At last, JP Morgan (JPM:NYSE) shareholders and their politcal representatives might find out exactly what transpired within the JPM Chief Investment Office. As much as the Wall Street Journal may try to get the story precisely correct, and as hard as JPM executives may try to spin their way out of an inexplicable situation, none of this is being done under oath. And that’s the wonderful thing about what’s to come: investors will actually find out what was being hedged, to what end, and how comfortable JPM is to say that they never took a naked bet on changes in the backdrop of the European economy.

Republican Senator Corker is trying to get ahead of the curve with his request, since JPM’s US$2.45B (and counting) in mark-to-market losses have added import to the demands of those who say the pending “Volcker Rule” is both required, and needs to be toughened. Corker figures that any details from JPM Executives will be better than what is in the public domain today. Smart move on his part.

Last month, I told Kim Parlee on BNN’s Business Day show that the Wall Street Journal’s original “London Whale” story illuminated that the Volcker Rule loophole, which permitted “portfolio hedging” by banks, made a mockery of the rule itself — which was to ban prop trading with bank capital. Banks should be in the business of making loans, and there’s nothing wrong with hedging those loans if you’re worried about your institutions’ exposure to the companies that underlie the loan portfolio. But you can’t effectively hedge that book in the Credit Default Swap market, I said, since you are taking counterparty risk the moment you try to lay off that risk onto some other institution. As we all witnessed with AIG in 2008; you think you’ve bought “protection”, but it turns out that in a global financial crisis there’s no one on the other side of your trade (other than Uncle Sam, of course).

Particularly if you are JP Morgan, North America’s best capitalized bank. If JPM needs to reduce its loan exposure there are only two ways it, or any other large bank, can accomplish same: don’t make the loans in the first place, or syndicate some of your loan exposure to another institution.

When a bank is either “putting on” or “laying off” risk via a CDS midstream, all they are really doing is taking a bet on what’s to come in the short term. And, despite telling the WSJ on April 12th that:

“The CIO balances our risks,” Braunstein told media members on a conference call. “They hedge against downside risk, that’s the nature of protecting that balance sheet.”

Braunstein added the bank is “very comfortable with the positions we have” and that all of the positions are “very long term in nature.”

It turned out that JPM’s definition of “very long term in nature” can be four weeks when they are offside a trade.

All of this is old news, by now. But the scary thing that has come to light isn’t that banks might lose money on their risk management activities. Mark Carney, Chair of the Financial Stability Board, thinks that goes with the territory. What annoys me is that JPM’s Chief Investment Office was responsible for investing US$374 billion of JPM assets, according to the WSJ.

Guess what these assets are? Deposits that aren’t invested in JPM’s loan book. The Chief Investment Office had a goal, according to the report: take these free balance deposits and earn a return higher than the bank’s cost of capital. Whether that means the targeted annual return was 5%, 6% or 8%, JP Morgan’s Board of Directors authorized the CIO Unit to trade in assets that total twice JPM’s equity capital base of US$189.7 billion.

When the 10 year U.S. Treasury is around 2%, what type of risks did JPM’s Board authorize its management team to take to achieve these 5-8% annual returns? Last year, JPM earned about US$19 billion in total. If JPM’s CIO until was producing even a 5% after tax return with its asset pool, that would represent almost 100% of JPM’s entire 2011 earnings.

Despite having US$374 billion to invest, the WSJ reports that “the CIO unit responsible for the bad trades had weaker risk management controls than other parts of J.P. Morgan.” How can that happen? Where were the regulators? They were probably doing their jobs — right there on the trading desk, keeping a watchful eye. Even then, this all came to pass just the same. As the WSJ reported over the weekend:

The bank’s CIO unit holds many trading positions. Late last year, they included insurance against defaults, or credit-default swaps, by 121 various companies on an index called the IG 9 maturing in December of this year. Meanwhile, the group sold CDS contracts on a similar index maturing in December 2017.

Early this year, however, Mr. Iksil and his group decided to become more bullish on corporate credit, according to traders. So Mr. Iksil began selling more CDS contracts on that corporate-debt index maturing in December 2017, a way to make a wager on the health of companies.

