Paper Wall Street Gold: Has JP Morgan Engineered the Flash Crash?

Recent developments in the gold markets seem to have exposed, which partly validates my view (if the below report is accurate), that the flash crash in Wall Street-Government Paper gold had been contrived.

From CNBC:

J.P. Morgan accounts for nearly all of the physical gold sales that Comex in the last three months, blogger Mark McHugh wrote in a blog on Friday, which was reposted on ZeroHedge.

McHugh, who writes the “Across the Street” blog, cited a report on the CME Group web site that details metals issues and stops year to date for his findings.

In the report, “I” stands for issues, the number of contracts it sold, “S” stands for stops, meaning the firm took delivery of the gold, McHugh said. It shows that just one firm accounts for 99.3% of the physical gold sales at the Comex in the last three months, he said.

Doing the math on J.P. Morgan, McHugh says the brokerage “fumbled ownership” of 1,966,000 troy ounces of gold since Feb. 1 through the reporting date of April 25. (One gold futures contract is 100 troy ounces.)

That nearly 2 million ounces of gold is 74% more gold than the U.S. Mint delivered through the U.S. Mint’s American Eagle program in all of 2012, said McHugh.

“One thing’s very clear: When it comes to selling physical gold, J.P. Morgan is acting alone,” he said.

Gosh. 99.3% of gold sales contracts.

 

Two days ago, Zero Hedge questioned the steep fall on JP Morgan’s eligible inventories (bold and italics original)

What many may not know, is that while registered Comex gold has been flat, the amount of eligible gold in Comex warehouses (the distinction between eligible and registered gold can be found here) in the past several weeks has plunged from nearly 9 million ounces, to just 6.1 million ounces as of today- the lowest since mid-2009.

What nobody knows, is why virtually the entire move in warehoused eligible gold is driven exclusively by one firm: JPMorgan, whose eligible gold has collapse from just under 2 million ounces as of the end of 2012 to a nearly record low 402,374 ounces as of today, a drop of 20% in one day, though slightly higher compared to the recent record low hit on April 5 when JPM warehoused commercial gold touched a post-vault reopening low of just over 4 tons, or 142,700 ounces.

This happened just days ahead of the biggest ever one-day gold slam down in history.

Some questions we would like answers to:

1. What happened to the commercial gold vaulted with JPM, and what was the reason for the historic drawdown?
2. Gold, unlike fiat, is not created out of thin air, nor can it be shred or deleted. Where did the gold leaving the JPM warehouse end up (especially since registered JM and total Comex gold has been relatively flat over the same period)?
3. Did any of this gold make its way across the street, and end up at the vault of the building located at 33 Liberty street?
4. What happens if and/or when the JPM vault is empty of commercial gold, and JPM receives a delivery notice?

Inquiring minds want to know...

Adding up the pieces of the jigsaw puzzle.

Falling comex gold warehouse inventories—both from the registered (top) and eligible (bottom) categories—appears to be consistent with the record sales exhibited by retail physical “real” gold markets worldwide. Both charts are from 24gold.com.

A drawdown in the Comex inventories may have been channeled to the physical markets, which also means that Wall Street-Central banks may have lesser leeway to continue with their stealth suppression attempt.

But marked distinction between the withdrawal in “registered” gold which is reportedly the “physical” inventory relative to the eligible “gold” which is “some else’s inventories” seems like another puzzle. Add to this JP Morgan’s collapsing ‘someone else’s’ gold holdings, which partially matches the reported dominance 99.3% of selling contracts over the last 3 months. Has JP Morgan shorted gold deposits of their clients? Could the client/s be the New York Federal Reserve? Or the US Federal Reserve?

Such mysteries will likely be made public soon.

I share the conclusions of Alasdair Macleod from GoldMoney.com:

For the last 40 years gold bullion ownership has been migrating from West to elsewhere, mostly the Middle East and Asia, where it is more valued. The buyers are not investors, but hoarders less complacent about the future for paper currencies than the West’s banking and investment community. There was a shortage of physical metal in the major centres before the recent price fall, which has only become more acute, fully absorbing ETF and other liquidation, which is small in comparison to the demand created by lower prices. If the fall was engineered with the collusion of central banks it has backfired spectacularly.

