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 of
shareholders' equity to control derivatives representing a notional value of a staggering
$26,276b. After we shook off the blunt shock of learning of an implied leverage of 626 to 1
by the United States' premier Wall Street bank and elite Dow 30 blue-chip company, we
continued to dig deeper into the revealing OCC Bank Derivatives Report.

The next pie graph was constructed from"Table 8","Table 9", and"Table 10" of the OCC
report. It shows a breakdown of how JPM's derivatives portfolio is comprised, of what
classes of derivatives constitute the JPM Derivatives Monster. The total pie size in this graph
is nine-tenths of one percent smaller than the earlier totals in the OCC report. The OCC
explained this small delta in a footnote claiming it was caused by the exclusion of some credit
derivatives as well as rounding differences. The large green slice of this pie is comprised of a
small amount of credit derivatives and other derivatives of which the OCC does not require
specific disclosure including"foreign exchange contracts with an original maturity of 14 days
or less, futures contracts, written options, basis swaps, and any contracts not subject to
risk-based capital requirements."

Once again, this graph exclusively represents only JPMorganChase's enormous $26t
derivatives portfolio, no other banks' or trusts' data is included in this gargantuan pie. The
sorcerer's apprentice is playing with powerful financial magic indeed!



As the pie illustrates, JPM's largest position by far is in interest rate derivatives. The huge red
king-sized slice of the pie graph represents interest rate derivatives with a notional amount
of a staggering $17.7t!

In interest rate derivatives, the notional amount represents the implied principal of a debt on
which interest rate derivatives are written. For instance, a debtor with $1m in debt and
variable interest rate payments may contract with JPM to hedge its interest rate payments
into a fixed interest rate scheme instead of a variable one. By having a fixed interest rate
payment schedule, the debtor company will not have to worry about market fluctuations in
interest rates as their counterparty JPMorganChase assumes that risk for a fee. Although the
interest streams in this small $1m debt example are swapped, the actual cash changing
hands may only be a few tens of thousands of dollars. The $1m in principal, however, is the
notional amount for our interest rate derivatives example and provides a true picture of JPM
positional exposure in the deal.

Gold investors may be surprised to see what a trivial portion of JPM's total derivatives
portfolio is deployed in the gold market. Only two tenths of one percent of JPM's notional
derivatives exposure is in gold. Of course, gold is an exceedingly small market compared to
the huge debt or foreign exchange markets so JPM's position in gold derivatives is still quite
large relative to the gold market itself. JPM reported $56.8b in gold derivatives in the Q1
2001 OCC report. By comparison, with only 2,500 metric tonnes of gold mined on the entire
planet each year, the whole freshly mined annual world gold supply is only worth $22b at
$275 per ounce.

JPM is controlling a notional amount of gold through derivatives equal to the value of every
ounce of gold that will be mined in the entire world for the next two and a half years
assuming gold production does not continue to plummet due to dismal gold prices, which it
probably will.

Why is a sophisticated superbank like JPM even interested in the small and devastated gold
market, let alone motivated enough to maintain derivatives exposure equal to more than
6,400 tonnes of gold? Why does JPM management want to maintain derivatives gold
exposure worth 1.35 times the capital owned by the shareholders of the company? With Wall
Street perpetually telling the world that gold is a"barbaric relic", why does the premier Wall
Street bank have such large gold derivatives positions? Ever more intriguing questions!

In the lower left corner of the graph above note the percentage of derivatives market shares
that JPM controls out of the entire US commercial bank and trust derivatives universe. JPM is
the utterly dominant player with 64% of the interest rate derivatives market, 49% of the
foreign exchange market, 68% of the equity derivatives market, and 62% of the gold
derivatives market among US commercial banks and trusts. JPM's management, for whatever
reasons, has effectively built up a derivates powerhouse that has almost cornered the entire
US commercial bank and trust derivatives market.

Zeroing back in on the $17.7t in interest rate derivatives, we wonder why such enormous
exposure to interest rates has been shouldered by JPM's management. In terms of interest
rate derivatives alone, JPM has an implied leverage ratio of notional interest rate derivatives
exposure to stockholders' equity of 422 to 1. Are JPM shareholders aware of this? It is hard
to fathom why anyone would want to have leveraged exposure to chaotic interest rates with
422 to 1 leverage, but an intriguing hypothesis has recently emerged that may illuminate the
decision by JPM to dominate the enormous interest rate derivatives market. Here is a quick
outline of this provocative theory.