So long as FDIC-insured deposits are invested in anything other than cash, T-Bills, government bonds and personal/commercial/corporate loans, the taxpayer is taking too much risk. That’s the lesson of the London Whale. In fact, the taxpayer is an unwitting pawn in a very distasteful business, where folks can make $15 million a year with Joe/Jill Lunchbucket as the ultimate safety net. Until Regulators, Bank Governors and Politicians get their arms around this reality, none of the rules that have been enacted post-financial crisis are worth the paper they are printed on.

MRM

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First announced in 2007 (see prior post “$165MM MRI Fund: blessing or curse?“ Dec 3-07), it has made just four commitments in the space of four years: BlackBerry Partners Fund, Edgestone Venture III (the commitment subsequently expired), Georgian Partners and XPV. That tortuously-slow pace is a problem, not just for the entrepreneurs, angels and broader VC industry, but also the government sponsor.

The mechanics of the fund were simple: 4 year term (or was it 5) and then re-up for the next vehicle. That clock has ticked, and it is time for the OVCF to go back to its hostages private sector LPs and see who wants to play again.

As we all recall, it took the Premier himself to get some of the private sector players to agree to commit in the first place. Each had their own reasons for playing or not, of course, but the lack of traction can’t have been missed by the senior management of Manulife, RBC and TD. OTPP will look back and say they were justified in passing, as was rumoured, at the time.

One has to assume the Cabinet has the bit in its teeth, too. As MRI Minister, a sincere Glen Murray referred to OVCF in 2010 as “struggling” (see prior post “No sacred cows for Murray“ Oct 26-10), and Finance Minister Dwight Duncan told a York Club audience last year that things “hadn’t worked out” at OVCF like the government had planned. Indeed, the Opposition has been on the file, too, and minority governments can’t ignore the mood across the aisle (see prior post “Tories pounce on Grits over Ontario VC stats“ March 2-10).

At the outset, one has to wonder if it was set-up for success. Although it has worked in B.C., Canadian funds of funds have a spotty track record. Some have made money, Edgestone successfully put the CPPIB money to work in the early part of the last decade, and certain provincial government vehicles have served their purpose. But the politicians are learning that building a successful VC ecosystem is more complicated than simply handing the public policy tool over to NorthLeaf Partners (manager of OVCF).

For NorthLeaf, the timing of a re-up could be crucial, too. Having acquired the TD Fund of Fund platform (TD Capital Private Equity Investors) from the bank for $1 a few years ago, prior to renaming it NorthLeaf, the firm has grown to 55 staff managing a variety of products. It is this critical mass that is rumoured to have drawn the M&A attention of Harbourvest, a US$28 billion goliath in the fund-of-fund space. Harbourvest has been acquiring regional players, and the drums are beating about a NorthLeaf/Harbourvest tie-up.

The OVCF is a marquee mandate to manage, and asset management platforms such as Northleaf are valued off their fee streams. Which means the timing of any eventual re-up, or the demise of OVCF itself, might have a bearing on more than just the local VC industry.

As the budget negotiations continue to Queen’s Park, entrepreneurs are left to hope that the Premier won’t throw the baby out with the bath water. The OVCF hasn’t worked, and Finance is looking for budget savings, but perhaps it wasn’t the basic idea of OVCF that has caused it to fall flat.

As fund managers at several VC firms would tell you, this was a failure of execution, not design. Give it another chance, but put the football in someone else’s hands.

MRM

You probably didn’t know, but I’ve thoroughly enjoyed watching your career blossom over the past 25 years. Indeed it was half-a-life ago when you were covering Dizzy Gillespie for The Gazette; whether his trumpet fired you up about journalism, or your love of music drew you to writing, the media is better for your decision to formally enter the fray and make a career out of it.

You’re both an excellent writer and cogent observer, which are too rare in the Fourth Estate. Simpson has the gift, too. But with the absence of Dalton, the two of you don’t have much company, at least in the world of Hill columnists. Awards may adorn your office shelf, but the delight with which you tackle each day tells us distant observers that you have the zeal to ply a difficult trade for decades to come. Whether or not the National Magazine Awards take notice from one year to the next.

With this success, a burden comes your way. The Parliamentary Press Gallery looks up to you, just as they did to Graham Fraser when you were fresh out of Undergrad. Which is why your humourous blog about Mark “Chuck Norris” Carney is so troubling. Do your media colleagues know you were kidding? That you weren’t suggesting Carney had jumped the shark?

History is at work here, I fear.

