Trade Alert: Shorting the Morgans

Let’s get right to it: I’m add short positions in JP Morgan JPM and Morgan Stanley MS to our Revolution Investing portfolio.  The rot at the banks has finally caught up to them, and I think this is a major historical inflection point.  As I wrote this weekend in The Cody Word:

I think shorting the financials right here right now is probably a terrific bet. At worse, it’s an excellent hedge to whenever these endless financial crises that these banks created finally come home to roost.

What’s bringing the chickens home is the LIBOR scandal.  If you didn’t know about LIBOR from the financial crisis, you should definitely know about it now.  The London Interbank Offered Rate, in very simplified terms, is the rate banks charge each other.  Banks get a call, they say what they would charge to lend their banking bretheren, and those numbers are averaged.  After years of rumors that the rate was being manipulated, regulators slapped Barclays BCS with a $450M fine.  Libor is pretty darn important, it’s a bellwether of stress in the lending system, and it underpins everything from Mark Zuckerberg’s mortgage to municipal bonds.

It’s great that the geniuses at Barclay’s laid out their fraud in email and IM form.  Here’s a snippet from an exchange:

on 27 May 2005:

Submitter:   “Hi All, Just as an FYI, I will be in noon’ish on Monday […]”.

Trader B:  “Noonish?  Whos going to put my low fixings in? hehehe”

While that makes for a good  laugh here’s the more pressing part of the complaint:

In addition, certain Barclays Euro swaps traders, led at the time by a senior trader, coordinated with and aided and abetted traders at other banks in each other’s attempts to manipulate Euribor, even scheming to impact Euribor on key standardized dates when many derivatives contracts are settled or reset.

This kind of fraud necessitates more than one participant.  I’m betting that all the banks colluded and the regulators aided them.  Be warned, we are in the very early stages of this, but the bodies are already stacking up. Recently deposed Barclays COO Del Missier just said that it was the Bank of England that made him artificially lower rates. And wouldn’t you know it, our regulators knew something was up back in 2007.

What we have is a perfect litigation storm that will drag on for years.  The estimates of $400M per bank are too low, I think billions at least is a much better starting point.  The fallout has consquences that go far beyond wonky bank liquidity metrics though.  It marks the beginning of the end of the derivatives-industrial complex. The banks are finally going to have to start admitting the actual value of their derivative bets and it’s going to get U-G-L-Y.

JPM’s admission of billions of dollars of losses is, in my exclusive analysis, a direct result of this LIBOR scandal coming to light, making these banks ability to rig their markets and lie about their derivative exposure and losses harder and harder. Do you really think no one knew just how big the London Whale’s bets were getting? Just the opposite, everyone inside the bank knew and encouraged it, because it was a major profit center when the trade was going well. And they would have never put on such a big trade if they didn’t think they could rig rates.

I think there’s a huge risk that the banks have to admit rigging LIBOR, which will kill the $800TT derivative market, and then the banks have to admit they were rigging oil and other commodities next. Check out this article from FT:

Blythe Masters, global commodities head at JPMorgan, said: “The length of time that the refinery is responsible for owning molecules is reduced.”

“Banks are not competitors of [the refiners] but rather facilitators for them. That, along with risk capacity and balance-sheet capacity, is the reason why banks play a role,” she said.


The banks’ increasing role in oil supply comes as US regulators proceed with new rules limiting the size of oil derivatives positions held by financial traders. But banks can use physical oil cargoes to offset against their quota of derivative positions.

All the banks have been going higher and higher up the value chain in all kinds of derivative bets for years.  They are desperate from revenue as bond trading and ibanking income have withered.  It shouldn’t be surprising that Goldman GS now controls much of the metals warehousing business and is ramping up private banking to sell the 1% byzatine tax evading derivatives.

LIBOR manipluation has enabled the banks to keep their balance sheets enormous via the derivatives market.  Once the banks have to admit that libor is manipulated, the derivatives business will be scrutinized, they’ll necessarily have to shrink the size of their derivative bets, and that will kill their earning power. Their ability to lie about the value of all these assets and therefore the ability to lie about the derivative bets on all these markets is about to disappear…the banks are going to have to stop rigging markets and profits from those riggings are about to disappear. The end game of the banks is probably here and we don’t want to sit on the sidelines while the piper comes to be paid.

Morgan Stanley is the weakest of the remaining financial institutions, and if it weren’t for some back room rigging with Moody’s, it would currently be rated junk.  Plus management screwed up and didn’t take a corrupt accounting gimme regulators threw their way, and now they can’t without raising billions in capital. I’ve been watching the MS CDS gyrate wildly, and I think it’s a good tell that the bank’s counterparties just don’t trust the management.  Plus MS is really deep into a lot of complicated commodities bets it doesn’t understand but will have to unwind over the coming months and years.  So if you’re Morgan Stanley and you’ve bought all these VLCC’s to store oil because you make physical oil contago bets, and you can no longer manipulate the interest rate assumptions that underpin those bets, you can’t make as much money, which means you’ll get out of the business.   That rush for the exits is going to play out in financial and physical derivative assets.

The Jamie Dimon halo is totally gone and unlike my friends who are JD apologists, I’m going to be harsh.  JPM’s entire leadership is incompetent, I don’t care if they were being lied to by a desk in London, it’s their job to not allow festering pockets of incompetence in the first place.  With some $70-odd-trillion in derivatives bets, JPM is the squarely in the Too Big To Change camp.  I’ve been hearing from my buddies at some of the biggest credit funds that JPM still hasn’t unwound all of the whale’s bets, and that every time they try to, they get sniped at.  So $70 trillion in bets, let’s say that JPM has some how netted (or, crudely, hedged) 99% percent of that exposure.  That’s $700B of derivative bets left.  That’s an insane amount to pare down, and even 5% of those bets going bad while doing so would be catastrophic.  The profit center of derivatives are over for the big banks and they won’t be able to swell the balance sheet and call it hedging.

I’m adding JPM and MS as short bets to the portfolio, using common stock to get started. I’m also covering the PNC and MBI short plays for about break even on both. I’d rather be short the Morgans at this point in time.