As growing numbers of investors around the world realize, American attorney Reginald Howe
filed a landmark complaint against the Swiss-based Bank for International Settlements on
December 7, 2000. In his lawsuit, which is highly recommended reading and available for
free download in PDF format at www.zealllc.com/howepla.htm, Mr. Howe carefully builds
the case that certain large banks that deal in gold derivatives were involved in an effort to
actively manipulate the world gold market in violation of key United States laws. Shortly
after Mr. Howe filed his complaint in United States District Court, we wrote a summary essay
outlining his lawsuit called"Let Slip the Dogs of War" which also has further background
information if you are interested in digging deeper.

In Howe v. BIS et al, both the pre-merger JP Morgan and Chase Manhattan were named as
defendants with the BIS. In his complaint, Howe points out anomalous gold derivatives
activity at both banks documented on earlier OCC bank derivatives reports that correlates
extremely well with unusual activity in the gold markets and gold price. The evidence is
highly suggestive that both banks, now a single entity, used carefully targeted strategic gold
derivatives transactions to help rein in the out-of-control gold rally that was sparked in late
1999 after European central banks agreed to curtail their gold sales and leasing with the
Washington Agreement.

Mr. Howe's complaint filed in the federal court elaborates on this odd activity by the two
banks that have since merged to form superbank JPMorganChase. Interestingly, Mr. Howe's
case will soon be heard before a federal judge in Boston, Massachusetts on October 9, 2001,
when defendants will present their arguments in support of their Motions to Dismiss.

With both ancestor banks of the new JPMorganChase already documented as having
well-timed anomalous gold derivatives activity prior to their merger, chances are the banks
had some level of insider-type knowledge of what was really transpiring in the gold market.
There is no way that JPM management would have acquired gold derivatives with a notional
value worth 1.35 times the total of their entire shareholders' equity base unless they knew
and intimately understood the gold market.

On May 30, 2001, ace researcher and analyst Michael Bolser and GATA Chairman Bill Murphy
co-published an analysis of JPMorganChase's interest rate derivatives in Mr. Murphy's
"Midas" column at the excellent www.LeMetropoleCafe.com contrarian investing website. Mr.
Bolser titled his research"GoldGate's Real Motive?". Current subscribers to
www.LeMetropoleCafe.com can see this analysis in the archives of the"James Joyce" table
at LeMetropoleCafe. In his analysis, Mr. Bolser pointed out that JPMorganChase had $16t
worth of notional interest rate derivatives exposure at the time and how incredible this fact
was. He noted that JPM's interest rate derivatives notional amounts had doubled since the
middle of 1998, an astronomical increase given the absolute amounts of dollars involved.

Mr. Bolser offered the stunning tentative conclusion that perhaps a suppressed or
shackled-down gold price was a necessary prerequisite to JPM assuming enormous amounts
of interest rate derivatives, as a managed gold price would ratchet down inflationary
expectations and make interest rate positions much less volatile and risky than in a truly free
market. Mr. Bolser planned to continue his research and was seeking earlier OCC reports to
model JPM's derivatives trading activities and exposures further back in time.

After Mr. Bolser's interest rate derivatives report revealing JPM's enormous and massively
out-of-proportion derivatives positions, there were a few tangential comments made about
this hypothesis over the summer by various market analysts, but for the most part it
remained an obscure area of inquiry that appeared to generate little popular interest.

Then, just a few weeks ago on August 13, 2001, Reginald Howe published a fascinating
commentary entitled"Gibson's Paradox Revisited: Professor Summers Analyzes Gold Prices"
available at www.GoldenSextant.com. In his essay Mr. Howe quotes a 1988 academic paper
from the Journal of Political Economy co-written by President Bill Clinton's future third
Secretary of the Treasury, Lawrence Summers. Among other things, Mr. Howe discusses Mr.
Summers' interpretation of an observation by the famous economist John Maynard Keynes on
the behavior of gold prices and real interest rates. Lord Keynes called the relationship
"Gibson's Paradox".

As Mr. Howe points out, per Lord Keynes, Gibson's Paradox, the solid relationship between
price levels including gold and interest rates under a gold standard regime was,"one of the
most completely established empirical facts in the whole field of quantitative economics." Mr.
Howe shows, using the writings of Professor Lawrence Summers and legendary economist
John Maynard Keynes that there is a rock-solid inverse relationship between gold and real
interest rates in a free market. We investigated this phenomenon as well in our essay"Real
Rates and Gold". In effect, real interest rates could be used to predict inverse moves in the
price of gold or gold could be used to predict inverse moves in the real interest rates.