Governor Carney is no Kim Campbell, and I’ve had the chance to watch them both. After building her up to be, literally, the second-coming, I know the Press Gallery felt burned when it turned out in 1993 that Ms. Campbell had none of the qualities and capabilities that they’d been led to believe were what made her different from any public figure they’d come across since Trudeau. Fluent in Russian? Could barely string a sentence together. Deep thinker? She’d leave cabinet committee meetings to call her Chief of Staff to see how she should vote on an item before the group. Loyal? There wasn’t a relationship that lasted more than a few years pre-Ottawa. Ray convinced the Gallery she was God’s gift, and it worked.

When the fraud was uncovered, the Gallery took it personally. Which is why I think they have been stomping on so many up-and-coming throats for the past 19 years. Once burned, etc., etc.

Carney is different. Unlike Campbell, Carney has actually done some meaty things prior to arriving in Bytown. Campbell’s resume reflected a life of hopping between lilly pads. Carney gives off no such dilettante-ish tendencies. Even if a career turn at Goldman Sachs is now akin to spending a year in jail, his nomination to run the Financial Stability Board is definitely the Finance industry’s version of an Oscar statue. The fact that Carney had a public set-to with JP Morgan CEO Jamie Dimon about capital ratios and the burden of regulation should serve as a call-to-arms for anyone who earns his living spilling ink.

And while the Norris piece was funny, the concern is that your colleagues will misunderstand. That they’ll think you were mocking the fact that three people close to the Bank of England believed that Carney was what the U.K. needed to get its own Central Bank in order. Whether the story was accurate or not, the fact that the gold standard of financial journalism believed it to be so tells you something about where Carney ranks in a variety of areas: leadership, judgment, conviction, sense of purpose…. The kinds of things that people like you and I yearn for in the public sector.

I think the Prime Minister has those qualities, as do John Baird and Jim Flaherty, for example. Whether or not you agree with them is never the point. The question is simple: would you rather a former assistant manager of the Oliver’s Pub, on the Carleton University campus, take their place? Or any of the U.S.C. VPs you watched over the years, myself included?.

I doubt it.

As much fun as you like to have with the people you cover, don’t forget that the country you hope to live in has to be governed by someone on our way to utopia, unless you’re prepared to do it yourself. Near as I can remember, you left the politics to the rest of us, and stuck with your love for the written word. Which makes it all the more important that you not forget that the only thing worse than having Chuck Norris protect your family, is having someone who isn’t a Texas Ranger failing you in the process.

MRM
(this post, like all blogs, is an Opinion Piece)

Since he once played goal for the Harvard hockey team, it seems appropriate to use a hockey analogy: there’s no way we should trade Bank of Canada Governor Mark Carney to the Bank of England. Not even if they send us back the rights to Rory McIlroy, Steven Gerrard and Graeme Swann. Maybe if the Duchess of Cambridge is added to the mix, although I doubt Her Majesty nor Prince William will let her go; but even then?

It is an honour, of course, for Canada, indirectly at least, to be getting this kind of attention. But this has much more to do with Governor Carney’s talents than the stability of the Canadian banking system (see prior post “No Canadian bank bailouts? Says who?” Dec 10-09). Governor Carney has been a rock star for a long time, as we well know (see prior representative posts “The subtext of the new Bank Governor’s appointment” Oct 12-07 and “Governor Carney’s future political career looking good” Sept 10-10).

As much as “The City” comes with a certain amount of intellectual excitement, one would hope that Governor Carney gets that via his current dual role as BoC Governor and the Chair of the Financial Stability Board. As for the money, there’s nothing that the BoE could pay that Governor Carney couldn’t make 25 times over on Wall Street. And, as has become apparent to many of us, money doesn’t seem to make this guy tick.

Service. Policy. The mandate, capacity and tools to bring about change in a variety of forms. That’s what must appeal to a guy who left Goldman for a public service job at the Department of Finance. I’d argue he should be tempted for something that allows him to broaden that skill set, such as political office (see prior post “How about Carney as Minister of Economic Transformation?” Feb 8-11).

But the Brit’s bank job? Feels a bit like changing four quarters for a dollar to me. If I thought for a moment that he’d have the tools to fix Europe, perhaps we Canadians could be our gracious selves and encourage Governor Carney to move up the ladder of Central Bankland. But there’s nothing about Europe that the UK government can fix, particularly if it has to write cheques.

To paraphrase a former Prime Minister, let’s hope he dances with the woman that brung him.