The time when central banks will be unable to continue to manage bullion markets by intervention has probably been brought closer. They will face having to rescue the bullion banks from the crisis of rising gold and silver prices by other means, if only to maintain confidence in paper currencies.

A blowback may be in the process.

How Government Policies Contributed to JP Morgan’s Blunder

Author and derivatives manager Satyajit Das, ironically a neoliberal, has a superb article at the Minyanville, which elaborates on how regulations and government policies, which I earlier posted, has shaped the incentives of Too Big to Fail institutions to take excessive risks and the failure of regulators to prevent them (all bold emphasis mine)

The large investment portfolio is the result of banks needing to maintain high levels of liquidity, dictated by both volatile market conditions and also regulatory pressures to maintain larger cash buffers against contingencies. Broader monetary policies, such as quantitative easing, have also increased cash held by banks, which must be deployed profitably. Regulatory moves to prevent banks from trading on their own account -- the Volcker Rule -- have encouraged the migration of trading to other areas of the bank, such as liquidity management and portfolio risk management hedging.

Faced with weak revenues in its core operations and low interest rates on cash or secure short term investment, JPMorgan may have been under pressure to increase returns on this portfolio. The bank appears to have invested in a variety of securities, including mortgage backed securities and corporate debt, to generate returns above the firm’s cost of capital.

Again, the failure of models…

Given JPMorgan vaunted risk management credentials and boasts of a “fortress like” balance sheet, it is surprising that the problems of the hedge were not identified earlier. In general, most banks stress test hedges to ensure their efficacy prior to implementation and monitor them closely.

While the $2 billion loss is grievous, the bank’s restatement of its VaR risk from $67 million to $129 million (an increase of 93%) and reinstatement of an older risk model is also significant, suggesting a failure of risk modeling.

The knowledge problem…

Banks are now obliged to report positions and trades, especially certain credit derivatives. This information is available to regulators in considerable detail. Given that the hedge appears to have been large in size (estimates range from ten to hundreds of billions), regulators should have been aware of the positions. It is not clear whether they knew and what discussions if any ensued with the bank.

External auditors and equity analysts who cover the bank also did not pick up the potential problems. Like regulators, they perhaps relied on assurances from the bank’s management, without performing the required independent analysis.

Hayek’s “Fatal Conceit” or the pretentions of knowledge by regulators to apply controls over society or the marketplace…

Legislators and regulators now argue that the rules for portfolio hedging are too wide and impossible to police effectively. In addition, the statutory basis may not support the rule. The legislative intent was intended only to exempt risk-mitigating hedging activity, specifically hedging positions that reduce a bank’s risk. Interestingly, drafters of the portfolio hedging exemption recognized the potential problems, seeking comment on whether portfolio hedging created “the potential for abuse of the hedging exemption” or made it difficult to distinguish between hedging or prohibited trading.

In a recent Congressional hearing, Former Fed Chairman Paul Volcker, who helped shape the eponymous provision, questioned whether the volume of derivatives traded was “all directed toward some explicit protection against some explicit risk.”

The pundits have been quick to suggest that the losses point to the need for more stringent regulations. But it is not clear that a prohibition on proprietary trading would have prevented the losses.

In practice, without deep and intimate knowledge of the institution and its activities, it is difficult to differentiate between legitimate investment and trading of a firm’s surplus cash resources or investment capital.

It is also difficult sometimes to distinguish between hedging and speculation. The JPMorgan positions that caused the problems were predicated on certain market movements -- a flattening of the credit margin term structure -- which did not occur.

Hedging individual positions is impractical and would be expensive. It would push up the cost of credit to borrowers significantly. All hedging also entails risk. At a minimum, it assumes that the counterparty performs on its hedge. But inability to legitimately hedge also escalates risk of financial institutions. Ultimately no hedging is perfect. or as author Frank Partnoy told Bloomberg: “The only perfect hedge is in a Japanese garden.”

Additional regulation assumes that the appropriate rules can be drafted and policed. Experience suggests that it will not prevent future problems.

