How JPMorgan profited from its massive trading loss

Yes, the title of this post is intentionally nonsensical. That's because we have clearly crossed over from the bizarre into the downright absurd, as was pointed out in this item on the Sober Look blog.

For those in need of a primer, on Thursday evening JPMorgan disclosed a massive $2B trading loss in a portfolio whose ostensible purpose was to "hedge" underlying bank risk, though it clearly does nothing of the sort (read Barry Ritholtz for more on that point). The bank's stock price plunged nearly 10% on Friday, and its bonds were hit hard as well. That last part is where the crazy comes in.

With all the talk about JPMorgan's losses out of the CIO's office, nobody is discussing the money the firm made on Friday due to the accounting magic called DVA. After all, CIO's positions were (at least in principle) meant to act as an offset to this earnings volatility. 

As an example the chart below shows the price action for JPM's newly minted bond (issued just last month). It's a 4% coupon bond maturing in 20 years. 

Source: Bloomberg

With roughly $12bn of this bond outstanding, JPMorgan will record a gain of some $350MM based on Friday's price move just for this bond. It's important to note that this bond represents only a fraction of the $2.3 trillion balance sheet funding. Since the firm's long-term debt is some 12% of total liabilities, one can do a quick back of the envelope estimate. A two point drop (which is lower than the bonds above moved on Friday) in JPMorgan's long term bonds results in roughly $5bn in DVA gains. This more than offsets the reported losses on the CIO's portfolio. Welcome to accounting magic.

That is absolutely amazing. By disclosing a $2B trading loss and sending its own outstanding debt to the woodshed, JPMorgan will actually get to disclose a paper profit as a result (as they did last fall, along with just about every other bank).

The concept of DVA is simple, but also completely retarded. Essentially, the downward movement in the bond price is interpreted as reflecting an increased likelihood that JPMorgan will default on its outstanding debt. In bank accounting land, that means that it won't have to pay back money that it previously expected to have to pay... free earnings!

Of course, in order to ACTUALLY realize these "earnings", JPMorgan will have to actually default on its debt, which would tank the company in every way imaginable. But in the magical short-term world of bank accounting, a $2B trading loss can instantly transform itself into a big-time profit.

And hey, that $5B DVA gain that was calculated in the blog post assumed only a 2-point decrease in bond prices (i.e. from 100 to 98). Just imagine what JPMorgan's earnings would look like if their bond prices REALLY got whacked, like... oh, I don't know... Spain?

So remind me again, how exactly am I supposed to know when a bank is actually making money these days? And why should I ever trust a bank earnings report? Shaking my head...

[Sober Look]