MRM

R&D shakeup is good news for Canada’s entrepreneurs

By Mark McQueen  | April 11, 2012

As Research In Motion slugs it out with the global handset Goliaths, and the Nortel carcass is picked apart by distressed debt investors, Finance Minister Jim Flaherty seems determined to put the full weight of the federal budget behind resurrecting Canada’s innovation sector. It comes not a moment too soon.

For more than a generation, successive Canadian governments have put most of their innovation funding eggs in the academic and scientific research basket, with the hope that the commercialization gods will eventually churn out high-value jobs and economic growth.That “trust the lab coat” public policy has created plenty of sinecures on university campuses and in government labs—but it has resulted in far too few actual tech and life-science spin-out corporations.

The big problem has not been the amount invested—after all the feds are spending $5 billion per annum on R&D funding—but that 17 different government departments and agencies are doling out the money. With that many cooks in the kitchen, it’s no wonder that Israel, with aquarter of our population, attracts more venture capital funding than all of Canada.

Luckily, Minister Flaherty, fresh from direct meetings with entrepreneurs here and overseas, seems to recognize that Canada doesn’t have a funding problem, it has an execution problem. So, after a multi-year decline in Canadian venture capital funding—hitting a low of just $1 billion in 2009, despite US$132 billion invested by venture capitalists south of the border over the past five years—the March budget finally screamed an end to business as usual.

The change that received the most attention was the decision to tighten the high-profile Scientific Research and Experimental Development (SR&ED) program, which gives out cash and tax credits for R&D spending in Canada. But it was the $400-million promise of new direct funding that could deliver the biggest bang for Mr. Flaherty’s buck. That’s because, rather than handing the capital over to any one of 17 government agencies with a finger in the innovation pie, or giving the money to the Business Development Bank of Canada, which deployed just $408 million of its $18.4 billion balance sheet to the venture capital industry, the Conservatives have decided to invest that money directly in entrepreneurs.

Some have concerns about this approach. Are the Conservatives looking to return to some 1950s idea of a planned economy? Will government officials take it upon themselves to pick winners versus losers? The simple answer is this: not if the government adopts the proven coinvestment model.

In such a model, when a Canadian venture capitalist invests $4 million in a Series A round, that private risk capital goes directly into new hiring and sales execution. These are high-valuejobs, right here at home, with companies that often already have revenue. If the government were to structure its new $400-million program as a coinvestment fund, as is available in several U.S. states and Canadian provinces, three important outcomes are guaranteed.

The first is that the private sector will end up leading the way, picking the winners and sitting on the boards of directors of the new corporations, with its own capital at risk. Second, Canadian entrepreneurs will have a better chance to execute their business plans, as the additional investment capital will give them more firepower to tackle their chosen markets. The third outcome is that—should the VC and entrepreneur succeed at creating the next Facebook or Research In Motion—the government’s coinvestment stake will earn the same handsome return as is being made by the private sector.

All three outcomes are crucial for Canadian innovation and competitiveness over the long term. The status quo is no longer an option, and Mr. Flaherty deserves credit for recognizing that it’s the entrepreneurs—not the antiseptic R&D departments—who create high-value jobs.

Wellington Financial is a new corporate sponsor of Moose Jaw-born Adam Hadwin, and we’re returning to another year of sponsorship of Richard Scott, from Kingsville, Ontario (see representative prior post “Put one down in the win column for Richard Scott” April 10-10). Both have status on the Nationwide Tour this year, although Richard might have time to play some Canadian Tour dates as well. In 2011, he lost the Canadian Tour Championship in a playoff, which would be incentive for anyone to return for another kick at the can.

Adam drew great attention at the 2011 Canadian Open, where he placed 4th overall. Just last weekend, he had a Top-5 finish at a Nationwide event, and is now 22nd on their 2012 Money list; eventually, that list will drive 2013 PGA Tour standing. He is currently ranked the 250th best golfer in the world, and the 2nd best Canadian, behind PGA player David Hearn. To give you a sense of how high #250 actually is, Stephen Ames is currently ranked 360th, and he’s got more than $19 million in career winnings.

Richard has won tournaments throughout North America, including the first round of the PGA’s Q-School last Fall. As a former Canadian amateur Champ, with an NCAA title under his belt as well, he’s proven that he knows how to win.

Please join us in wishing them both a successful season.

MRM