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The JPM Derivatives Monster

Out of all the incredible financial developments of the 1990s, one of the most important
fundamental structural changes in the nature of the operation and interaction of the global
financial system was the literal explosion of the use of derivatives.

Derivatives are often highly complex financial instruments that"derive" their value from
some other underlying asset. As the use of these instruments evolved and advanced to a
stunning degree in the 1990s, an intriguing bifurcation of opinion on the merits of the hybrid
instruments developed. Among the Wall Street power players and aggressive private
speculators, derivatives were seen as a wonderful financial innovation that would lead to
highly customizable risk management and a huge new profit stream for Wall Street.

Outside of the financial halls of power, however, derivatives began to acquire a reputation of
being staggeringly risky financial instruments that could turn sour in a heartbeat and devour
the financial wizards who created them like hungry sharks. Like the young sorcerer's
apprentice in Walt Disney's classic 1940 masterpiece"Fantasia", a general public perception
of derivatives gradually evolved that perceived the growth of derivatives as a dangerous
experiment being recklessly played out in the financial world. Like the sorcerer's apprentice
dabbling in powerful magic when the master was not around to manage the unleashed forces,
derivatives creation was increasingly seen by the average investor as being hazardous
attempts to harness enormous financial tides and forces that were simply too big and too
complex to be decisively tamed.

A string of massive derivatives debacles in the 1990s helped buttress this negative popular
perception of derivatives and provided strong support for the"derivatives are very
dangerous" side of the great derivatives debate.

In December 1993 the large German industrial conglomerate Metallgesellschaft AG reported
huge derivates related losses racked up by its US subsidiary. Through an intricate hedging
strategy involving heavy energy derivatives use that spun out of control, the US subsidiary of
the German giant watched in horror as its complex custom-tailored financial instruments
exploded in unforeseen market conditions. Total losses were originally estimated at $1b,
enough to push Metallgesellschaft, Germany's fourteenth largest industrial corporation, to the
brink of bankruptcy. Metallgesellschaft eventually had to cough up $1.9b as a last-ditch
rescue package to stave off bankruptcy. What was perhaps the first well-known large
derivatives debacle in the 1990s was only a grim taste of things to come.

Unfortunately, the misfortune of Metallgesellschaft in attempting to conquer the brave new
derivatives world proved to be only the tip of the iceberg in derivatives disasters of the
1990s. Cargill lost $100m playing with mortgage derivatives, Askin Securities lost $600m
dabbling in mortgage-backed securities, US blue-chip Dow 30 company Procter & Gamble
lost $157m hedging with currency derivatives, and Codelco Chile obliterated $200m on
copper and precious metals futures. We could add Daiwa Bank of Japan, Sumitomo
Corporation, Ashanti Goldfields, and the list goes on and on. And these are just a few of the
less well-known derivatives debacles!

In 1994 the County Treasurer of one of the wealthiest counties in the United States, Orange
County, California, brought the mighty county to its knees in bankruptcy. Robert Citron
deployed risky exotic derivatives including reverse repurchase agreements to produce very
high returns for the County Investment Pool he managed. Unfortunately, when the markets
moved against his huge leveraged positions, the retirement funds under his custodianship
quickly hemorrhaged $1.5b. In a hearing before the California State Senate in 1995, Citron
said,"I must humbly state I certainly was not as sophisticated a treasurer as I thought I
was."

In February 1995 the proud and strong 223 year-old Barings Investment Bank of England,
which even counted Queen Elizabeth as a client, was annihilated by unauthorized derivatives
trading activity that imploded as the markets did not move as planned. Nicholas William
Leeson, a 27-year old hotshot derivatives trader based in Singapore, managed to quickly lose
$1.3b in the highly leveraged derivatives market before Barings' management in London
realized what was happening.

Rogue trader Nick Leeson was betting heavily on the future direction of the Japanese
blue-chip Nikkei stock index using common options. He placed hundreds of millions of dollars
at risk on the premise that the Nikkei was due for a major recovery in 1995. As we all know
today as we watch the embattled Nikkei index rip through 17 year lows like a meteorite
through a circus tent, Nick Leeson made the wrong bet. His personal derivatives debacle was
so extreme that it killed the proud Barings Bank. Barings had been around for centuries and
had even helped finance the rise of the great British Empire in the 19th century. A respected,
conservative monolith of a British institution died at the hands of powerful and inherently
uncontrollable forces unleashed by a young sorcerer's apprentice halfway around the world
in Singapore.

