Monday, April 27, 2015

Jamie Dimon on Regulation, Treasuries and the Next Crisis

I'm still penciling through some recent bank financial reports, and I keep coming back to JPMorgan Chase CEO Jamie Dimon's shareholder letter.  Around page thirty on, there are plenty of good nuggets.

He notes that banks today, driven by backward-looking regulation, are part of a banking system "that is stronger than it ever has been."  Yet, the bond market, and particularly the Treasury market, could be the venue for an event-driven crisis in any one of three or four hotspots around the world.

Regulation has made market making in bonds less profitable, and although bond market spreads have come down and stayed low, the market depth has actually declined. The letter says, "..the market depth of 10-year Treasuries (defined as the average size of the best three bids and offers) today is $125 million, down from $500 million in 2007."  This despite the fact that today's Treasury market is $12.5 trillion as opposed to $4.4 trillion in 2007.  Dealer inventories are down 75% from their 2007 levels.  There's no need to run a complex stress test to see that this is not a healthy market for the asset of choice in a global crisis.

For all the talk about a "flash crash" in stocks, the October 15th, 2014 one day move of 40 bp in Treasuries was a much more serious "shot across the bow."  As the CEO's letter points out, this was a move of 7-8 standard deviations!

Bond investors like Blackrock and others have been writing about the need to innovate these markets for some time, but the point is now that the time to formulate a new structure, agree among the market participants, issuers and regulators will be years in this political environment. A crisis could come in the fall, as they often do.

The supply of Treasuries available for sale is relatively small, given the large size of the stock and the burgeoning demand. Total Treasuries outstanding are said to be $13 trillion.  At least $6 trillion are tied up in central bank forex holdings, another $2.5 trillion on the Fed balance sheet, and another $0.5 trillion held by big banks as liquid assets.  Take out this $9 trillion, and about $4 trillion are potentially available to be traded.

The Japanese central bank, for currency and other economic reasons, has published aggressive targets for purchasing Treasuries on top of the $1.238 trillion which they already hold.

In the event of a typical run, driven by the next crisis, global investors will look to U.S. Treasuries as they did in the last crisis, when more than $2 trillion in demand was created by the fire sales of risky assets.

On April 6th, Wall Street Journal correspondent Michael Casey's lead sentence was "The bond market is malfunctioning."  In a full-blown flight from risk, this could be an understatement.

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