For us, Howe's fantastic"Gibson's Paradox Revisited" essay finally lit the proverbial
lightbulbs above our heads that triggered a solid understanding of Michael Bolser's shrewd
earlier hypothesis on JPM's enormous interest rate derivatives exposure! Gibson's Paradox
helped to reconcile the puzzle and answer nagging questions about JPM's gargantuan interest
rate derivatives position and how it could relate to the active management of the price of
gold.

If factions of the US government in the Clinton years from 1995 to late 2000 were really
actively manipulating the gold price (as the latest amazing research of government records
by James Turk and Reginald Howe certainly strongly suggests through ever-increasing
evidence), and if JPM really had inside knowledge of some of these operations as its
anomalous gold derivatives activity seems to imply, then it is only a short logical step to
assume that a possible catalyst for the explosion in JPM's interest rate derivatives operations
was the artificially pegged price of gold!

Gibson's Paradox, defined by Lord Keynes, effectively claims that under a fixed gold price
regime real interest rates remain predictable. If JPM top management was participating in
any US efforts to cap gold, they had full knowledge that a de facto fixed gold price regime
had been stealthily established and they would have had a carte blanche to massively balloon
potentially highly lucrative interest rate derivatives exposure. After all, if JPM was convinced
gold was under control, and that gold prices were a prime driver of real interest rates, then
what better time to become the king of the interest rate derivates world than when gold was
being quietly hammered down through massive sales of official sector gold from Western
central banks' coffers?

Our superficial presentation here certainly does not do this startling hypothesis justice, but
the JPMorganChase interest rate derivatives explosion due to JPM upper management
knowledge of and possible involvement in stealthy government machinations in the gold
markets is a very intriguing hypothesis that definitely warrants further investigation and
discussion. We may write a future essay on this topic alone after we dig deeper, and we
certainly hope other analysts and researchers follow Michael Bolser's original lead and do
some serious investigating.

Back to the JPMorganChase Derivatives Monster for now, we have to wonder how many JPM
shareholders realize just how incredibly leveraged their superbank has become. Do they
think they are holding a safe conservative blue-chip elite Wall Street bank, or do the average
shareholders desire to hold a hyper-leveraged mega hedge fund with 600+ times implied
leverage on stockholders' equity? Do JPM shareholders understand how dangerous large
derivatives positions have proven historically for other companies?

JPM currently has something like 2,700 large institutional shareholders who hold almost
61% of its common stock. Do the managers of these mutual funds and pension funds
understand that JPM management has built the biggest most highly-leveraged derivatives
pyramid in the history of the world per US government OCC reports? Do fund managers
understand the inherent risks in leveraging capital hundreds of times over? These are
important questions that ALL JPM investors should carefully consider, especially in this
incredibly turbulent and volatile market environment we are experiencing today.

One of the most dangerous possible events for high derivatives exposure is unforeseen
market volatility, especially that caused by unusual and unexpected major discontinuities in
market pricing. The following graph is also shamelessly taken from the OCC report,"Graph
5C", which shows the"charge-offs" taken on derivatives written off in each quarter since
1996 by commercial banks and trusts alone. Note the enormous loss that occurred in the
third quarter of 1998 coincident with the Russian Debt Crisis/LTCM debacle and the large
losses in late 1999 following the Washington Agreement gold spike.



When a non-linear market event that is inherently unpredictable like the Russian Debt Crisis
occurs, its effects on carefully crafted derivatives portfolios can be catastrophic. Long Term
Capital Management folded during the 1998 crisis. It was an elite hedge fund run by some of
the most brilliant market geniuses of the entire last century. The all-star brain trust at LTCM
could probably have helped put men on Mars, as the stellar IQs and acclaim of the founders
were without equal in the financial world. The gentlemen helping to build the sophisticated
computer derivatives trading models for LTCM were Nobel-prize winning economists who
understood more about markets and volatility than pretty much everyone else on the planet.
Here are a few paragraphs on LTCM from an earlier essay we penned on gold derivatives
volatility titled,"Gold Delta Hedge Trap (Part 2)".

