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Auntie Fannie and Uncle J.P.


A flat yield curve makes it difficult for these behemoths to make money.


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Editor's Note: Minyanville is a community of people who share an interest in fiscal literacy. As perspective is an important aspect of our daily routine, we share this exchange with hopes that it adds balance to your process.

Prof. Succo -

Thanks for keeping our friends at Fannie Mae (FNM) front-and-center. I've got a question related to the contagion theme. You've cited several times that J.P. Morgan (JPM) is the largest counterparty to Fannie in their derivatives portfolios. Today, as Fannie tanks, JPM yawns. So what's awful for Fannie isn't necessarily awful for JPM (or maybe the Minx just doesn't care, yet).

Could you tell the Minyanship a bit more about the counterparty relationship (i.e., who owes what stream of cash flows to whom and under what conditions), and explore the possibility that what's really bad for Fannie might (1) not matter much to JPM or (2) might actually be good for JPM? Thank you.

Minyan Ben
(disclosure: short FNM)

MB -

JPM is a completely different animal with completely different risks.

They are the largest counter-party to FNM, taking a fair portion of the company's interest rate (volatility) risk: FNM buys a derivative from JPM that hedges their interest rate volatility risk, thereby transferring it to JPM. So JPM will lose money if the bond market gets more volatile (they get paid a good premium to take this risk). Of course, if FNM were to "default" on their derivatives, JPM could lose billions of dollars, but this won't happen. The government (taxpayers) would almost certainly step in and guarantee performance on those contracts. Otherwise, FNM could cause a financial melt-down.

The risk that JPM entered into finite insurance arrangements (these arrangements really only "smooth" earnings, acting as a pool of funds a company can draw upon from time to time) similar to FNM is not higher than any other company just because JPM did business with FNM.

That being said, I have other reasons to be negative on JPM and other central banks like Citigroup (C) and Banc of America (BAC): a flat yield curve makes it difficult for these behemoths to make money, these are the largest credit card dealers in the world and that business in my mind is likely to hit a rough patch, the risk controls are not conservative enough, and they have large derivative exposure (an understatement especially for JPM) that I believe is not marked to reality.

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Position in c, jpm, bac

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