Derivatives disasters continued to blossom around the world like isolated mushroom clouds in
the late 1990s, with the most memorable and dangerous being the catastrophic Long Term
Capital Management debacle in 1998 on the heels of the Russian Debt Crisis, which we
discuss further later in this essay. In light of the frightening record of the enormous risks and
leverage of derivatives humbling the mighty in the 1990s, it is no surprise that most people
today rightfully believe that derivatives are a highly risky and unforgiving high-stakes game.

As derivatives use continues to explode around the globe, it is prudent for investors to closely
monitor derivatives and the companies dealing in them. The markets, if they have taught us
anything in this chaotic past year, have certainly reinforced the historical truism that they are
as unpredictable as ever over the short-term. Major discontinuities in price and unforeseen
volatility events can erupt at any moment, potentially putting unfathomable structural stress
on highly-leveraged derivatives portfolios.

As we plunge through the early years of our new millennium, any study of derivates in the
United States among leading blue-chip financial institutions inevitably leads to one
conclusion. Virtually all paths of derivatives inquiry lead to the same destination. Today, more
than ever before in the short history of derivatives, one leading United States institution
effectively IS the derivatives market. This company, as we will explore in this essay, is the
American giant superbank JPMorganChase (www.JPMorganChase.com).

Before we begin our exploration of JPMorganChase's (JPM-NYSE) mind-boggling exposure to
the high-leverage high-risk global derivatives market, a quick and dirty explanation of
derivatives is in order.

As we mentioned above, derivatives are simply financial instruments that derive their value
from some other underlying asset. The term"asset" is employed rather loosely here, as in the
derivatives world it can also include interest rates, currency exchange rates, stock indices,
and other market indices. Common examples of derivatives include options, futures,
forwards, swaps, and various combinations of these instruments.

The humble option is one of the simplest forms of derivatives. An option is simply the right to
buy (call) or sell (put) a certain investment at a contractually set price for a limited time in
the future. Options are also used as building blocks to assemble much more complex highly
exotic derivatives instruments, kind of like the financial equivalent of the toy Lego blocks
perpetually popular with children. Options are a fantastic tool to help comprehend and
understand the enormous leverage inherent in derivatives and the huge risks that are
shouldered when trading them. In order to wrap our minds around options, it is best to start
our illustration with normal equity investing and then move to simple lone options.

Imagine you have saved up $5,000 of risk capital you want to sow into the markets in the
hopes of reaping some profits. The conventional stock investing strategy is simply to find
some undervalued stock and buy it. You do your due diligence, find an undervalued stock
trading at a fair multiple with good future prospects, and you buy your shares of the
company. For this example's sake, let's assume that your investment in"XYZ Company" was
made at a share price of $50. Your $5,000 bought you 100 shares of XYZ Company.

Now that your capital has been successfully deployed, let's fast-forward six months into the
future and examine two scenarios. In the"Win Scenario", XYZ rallies 50% and you win some
healthy capital gains on your investment. In the"Loss Scenario", XYZ plunges 50% and you
begin to feel like a typical NASDAQ investor today.

In the Win Scenario when you are simply buying stock outright, your gains are easy to
calculate. Your 100 shares of XYZ that you purchased at $50 ran up 50% to $75, leaving you
with an equity position worth $7,500, a straightforward $2,500 profit. In the Loss Scenario,
XYZ plunged to $25, vaporizing one half of your original capital deployed. Your shares are
still worth $2,500, however, even after the share price implosion of XYZ. This clear-cut
equity example which we all intuitively understand is a pure unleveraged position that is
most useful to contrast with the extraordinary risks and potential rewards/losses inherent in
derivatives trading.

Next, let's warp back in time to your original decision to deploy your $5,000 of risk capital.
Let's assume that the money is not super-important to you and that you have a very-high risk
tolerance, so you decide to place the money in options instead of stock. You still like XYZ
Company and its prospects but you crave higher leverage and you are willing to accept higher
risks of loss to attain that leverage. You fully realize the risks in playing options are very
high, but you will not shed any tears if your $5,000 speculation does not pay off. You do
some research and find that you can buy a standard call option, the right to purchase, XYZ
stock at a strike price of $55 for seven months into the future for $1 per option.