Bankers and regulators have always been seduced by an elegant vision of a scientific and mathematically precise vision of risk. As the English author G.K. Chesterton wrote: “The real trouble with this world [is that]…. It looks just a little more mathematical and regular than it is; its exactitude is obvious but its inexactitude is hidden; its wildness lies in wait.”

In reality it is not just “without deep and intimate knowledge of the institution and its activities” but about having the prior knowledge of the choices of the individuals behind these institutions. This is virtually unknowable.

Finally, the monumental government failure…

How do regulatory initiatives and monetary policy action affect bank risk taking? Central bank policies are adding to the problem of banks in terms of large cash balances which must be then invested at a profit. The implementation of the Volcker Rule may have had unintended consequences. It encouraged moving risk-taking activities from trading desks where the apparatus of risk management may be marginally better established to other parts of banks where there is less scrutiny.

The most important question remains whether any specific action short of banning specific instruments and activities can prevent such episodes in the future. It seems as Lord Voldemort observed in Harry Potter and the Deathly Hallows Part 2: “They never learn. Such a pity.”

People who are blinded by power and or the thought of power never really learn.

Who is to blame for JP Morgan’s $2 billion loss?

It’s all about bad decisions, argues Mike Brownfield of the conservative Heritage Foundation

Heritage’s David C. John explains that while JP Morgan’s loss represents a clear failure of management, it’s not a systemic problem that requires or would be fixed by additional regulation. For starters, JP Morgan is a $2.3 trillion bank with a net worth of $189 billion, meaning that this loss reduced the bank’s capital ratio from 8.4 percent to 8.2 percent. In other words, the bank can absorb the loss, and it’s nowhere close to needing any form of federal intervention.

Some more perspective could be gleaned by examining the $3.2 billion loss the U.S. Post Office experienced in the most recent quarter, or the billions lost on risky green energy bets made by President Obama and Energy Secretary Steven Chu. Only those losses weren’t incurred by private investors, but by you the taxpayer.

What’s more, John explains, the regulations that are now being called for — particularly the so-called Volcker Rule — would not have prevented the losses since it would not have affected this transaction. Finally, John writes, the system worked as is. “JPMorgan Chase losses were not discovered by regulators; they were discovered by the bank itself conducting its own management reviews.”

What America is witnessing is the left using the news of JP Morgan’s bad judgment as an excuse for more government regulation. But as even Carney acknowledged, regulations “can’t prevent bad decisions from being made on Wall Street.”

It’s true that regulations “can’t prevent bad decisions”. But I’d go deeper. Regulations, on the other hand, can induce bad decisions.

Moral Hazard is when undue risks are taken because the costs are not borne by the party taking the risk. So when regulations and political actions (such as bailouts) rewards excessive risk taking, by having taxpayers shoulder the burden of the mistakes of the privileged parties like JP Morgan and other Too Big To Fail banks, then we should expect more of these.

At the Think Market Blog, Cato’s Jerry O’ Driscoll expounds further,

Reports indicate that senior management and the board of directors were aware of the trades and exercising oversight. The fact the losses were incurred anyway confirms what many of us have been arguing. Major financial institutions are at once very large and very complex. They are too large and too complex to manage. That is in part what beset Citigroup in the 2000s and now Morgan, which has been recognized as a well-managed institution.

If ordinary market forces were at work, these institutions would shrink to a size and level of complexity that is manageable. Ordinary market forces are not at work, however. As discussed on this site before, public policy rewards size (and the complexity that accompanies it). Major financial institutions know from experience they will be bailed out when they incur losses that threaten their surivival. Morgan’s losses do not appear to fall into that category, but they illustrate how bad incentives lead to bad outcomes.

Large financial institutions will continue taking on excessive risks so long as they know they can off-load the losses on taxpayers if needed. That is the policy summarized as “too big to fail.” Banks may be too big and complex to close immediately, but no institution is too big to fail. Failure means the stockholders and possibly the bondholders are wiped out. Until that discipline is reintroduced (having once existed), there will be more big financial bets going bad at these banks.