"LTCM employed Scholes' and Merton's work to hedge and protect its bets. Through Black and
Scholes based hedging strategies, LTCM became one of the most highly leveraged hedge
funds in history. It had a capital base of $3b, yet it controlled over $100b in assets
worldwide, and some reports claim the total notional value of its derivatives exceeded an
incredible $1.25 TRILLION. LTCM used extraordinarily sophisticated mathematical computer
models to predict and mitigate its risks."

"In August 1998, an unexpected non-linearity occurred that made a mockery of the models.
Russia defaulted on its sovereign debt, and liquidity around the globe began to rapidly dry up
as derivatives positions were hastily unwound. The LTCM financial models told the principals
they should not expect to lose more than $50m of capital in a given day, but they were soon
losing $100m every day. Four days after the Russian default, their initial $3b capital base
lost another $500m in a single trading day alone!"

"As LTCM geared up to declare bankruptcy, the US Federal Reserve believed LTCM's highly
leveraged derivatives positions were so enormous that their default could wreak havoc
throughout the entire global financial system. The US Fed engineered a $3.6b bailout of the
fund, creating a major moral hazard for other high-flying hedge funds. (Expecting the
government or counterparties will bail them out of bad bets once they get too large, why not
push the limits of safety and prudence as a hedge fund manager?)"

Long Term Capital Management had $3b in capital allegedly supporting $1,250b of
derivatives notional value, an implied leverage ratio of 417 to 1. JPMorganChase, per its own
reports filed with the US government, has $42b supporting $26,276b of derivatives notional
value. Incredibly, JPM's implied capital leverage on its derivatives is far, far higher than
LTCM's at 626 to 1. Isn't it disconcerting to realize JPM management has further leveraged
its shareholder equity than even the infamous Long Term Capital Management?

LTCM had the best economic minds in the world running the fund, unlimited brain and
computer power, but still an unpredictable volatility event spurred by the Russian Debt Crisis
caused their painstakingly developed computer derivatives models to blow up. By many
reports, including from the Federal Reserve, the LTCM failure was so dangerous it threatened
to take the whole financial system down if LTCM's obligations to its counterparties were
defaulted upon.

We are NOT suggesting that JPM is another LTCM. We know that the men and women running
JPM are very intelligent and have a deep understanding of the global markets in which their
company operates. We know they have cross-hedged and carefully modeled their enormous
derivatives portfolio to try and make it net market neutral and therefore resilient to shocks.
But, just as a tiny imperfection can cause a massive hardened-steel shaft connected to a
nuclear aircraft carrier's propeller to vibrate uncontrollably until it shatters, even a
"balanced" net derivatives portfolio of massive size is highly vulnerable to market shocks
that can push it out of proper equilibrium and spin the computer hedging models out of control
far faster than derivatives can be unwound.

There comes a point when leverage becomes so extreme that even a tiny unforeseen event
can break down the complex contractual glue that holds the various components and players
of the convoluted derivatives world together and cause the whole structure to shake or
crumble.

We believe that JPM's management is taking a mammoth gamble with the wealth of its
shareholders by supporting derivatives with a notional value of over $26 TRILLION dollars
with a relatively trifling $42 billion of shareholder equity. Any discontinuous market volatility
event that is unforeseen and beyond JPM management's control could conceivably cause this
immense pyramid to rapidly unwind, utterly annihilating the company's capital in a matter of
days or weeks.

Also, JPM, just by virtue of having extreme leverage, is placing itself at risk for a Barings
Bank type scenario, where a rogue trader hid derivatives trading activities from management
until it was too late and the damage was irreparable. What if some twenty- or
thirty-something derivatives trader working for JPM accidentally makes a big mistake in his
or her trading and destroys that fragile balance supporting the whole massive JPM
derivatives pyramid and the whole structure comes crashing down?

By its own reporting to the US government, JPMorganChase has shown itself to have evolved
into a real-life Derivatives Monster. Derivatives offer extreme leverage and the potential for
mega-profits, but with that they carry commensurate extreme risks. Until the JPM
Derivatives Monster begins to deflate its leverage and exposure, we believe individual and
institutional investors alike should be very careful in assessing the potential extreme risk of
holding JPM stock.

We can't help but feeling that essentially unlimited leverage is the modern financial
equivalent of Walt Disney's sorcerer's apprentice in"Fantasia" unleashing forces he couldn't
possibly hope to control.

Adam Hamilton, CPA, MCSE
aka Zelotes
7 September 2001

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appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an
in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance,
and investing delivered from an explicitly pro-free market and laissez faire perspective.
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