Each option contract on XYZ represents options on 100 shares, so at $1 per share a contract
runs $100. With your $5,000 of risk capital you can buy 50 option contracts, yielding a total
span of control of 5,000 shares. The enormous leverage inherent in derivatives such as
options is immediately apparent. If you buy XYZ outright, you only can afford 100 shares
with your $5,000. On the other hand, if you play the risky derivatives market through call
options on XYZ, you can control the gains and losses on 5,000 shares, a staggering 50 times
increase in absolute leverage. With leverage through derivatives comes the potential for far
greater returns, but also far greater losses. Leverage is ALWAYS a sharp double-edged
sword.

In the Win Scenario, XYZ rockets to $75 in six months. Your 50 contracts of XYZ call options
at a $55 strike price are still one month from expiration and have grown very valuable. As
each option grants you the contractual right to purchase a share of XYZ at $55 even though it
is now trading at $75, the option on every individual share is now worth $20. The option, a
derivative, derives its value from the movements in its underlying asset, the actual shares of
XYZ. Since you bought 50 contracts each representing 100 shares worth of XYZ call options,
your $5,000 speculation has grown into $100,000 in six months! Through the use of
derivatives, your dramatic increase in leverage yielded an awesome $95,000 profit instead
of the $2,500 you would have made through outright XYZ stock ownership. When the
markets move your way, leverage attained through derivatives can be utterly exhilarating.

In the Loss Scenario, XYZ plummeted to $25 in six months, mimicking the 2001 action of the
crippled NASDAQ. Because your options are now so far"out of the money", they are nearly
worthless. Even though there is one month left until they officially expire, no one in the
market wants to buy your right to purchase XYZ at $55 when they can just go buy the actual
stock at $25 in the open markets. In this scenario, your $5,000 of risk capital has been
ground down into oblivion, a catastrophic 100% loss. If you had just bought the stock
outright instead, at least you would still have $2,500 dollars left, but through deploying
options you basically made an all-or-nothing bet that the XYZ stock price would rise over the
limited time horizon of the options. When the markets move against your derivatives, your
hard-earned capital can be literally obliterated in mere hours or days, a very difficult and
excruciating experience.

Options, the simplest of derivatives, help illustrate the extraordinary leverage and the
mega-risk that derivatives exposure entails. Amazingly, long options are one of the lowest
risk forms of derivatives because one can never lose more capital than what they paid to
purchase the options. Many other more exotic derivatives have dangerous unlimited loss
potential and can ultimately destroy far, far more capital than what was actually paid for the
financial instruments.

Another critical concept for understanding the strange world of derivatives is"notional value"
or"notional amount". This is a quasi-fictional number that illustrates how much capital a
given derivative effectively controls. Although the notional amount does not change hands in
a derivatives transaction, it is used to calculate the actual payments that must be made to one
counterparty or the other in a derivatives transaction. Furthering our options example above,
we can also gain a glimpse into the world of notionality in derivatives.

Although you only deployed $5,000 worth of risk capital in your XYZ call option purchase,
you controlled the equivalent of 5,000 shares of stock since each option only cost $1. As the
stock was trading at $50 when you originally purchased your options, you controlled a
notional amount of XYZ stock worth $50 per share times 5000 shares, or $250,000. In the
Win Scenario when XYZ rose 50%, the notional value of your options rose to $75 per share
times 5000 shares, $375,000. By purchasing call options you harnessed the extreme
leverage of derivatives to enable yourself to originally control the notional equivalent of
$250,000 worth of XYZ stock while only risking $5,000 of your own capital.

Realize that the notional amount is not a real number but simply a descriptive fiction detailing
how much of the equivalent underlying asset your derivatives position effectively"controls".
Notional amounts are used in the derivatives world to show the effective span of control that
derivatives grant market participants over underlying assets at any given point in time. By
comparing changing notional values over time, they can be used to measure and analyze
positional changes in derivatives exposure over a given time horizon.

Also critical, realize that notional amounts are NOT volume or turnover data, but positional
data points. A notional derivatives amount for the end of a given quarter is like a balance
sheet presentation of potential exposure at that moment in time, NOT an income-statement
like account of activity or turnover in a given quarter. Some prominent analysts have crossed
this line out of reality and made the embarrassing public mistake of publishing research
where they articulated the twisted fantasy that notional amounts are transactional and not
positional. Notional derivatives amounts ARE positional, a snapshot of exposure at a single
moment in time.

