So, obviously, we don’t wanna tick off employees of JP Morgan, especially as no one reading this blog had a darned thing to do with the recently revised loss of between $6-7 billion from bad derivatives trading. But, there is a tie-in to a couple of testable points, and all public companies are fair game, so here goes. When/if you see the term “forward” on your exam, you’ll need to remember that these derivatives are private, unregulated arrangements between two parties. Because forwards–unlike options and futures–do not trade on regulated exchanges, with settlement dates and margin requirements enforced, we occasionally end up hearing about some tsunami-like effect when one side finally has to admit to themselves, their trading partners, and the regulators–uhhhhhhhhhh, we really screwed up here–wtf? Even though the housing crash was inherently linked to the speculation in mortgage-based derivatives, here we are four years later with the same stuff still happening.
Why? Way beyond the scope of the exam and this blog. I just want you to associate the term “forwards” with “unregulated derivatives” and remember that they are private arrangements between two parties.
And, man, do some of these contracts get creative. You’re afraid that a corporation you lent $300 million to might default? Structure a derivative in which the other side agrees to pay you X amount if that happens. You find yourself sitting on a portfolio of $5 billion worth of “sovereign debt” issued by OPEC nations and start to worry they maybe cannot or will not pay? Structure a derivative that works like an insurance contract that pays out if that disaster strikes. Or, just make wild speculative bets that X, Y, or Z will occur across the globe, whether it’s a bond default, a weather-based event, or probably a hundred things my limited imagination has never considered. Unfortunately, not everyone fully understands what they’re getting into, and they frequently forget that the things in life that will “never happen” always do eventually. Only worse.
In any case, I’m not worried about the survival of JP Morgan, but I definitely understand the concerns of the regulators trying to avoid another credit crunch or series of big bank failures. The “banks” these days get to take FDIC insured deposits and then use those funds to make esoteric bets using unregulated derivatives few seem to understand. Obviously, it doesn’t work out so well sometimes. Who should pay the price? Shareholders, in my opinion. And then the you-know-what needs to roll UP hill–the shareholders need to organize, vote down the executive compensation packages and even remove the members of the board of directors who don’t seem to have any more ability to avoid a $7 billion loss than any random person swearing at an ATM at any Chase(TM) location this afternoon.