by Tyler Durden
As part of the Appendixed disclosures in the aftermath of JPM's London Whale fiasco, we learned the source of funding that Bruno Iksil and company at the firm's Chief Investment Office used to rig and corner the IG and HY market, making billions in profits in what, on paper, were supposed to be safe, hedging investments until it all went to hell and resulted in the most humiliating episode of Jamie Dimon's career and huge losses: it was excess customer customer deposits arising from a $400+ billion gap between loans and deposits (with shadow liabilities and assets offsetting each other).
After JPM's fiasco went public, the firm hunkered down and promptly unwound (or is still in the process of doing so) its existing CIO positions at a huge loss. However, that meant that suddenly the firm found itself with nearly $400 billion billion in inert, non-margined cash: something that was unacceptable to the CEO and the firm's shareholders. In other words, it was time to get to work, Mr. Dimon, and put that cash to good, or bad as the case almost always is, use.
So what has JPM allocated all those billions in excess deposits over loans, which as of the most recent quarter hit a record $477 billion and rising as shown in the chart below:
Courtesy of Fortune magazine we now know the answer - CLOs: that remnant of the credit bubble excess from the mid 2000s, and which has logically made a stunning comeback now that the second credit bubble nearly popped a month ago following a few unprepared remarks by Ben Bernanke, is what JPM is actively funnelling cash into. Yes, the CIO is buying CLOs... With your deposit cash of course.
From Fortune Magazine:
According to several people familiar with the deals, JPMorgan's London chief investment office, which last year lost more than $6 billion betting on credit derivatives, is in the process of inking deals to buy significant portions of collateralized loan obligations, which are structured bonds that are backed by groups of loans to below investment-grade companies.
John Timperio, a lawyer at Dechert who specializes in CLOs, says he is working on two deals right now in which JPMorgan (JPM) is expected to be the main buyer. One is for loans to mid-sized companies, which carry more risk, but higher yields. In another deal, JPMorgan is planning to buy nearly all of the highest-rated piece of the CLO. "It's a fairly large deal," says Timperio. "JPMorgan is back in this market."
As a reminder for those who may have forgotten, CLOs are nothing more than a levered way to make the TBTF circle jerk even TBTFer, as one bank will arrange the CLO (by providing cash to junk-rated firms), tranche it, and then sell it, with other banks almost always picking up the vast majority of the issuance. In doing so, the financial system ends up effectively enmeshing itself in cross-default provisions, and any liability-cum-asset impairment (because one bank's liability ends up being another bank's asset and vice versa in the most phenomenal circle jerk) reverberates and picks up as much speed and destruction as there is leverage in the system. Per Forbes:
Perhaps the most surprising thing about the CLO revival is this: The entities that have emerged as the biggest buyers of the packages of risky bank loans are the banks themselves. JPMorgan holds more CLOs than any of its rivals. In the past two years, the bank has nearly doubled its holdings of CLOs to $27 billion, as of the end of the first quarter, which was the last time it disclosed its holdings. According to its filings, the CLOs were purchased by JPMorgan's chief investment office, which is the unit where Bruno Iksil, who was nicknamed the London Whale, worked. Three people confirmed that JPMorgan manages its CLO portfolio out of its London office. JPMorgan's CIO unit, which invests the bank's excess reserves, is now headed by Craig Delany, who took over for long-time CIO chief Ina Drew, who left shortly after the bank's multi-billion losses were revealed. JPMorgan slowed its CLO purchases in the wake of those losses. But it appears the bank is in the process of ramping up their purchases again.
Why are banks so eagerly returning to the worst practices that led to the credit crisis (aside from Bernanke's zero cost investable and fungible cash)? Two reasons: regulatory arbitrage, and leverage, of course.
Almost everyone in the CLO market, including many bankers, say one of biggest reasons banks are buying CLOs has to do with regulations. Financial reform was supposed to stamp out regulatory arbitrage, in which banks are able to swap one similar asset for another in order to be able to increase their leverage, which generally increases risk.
But that hasn't happened in the CLO market. Under the new capital rules, which were approved by the Federal Reserve in early July, loans to corporations have a risk weighting of 100%. The AAA slices of CLOs, which are the portion of the deals banks typically buy, have a risk weighting of only 20%. That means banks can invest five times as much in CLOs as they can in the underlying high-yield loans with the same amount of capital. The additional funds come from borrowing, which increases a bank's leverage.
In other words, when risk is repackaged as a CLO, it affords the bank 5x more leverage on the underlying equity. As for the ultimate collateral: as noted above it is the security of junk-rated companies - those which have a bad habit of going bankrupt every so often.
So assume a 50 cent recovery on the underlying loan in a standard scenario when the recession comes back and the delayed wave of corporate defaults finally hits, and further assume 5x leverage using the CLO structure: it means a 90% wipe out on invested equity.
As for what is the source of invested equity? Why client deposits of course: deposits which traditionally has been used to match loan growth, and thus have faced far less risk of 100% wipeout. Deposits, which represent a loan by a client to the bank in exchange for interest or what used to be interest before Bernanke came along. Sadly, in the New Normal, a deposit is merely a loan to the bank that retains all of the downside (i.e., full loss net of whatever FDIC protection the government may provide) and none of the upside: something US banks have been quite happy to take advantage of.
Cyprus may have had a forced bail-in, but US banks have a better plan: go all in with deposit capital, and pray for the best. Should a worst case scenario hit, and deposits get a 90% wipe out, then... oh well. It was coming anyway.
And while some $30-40 billion of the CIO cash gambling investing may be accounted for, it means some $400 billion is still "out there."
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