Although it has lately become somewhat popular on Wall Street and financial circles to claim
that notional amounts of derivatives bear no relation to the risk of derivatives positions, we
strongly disagree. The higher the notional amounts of an entity's total derivatives exposure,
generally the higher the leverage it has used to pyramid its derivatives positions. The greater
the leverage employed, the higher the aggregate risk of a derivatives portfolio. We will
discuss this important concept in more detail further below.

In the United States, commercial banks and trusts are required to report their derivatives
exposure once every quarter to the United States Comptroller of the Currency. The Office of
the Comptroller of the Currency was founded in 1863 as a bureau of the US Treasury and has
been responsible for ensuring a"stable and competitive national banking system". Per the
OCC's website at www.occ.treas.gov, the OCC claims it has four objectives:"To ensure the
safety and soundness of the national banking system, to foster competition by allowing banks
to offer new products and services, to improve the efficiency and effectiveness of OCC
supervision, including reducing regulatory burden, and to ensure fair and equal access to
financial services for all Americans."

The OCC prepares a quarterly report called the"Bank Derivatives Report" which details
general derivatives positions for all US commercial banks and trusts that operate in the
derivatives market. US commercial banks and trusts are required by law to report their
general derivatives positions to the OCC each quarter. Although the OCC Bank Derivatives
Report does not include the derivatives positions of non-commercial bank entities like
Goldman Sachs, which is an investment bank, the OCC report is still extremely useful in
providing a sample or cross section of derivatives market activity and positions in general.
We are not sure what percent of the total derivatives market that commercial banks and
trusts represent, but we suspect it approaches a majority.

In this essay, all the derivatives data cited is directly from the latest available OCC Bank
Derivatives Report, for the first quarter of 2001, available at
www.occ.treas.gov/ftp/deriv/dq101.pdf. All of our graphs and derivatives numbers are
either lifted directly from or calculated directly from this important US government report. As
the data we are reporting is so mind-blowing as to appear unbelievable, we strongly
encourage you to check out this original OCC document with your own eyes. An analysis of
this official report makes it quite evident that the enormous derivatives market is dominated
by one US holding company, the elite blue-chip Dow 30 superbank JPMorganChase.

Our first graph was constructed using data from"Table 1" of the OCC Q1 2001 Bank
Derivatives Report. It clearly shows who the largest derivatives players are out of all the
395 US commercial banks and trusts that dabble in the derivatives market. The first point
that leaps out of this pie graph like a central banker sitting on a thumbtack shows the
overwhelming iron-fisted dominance that JPMorganChase (Chase Manhattan Bank and
Morgan Guaranty together) exercises over the US derivatives market.



As we delve into the often cryptic world of derivatives, it rapidly becomes apparent that the
amounts of dollars of capital effectively controlled through derivatives is absolutely
staggering. The notional amount pie in our first graph above is a monstrous $43,922 billion,
or almost $44 TRILLION dollars. Rarely at a loss for superlatives, we cannot even think of
enough to describe how large these numbers truly are! It is virtually impossible for humans
to grasp how big even one trillion is, so we are enlisting the help of the fascinating
"MegaPenny Project" website which was created to illustrate enormous numbers.

The MegaPenny Project is located at www.kokogiak.com/megapenny/ and is designed to
illustrate large numbers by stacking given numbers of common US one-cent pennies and
showing the relative size of the stacks. We encourage you to take in the whole fascinating
MegaPenny tour, but for this essay we are particularly interested in its two pages describing
one trillion pennies, beginning at www.kokogiak.com/megapenny/thirteen.asp. The
MegaPenny Project does a wonderful job graphically illustrating just how much space one
trillion pennies would take up.

According to the fine folks at MegaPenny, a solid block of one trillion pennies tightly stacked
on top of each other would create a cube 273 feet on each side, each axis of the cube almost
as long as an American football field. For comparison purposes, remember that all the gold
mined in the last six millennia would fit in a much, much smaller cube only 62 feet on each
side! The cube of one trillion pennies would weigh an amazing 3,125,000 tons, almost half as
much as the estimated entire weight of all the huge stones comprising the Great Pyramid on
the Giza plateau in Egypt! If the trillion pennies were laid flat side-by-side instead of stacked,
they would cover 89,675 acres, or over 140 square miles. Stacked on top of each other in a
single mega-column, one trillion pennies would create a stack of pennies 986,426 miles high.
The average distance from the Earth to the Moon is only around 238,866 miles, so one trillion
pennies stacked could travel between the Earth and Moon over four times!

