the net exposure position as the figures are only the gross outstandings. And we don't know whether their position is long or short gold and how it might relate to physical holdings. Still it did represent a drop of US$ 14.8 billion or 26.5% from the outstandings at the end of the second quarter. Quite a drop.

JPM has been referred to as a house of cards because of the huge outstandings in derivatives. But of course we only know the gross position and not the net position that may be offset with physical holdings in bonds, loans, equity and gold. The vast majority of the positions are termed in JPM's annual report as trading positions as opposed to hedging positions. That could mean almost anything although oddly enough in twenty plus years in the investment industry many of them spent as a derivatives trader, trading positions meant speculative leveraged positions.

The so-called rogue trader Nick Leeson who made a huge derivatives bet on the direction of the Japanese Nikkei Dow brought on the aforementioned collapse of Barings Bank PLC. The collapse of Long Term Capital Management (LTCM), a hedge fund that had a former derivatives and bond dealer from Salomon Brothers and two Nobel Prize winners in Economics as principals, collapsed because of huge leveraged bets in currencies and bonds. Finally a lot of the problems of Enron were brought on by leveraged derivatives and using derivatives to hide problems on the balance sheet. Annual reports say nothing about the leveraged positions of JPM.

More questions have come to JPM since the supposed mysterious leaving of Dinsa Mehta, JPM's former head of global commodity risk management and global foreign exchange. Mr. Mehta had been with JPM for 26 years. One of his responsibilities was JPM's gold portfolio. Rumours had persisted that there was something wrong in their precious metals book. After the financial debacles of Enron, Global Crossing and Argentina all we can say is that the "House of Morgan" is still around. As for Mehta all he says is that "Conspiracy theorists are doing what they do best; provide entertainment from the sidelines". JPM is being sued in conjunction with lawsuits brought against Enron and Mr. Mehta has been named along with others to appear and provide documentation on matters related to Enron to the House Committee on Energy and Commerce.

We leave you with a chart of J.P. Morgan Chase & Co. and the Philadelphia Gold & Silver Index (XAU) two charts going in opposite directions. JPM is a key component of the Dow Jones Industrials. The gold sector has been the best performing sector over the past year. Where there is smoke, there could be fire. As gold goes up is there a debacle in waiting sitting in their gold derivatives portfolio? Or for that matter in their interest rate derivatives portfolio as interest rates are pressured if the US Dollar continues its current fall? We would keep a close eye on JPM.

June 12, 2002

Charts and technical commentary by David Chapman of Union Securities Ltd. 69 Yonge Street, Suite 600, Toronto, Ontario, M5E 1K3 (416) 604-0533, (416) 604-0557 (fax) 1-888-298-7405 (toll free) email [email protected]

www.davidchapman.com

The opinions, estimates and projections stated are those of David Chapman as of the date hereof and are subject to change without notice. David Chapman, as a registered representative of Union Securities Ltd. makes every effort to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete. Neither David Chapman nor Union Securities Ltd. take responsibility for errors or omissions which may be contained therein, nor accept responsibility for losses arising from any use or reliance on this report or its contents. Neither the information nor any opinion expressed constitutes a solicitation for the sale or purchase of securities. Union Securities Ltd. may act as a financial advisor and/or underwriter for certain of the corporations mentioned and may receive remuneration from them. David Chapman and Union Securities Ltd. and its respective officers or directors may acquire from time to time the securities mentioned herein as principal or agent. Union Securities Ltd. is an independent investment dealer and is a member of the Toronto Stock Exchange, the Canadian Venture Exchange, the Investment Dealers Association and the Canadian Investor Protection Fund.