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Size Can Be Deadly in a Low-Rate World

Imagine for a minute that you are sitting on a $360 billion-odd pot of cash. Somehow you have to stash that money in an incredibly safe place, but also produce some returns. So where do you put it? In Treasurys, which carry negative real returns and are becoming riskier by the day? In euro zone bonds or corporate credit? Or can you find something else, without creating new risk?

JP Morgan London Offices
Bloomberg via Getty Images
JP Morgan London Offices

It is a question that cuts to the heart of the story unfolding at JPMorgan Chase in recent days. As revelations about its chief investment office’s antics have tumbled out, some tales have caused rivals to blink in shock. It looks odd, for example, that the bank’s head, Jamie Dimon, was allowed to run the CIO so separately from the investment bank, reporting to him — and the CIO used different risk-measurement models from that investment bank. It is also peculiar that Dimon declared with such confidence last month that the CIO trading positions were irrelevant — and changed his tune so radically last week. If nothing else, this raises big questions about the bank’s accounting.

But while those stories raise eyebrows, there is one aspect which does not surprise rivals, instead generating a weary sigh of recognition: The investment dilemma JPMorgan found itself in in recent years. Notably, it seems one key reason why the CIO office was engaging in funky derivatives trades was that the wider climate made it so difficult for any firm to produce safe returns without taking outlandish bets. And doing this in a “hedged” way has become doubly difficult if you are a behemoth with $360 billion of cash.

Part of the problem lies with the ultra-low interest rate climate. This week the 10-year Treasury yield fell yet again, as the euro zone’s woesintensified. And yet investors keep piling in: This week, for example, I listened to Brazilian asset managers tell me they felt compelled to keep buying Treasurys for “safety,” even at negative real yields — and even though their own economy needs more long-term infrastructure investment, which could produce much higher returns.

At a meeting of corporate treasurers Thursday, those wails were echoed again: U.S. groups are now stuffed with cash (more than $2 trillion at last count), but are finding it harder than ever to find anywhere to invest it.

But if this is a headache for corporate treasurers, it is doubly problematic for banks — not least because that corporate money has been flooding into JPMorgan, as companies pull their money out of euro zone banks. And as the money under the CIO’s control swelled, it has become harder to “hedge” a portfolio in any meaningful way, not least because the peculiarly distorted nature of the financial system today is also raising the levels of correlation between different asset classes.

One issue that appears to have contributed to the losses at JPMorgan, for example, was that it became extremely dominant in a corner of the credit derivatives world, linked to the so-called CDX.NA.IG.9 index, prompting hedge funds to take pot shots. But while the situation in IG.9 seems to have been extreme (and badly managed), it may not have been rare.

On the contrary, as the CIO function has moved into structured credit markets and other areas to find yield, it has ended up with a dominant role in many markets; as my colleagues Sam Jones and Tracy Alloway report, for example, the CIO has accounted for about a quarter of the U.K. structured mortgage market in recent years. That dominance makes it potentially vulnerable to other “squeezes” — particularly since it is hard to hedge its risks in a meaningful way.

All this adds fuel to a debate that has been raging in recent weeks among American regulators about whether banks should be allowed to hedge their risks on a “portfolio” basis (across the entire bank), rather than in a “correlated” manner (ie within asset classes). It also highlights how the ultra-low interest rate world is stoking up bigger systemic imbalances.

But to my mind, perhaps the most immediate question is that old chestnut about whether banks such as JPMorgan are now just “too big” for their own sake. For quite apart from the moral hazard posed by outsized banks — and huge management headaches — the swelling size of groups such as JPMorgan is making the system ever more concentrated, in a dangerous way. The crucial point to understand, in other words, is that what happened in IG.9 in terms of concentration, is merely a proxy for a bigger structural pattern.

Usually this does not matter; after all, that CIO’s office earned billions of dollars of profit in previous years, when its strategies went right. But the problem is that concentration can sometimes be deadly; size can sometimes be a victim of its own success; and doubly so when the world’s financial markets are so distorted by those ultra low interest rates.

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