Ben Bernanke Really Wants You to Buy a House

The Federal Reserve is doing everything in its power to get you to buy a house. On Thursday the Fed’s rate-setting committee said it will start buying $40 billion of mortgage-backed bonds every month from now until—well, it didn’t say when. Buying those bonds should translate into lower mortgage interest rates, speeding up the tentative recovery of the housing market. The Fed is betting that a stronger housing market will help lift the overall economy, which remains stuck in low gear more than three years past the end of the 2007-09 recession.

The Fed’s announcement—immediately dubbed QE3 by the markets, for round three of quantitative easing, or buying bonds to drive down long-term interest rates—had an electric effect on the mortgage market. Investors clamored for mortgage bonds, bidding up their price and thus pushing down their yields. The yield—that is, the effective rate that new investors receive—fell to just 1.01 percentage points above the yield on Treasuries. That was the narrowest spread in almost 15 years, signaling that investors are demanding only a small premium to own mortgage bonds instead of Treasuries. (Technically, that 1.01 is the difference between the yields on a Bloomberg index of Fannie Mae-guaranteed mortgage bonds and the average of 5- and 10-year Treasury notes.)

Mortgage rates are already at historic lows. The average rate on a 30-year fixed-rate mortgage in August was 3.6 percent, says Freddie Mac, down from 6.1 percent at the start of the recession in December 2007.

“If the outlook for the labor market does not improve substantially, the committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases and employ its other policy tools as appropriate,” the Federal Open Market Committee said in a statement at the end of its two-day meeting in Washington. At a press conference after the statement was released, Fed Chairman Ben Bernanke said that while the U.S. has “enjoyed broad price stability” since the mid-1990s, the employment situation remains a “grave concern.” He added: “The weak job market should concern every American.”

The rate setters said they expect the federal funds rate will stay at “exceptionally low levels” at least through mid-2015—vs. a previous expectation of late 2014.

The Fed also released new forecasts in which FOMC participants upgraded their estimate for 2013 economic growth to a range of 2.5 percent to 3 percent, vs. a forecast in June of 2.2 percent to 2.8 percent. They predicted that unemployment in the final three months of this year will average 7.6 percent to 7.9 percent, in line with the June forecast of 7.5 percent to 8 percent.

Since the financial crisis began, the Fed has bought more than $2 trillion worth of Treasury bonds and mortgage-backed securities. Lately it had focused its efforts on Treasuries. Its holdings of mortgage-backed securities peaked at around $1.1 trillion in 2010 and has lately been a little more than $800 billion. The purchase of $40 billion a month, in addition to the continuing reinvestment of the proceeds from maturing securities, will quickly swell that amount.

Economists called the Fed’s move dramatic. Michael Feroli, chief U.S. economist of JPMorgan Chase (JPM), told clients in a note that the Fed’s actions were “extremely aggressive.” Scott Anderson, senior vice president of Bank of the West (BNP), wrote, “The Federal Reserve went all in today.” Barclays (BCS) Research called it “a bold shift in Fed policy.”

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How JPMorgan Lost $2 Billion Without Really Trying

The $2 billion trading loss that JPMorgan Chase (JPM) announced in a hastily scheduled conference call on May 10 has its roots in credit-default swaps, the same derivatives that helped trigger the financial crisis—only this time there were no mortgages involved.

The bank has launched an internal investigation, regulators are swarming, and the Department of Justice has said it is pursuing a criminal probe. The bank has not yet released details of the money-losing trades. But based on publicly available information plus interviews with traders, former JPMorgan employees, and fund managers, it’s possible to draw the basic outlines of what may have gone wrong.

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The mistakes were made in the bank’s Chief Investment Office, run by Ina Drew, who left the company on May 14. The office is in charge of managing excess cash and some of its investments. In the past five years, Chief Executive Officer Jamie Dimon has transformed the operation, increasing the size and risk of its speculative bets, according to five former executives with direct knowledge of the changes, Bloomberg News reported in April. The mandate was to generate profits, a shift from the office’s mission of protecting JPMorgan from risks inherent in its banking business, such as interest-rate and currency fluctuations. A spokesman for the bank declined to comment.

JPMorgan Chase/Bloomberg

Credit-default swaps are insurance-like contracts between two parties. The buyer makes regular payments to the seller, who must make the buyer whole if an insured bond defaults. In addition to buying credit-default swaps on a particular bond, investors can buy swaps on indexes of bonds, such as the ones created by Markit Group, a deriviatives firm. The indexes rise when economic conditions worsen and the likelihood of corporate bond defaults increases. Traders use them to speculate on changing credit conditions. Buying the index can be a way for someone who owns a lot of corporate bonds to hedge against a decline in their value.

In 2011, JPMorgan profited by betting that credit conditions would worsen. In December, though, the European Central Bank provided long-term loans to euro zone banks, igniting a bond rally. Suddenly, JPMorgan’s bearish bets were vulnerable. Early this year, London-based traders in JPMorgan’s Chief Investment Office made offsetting bullish bets, according to market participants. It sold credit insurance using a Markit CDX North America Investment Grade Index that reflects the price of credit-default swaps on 121 companies that had investment-grade ratings when the index was created in 2007. The bank is thought to have sold insurance on the index using contracts that expire in 2017.

