How Are Dogs and Investors (Including Banks) Alike?

Dogs chase cars.  Investors chase yields.  Especially in low yield environments.  And the consequences of “succeeding” in the chase is often the same for dogs and investors: they get crushed.

Many financial disasters occur in low yield environments, as investors despairing of finding the kinds of returns they expect in low risk instruments, pile into higher risk ones-especially ones with a lot of embedded short options.  Orange County and Gibson Greetings are two examples from the early-to-mid-1990s.

And we may be seeing a similar phenomenon in the Morgan loss.  Many big banks are swimming in deposits, and looking for places to invest the money.  That’s what Morgan’s (MS) CIO was doing:

The unit made a deliberate move out of safer assets such as US Treasuries in 2009 in an effort to increase returns and diversify investments. The CIO’s “non-vanilla” portfolio is now over $150bn in size.

Moreover, this is apparently an issue with all major banks (though you might want to take this statement with a grain of salt, coming as it does from Dimon, who, er, has something of a stake in the matter):

JPMorgan Chief Executive Officer Jamie Dimon said on a conference call with analysts on May 10 after announcing the loss that all banks have “these fairly large portfolios” that invest excess cash. Dimon had encouraged the unit to boost earnings by buying higher-yielding assets, including structured credit, equities and derivatives, ex-employees said in April.

But have no fear! The Fed is studying the problem:

JPMorgan Chase & Co. (JPM)’s $2 billion trading loss has prompted the Federal Reserve Bank of New York to examine how banks in its district are managing cash after receiving a flood of deposits since the credit crisis, according to a person familiar with the matter.

New York-based JPMorgan’s trading loss, announced last week, occurred in its chief investment office, which oversees about $360 billion, the difference between deposits and what the bank lends. The New York Fed is reviewing the structure of investment units and similar businesses at other banks it regulates, said the person, who wasn’t authorized to discuss the matter publicly and declined to be identified.

This pegs the irony meter.  Hell, it breaks it.  This problem is a consequence-unintended, surely, but still a consequence-of deliberate Fed policy to flood the market with liquidity.  You can defend that policy, but the Fed has to live with the reality that yield chasing is the inevitable consequence of ZIRP.  Indeed, it has long wanted to rejuvenate the mortgage and securitization markets, and that necessarily entails risk. The Fed appears to be doing its best Captain Renault impersonation here, expressing Shock! that banks are taking on risk in a low interest rate environment deliberately created by the Fed.

So, one wonders if in its “study”, the Fed will realize that the underlying fault is not in the banks, but in itself.

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About Craig Pirrong 238 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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