One trillion is a ridiculously large number and almost impossible to visualize in the abstract.
Trillions of dollars of derivatives exposure blow the mind! According to MegaPenny, it would
take 1.8t pennies to create an exact full-scale replica of the Empire State Building out of
pennies. It would take 2.6t tightly stacked pennies to create a life-sized perfect replica of
Chicago's mighty Sear's Tower.

It is very hard to believe that the total US notional derivatives positions of US commercial
banks and trusts is $43.9 TRILLION dollars. By comparison, the US GDP, all the goods and
services produced and consumed in our entire great nation by every single American each
year, was only running $10.1t in the first quarter. The US M3 money supply, the broadest
measure of money, was only $7.4t at the time. The 500 best and biggest companies in the
United States, the S&P 500, were only worth $10.4t at the end of the first quarter. Clearly,
the $43.9t dollars of the notional value of derivatives that a mere 395 commercial banks and
trusts control is simply staggering as it far exceeds the entire US GDP, the entire broad US
money supply, and the entire value of all the stocks traded in the United States! BIG, BIG,
BIG numbers!

Of that huge $43.9t, JPMorganChase, a single holding company, controls a breathtaking
$26.3t worth of derivatives in notional terms! JPM represents 59.8% of the total derivatives
market controlled by US commercial banks and trusts per the OCC. Why on earth would one
entity run up such gargantuan exposure to derivatives? Perhaps JPM controls nearly 60% of
the commercial bank segment of the derivatives market because maybe it holds 60% of the
commercial bank assets in the United States of America. We constructed the next graph from
"Table 1" of the Q1 2001 OCC Bank Derivatives Report as well to investigate this very
question.



Although JPM is a very large commercial bank, it only represents around 12.6% of the total
commercial bank assets in the United States per the Q1 OCC report. The pie size in this
second graph is $4.9t. This number implies that, in general, the US commercial banking
system has a derivatives notional value to assets ratio of 9 to 1, pretty extraordinary
leverage when one realizes that a large portion of a given bank's assets are not usually the
shareholders' but represent funds entrusted to the bank by depositors in various forms. It is
also pretty extraordinary gross leverage for an industry that prides itself in being
"conservative". A 9 to 1 implied leverage to assets achieved through derivatives sounds
more like hedge fund territory than banking!

JPMorganChase controls 12.6% of the total commercial bank and trust assets in the United
States, but a whopping 59.8% of the total commercial bank and trust derivatives market.
JPM's implied derivatives leverage on assets ratio is a colossal 43 to 1. Why would one
superbank risk such extreme derivatives exposure relative to its asset base?

Even more provocative and outright frightening is the ratio of the notional value of JPM's
derivatives positions to its shareholder capital. Per JPM's latest 10-Q quarterly financial
report filed with the US Securities and Exchange Commission available at
www.jpmorganchase.com/pdfdoc/jpmchase/10Q2Q01.pdf, JPM reported a stockholders'
equity balance of $42b. $42b is a lot of capital and is nothing to scoff at, but when compared
to an outstanding aggregate derivatives position with a notional value of $26,276b, JPM's
implied leverage on stockholder equity is utterly mind-blowing. For every dollar that JPM's
shareholders own free and clear, JPM management has pyramided on almost $626 worth of
derivatives exposure in notional terms to the highly risky and highly volatile derivatives
market! 626 to 1 implied leverage?!? Why, why, why?

While the latest JPM 10-Q was released in mid-August and pertains to Q2 while the latest
OCC derivatives report is from Q1, this cross quarter comparison still accurately shows the
hyper-extreme leverage inherent in JPM's aggregate derivatives exposure. If we instead use
JPM's Q1 10-Q to ensure we are comparing apples to apples, the implied leverage on
stockholders' equity changes little to 611 to 1 on $43b of stockholders' equity.

In financial circles 10 to 1 leverage is considered very aggressive, 100 to 1 is considered to
be in the kamikaze realm, but we don't ever recall hearing about large-scale leveraged
operations exceeding 100 to 1 outside of the horrible example of the doomed super hedge
fund Long Term Capital Management. JPM's management may have effectively created the
most leveraged large hedge fund in the history of the world by using $42b worth

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