If you notice JP Morgan’s 2019 Interest Income , you will see that 12.8% of it came from Trading – assets of debt securities and 11.4% of it came from Trading assets – Investment securities. Together they contributed interest income of $20.4 billion, computed on a Tax-Equivalent basis (see our earlier post on how 1 + 1 is not equal 2).
So what is in a Trading Book?
Trading Assets / Trading Book.
As of end 2019, JP Morgan had trading assets of $411 billion and Investment Securities of $398 billion. For its trading book, on average $334 billion were debt securities, so JP Morgan is a big debt shop, with the remainder being mainly stocks. While the loans is overwhelmingly US based, the debt securities potion trading book is split $223 billion US based (66% US based) and $111 billion.
JP Morgan is definitely a debt-sweat-shop.
So before we go further, lets clarify something : Why this violence?
The violence arises because we have to differentiate the Trading book from the Banking book.
The long and the short is , balances of Financial instruments on the Trading book are revalued using market values periodically. Whereas on the Banking book, Financial Instruments the balances are based on fixed formulas that should not change so long as the assumptions underlying the formulas hold true.
So in a nut-shell, trading book assets are for trading I.e buying and selling, like in Wolf of Wall Street, whereas Banking book assets are for collecting interest like ah-long.
The reason is that assets on the Trading book are predominately classified as Available-For-Sale , in contrast with assets on the banking book which are classified as Held-To-Maturity. For assets classified as Available-For-Sale, they are subject to periodic re-measurement with changes in values recorded in 2 places:
a) investment securities gains/ (losses) which appear in the Income Statement, also known as “realized gain or losses”
b) Unrealized gains/(losses) are reported in Other Comprehensive Income
You can consider a) as being the real gain or loss and b) as being “paper gain or loss” as Tun Mahathir once said.
For assets held on the banking book, it is not subject to the same kind of market based re-valuation. So if tomorrow, the bond market went bananas and interest rates rose to 5%, then the losses felt by JP Morgan will be on its trading book and not on its banking book because the banking book loans are not revalued due to changes in market interest rates.
Of the $334 billion of debt securities in 2019, they were mainly $50 billion in US Government backed Mortgage bonds called Freedies and Fannies, $88 billion in US Treasury, $54 billion in Non-US Government securities like UK Gilts, Samurai bonds and of course, the much coveted Malaysian Government Securities. JP Morgan also had about $50 billion in tradeable loans – these mostly must have arose from their investment banking activities where they underwrite bridging loans or when they buy loans and sell it on a Covenant-Lite basis to asset managers. Lastly, surprisingly – only $19 billion was in corporate debt securities.
Now here comes a kicker – one of the biggest risk they face is not so much credit risk but interest rate risk. Those $50 billion of Freedies and Fannies have this awful habit of negative convexity. What this means is that folk will try not re-pay when rates go up , so the bond loses value, and when rates go down, folks tend to re-pay much quicker, so the bond does not increase in much value.
[ Note to the world: Bond values go up when interest rates go down, and go down when interest rates go up. The reason is that bond values are determined mathematically with interest rates in the denominator. Prices track values so long as the market is not rigged, which means to say that the Cabal has not determined the “appropriate price”. The last assumption is true may be 90% of the time, with 10% prices differing wildly from values due to The Cabal. An example of this case not holding recently was the price of Occidental bonds which plummeted in 1Q20 before recovering in 2Q20. At that time, little did we know that Bill Gates was an eco-warrior. ]
But management of interest rate risk is an art, and given JP Morgan’s sizable cash balance as we discussed earlier, very much doubt that this is an issue. $50 billion of Freedies and Fannies is really quite small considering $500 billion in cash.
But this is not investment advise, just our thoughts.
Our view, which is for our own consumption, is that there is a significant political risk event that could take place in the United States which is considered a black swan event. There is just too much political risk in the country, and given JP Morgan’s yuge exposure to the US, that could be a potential risk factor.
Our new friend called Dr SOCE.
We also want to take this time to say hello to our new friend called SOCE, or “Statement of changes in equity”. For too long we suffered on unbalanced assets and liabilities as we ignored SOCE. SOCE is a very important friend in ensuring that financial models balance , even more important than Mr Cashlow Statement.
Welcome Dr. SOCE!