To protect against short-term losses, it also bought insurance on the index using contracts that expire at the end of 2012. That could have been a profitable strategy, because the 2017 insurance was more expensive than the 2012. And as long as the spread between the prices of the two contracts remained relatively stable, any decline in the value of one would be offset by an increase in the other, reducing the bank’s risk of an overall loss on the position.

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JPMorgan bought and sold so many contracts on the Markit CDX that it may have driven price moves in the $10 trillion market for credit swaps indexes tied to corporate health, according to market participants. At one point the cost of insurance via the index fell 20 percent below the average cost of insuring the individual bonds that composed the index. “The strategy overall got too big,” says Peter Tchir, a former credit derivatives trader who now heads TF Market Advisors, a New York trading firm. “Once their activity was moving the market, they should have stopped and got out.”

Sensing an opportunity, some hedge funds bought the 2017 contracts and sold credit insurance on the underlying bonds, hoping to profit when the relationship between the prices returned to normal. But because JPMorgan continued to be a big seller of insurance, the prices got even more out of whack, giving the hedge funds a paper loss. That led some traders to complain about the situation to the press. On April 5, Bloomberg News published a story saying that Bruno Iksil, a London-based trader for JPMorgan, had amassed a position so large that he may have been driving price moves in the credit derivatives market. The information was attributed to five traders at hedge funds and rival banks who requested anonymity because they were not authorized to discuss the transactions. Iksil’s influence on the market spurred some counterparts to dub him the London Whale.

Once the news got out, things quickly went south for JPMorgan. Hedge funds increased their bets that prices would come back in line. Thanks to their trades plus deteriorating credit conditions, the prices of the 2017 index contracts rose more than the prices of the 2012 contracts. JPMorgan’s paper losses mounted.

Compounding the losses were the sheer size of the bets, which made it difficult for the bank to unwind its trades. “These had to be massive positions” to inflict the loss JPMorgan suffered, says Michael Livian, CEO of Manhattan asset manager Livian & Co. and a former credit derivatives specialist at Bear Stearns. “And when you build that kind of size in the credit derivative market, you have to know you can’t just exit the position overnight.”

On the May 10 conference call, Dimon confessed: “The portfolio has proven to be riskier, more volatile, and less effective as an economic hedge than we thought.” For JPMorgan, the nation’s largest bank, the stakes are far bigger than a $2 billion paper loss. Since the bank announced its loss, investors have driven the stock down 13 percent, knocking $20 billion off the company’s market value as of May 16.

The episode has reignited the debate over how much freedom banks should have to make bets. Dimon had been a vociferous opponent of the Volcker Rule, a section of the Dodd-Frank financial reform law that would greatly limit the kinds of risks banks can take. Now, as Dimon himself pointed out, the proponents of the rule can point to JPMorgan to buttress their case. “This is a very unfortunate and inopportune time to have had this kind of mistake, yeah,” he said in an appearance on NBC’s Meet the Press.

The loss also raises the question of why the bank was putting shareholders at risk to gamble in a market of arcane indexes, where specialized hedge funds seek to profit from pricing anomalies. “JPMorgan was definitely in the very dark gray area between insurance and speculation,” says Robert Lamb, a finance professor at New York University who has studied risk on Wall Street. “To be the one side of the market and to think you were immune from the crowd on the other side is not safe, sane, or reasonable.”

The bottom line: Big bets on arcane credit derivatives left JPMorgan vulnerable to moves by hedge funds and rival traders.

With Mary Childs and Shannon Harrington

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Why Warren Buffett Really Likes Newspapers

When Warren Buffett announced that his company, Berkshire Hathaway, was buying 63 newspapers from Media General on May 17, he issued a soaring statement about his belief in a beaten-down industry.

“In towns and cities where there is a strong sense of community, there is no more important institution than the local paper,” Buffett said. “The many locales serviced by the newspapers we are acquiring fall firmly in this mold, and we are delighted they have found a permanent home with Berkshire Hathaway.”

Many see the deal as a rare expression of faith by an important investor in an industry that Wall Street has shunned. “It’s obvious … that this is a statement that local newspapers are going to be around for a while,” veteran newspaper industry analyst Ed Atorino of Benchmark told the Richmond Times-Dispatch, a Media General paper.

It’s true that Buffett is a newspaper fan. Berkshire Hathaway already owns the Buffalo News and a stake in the Washington Post. It also startled some observers with its purchase last December of the Omaha World-Herald, Buffett’s hometown broadsheet.

Yet it’s also important to look at the price Berkshire is paying for the Media General papers. As recently as six years ago, newspaper companies sold for more than 9 times Ebitda (earnings before interest, taxes, depreciation, and amortization). Bank of America Merrill Lynch’s Stephen Weiss writes today that Buffett’s company paid around 4 times Ebitda for the Media General assets.

At that low price, Berkshire Hathaway could make a nice return on its money. As the Wall Street Journal reported earlier this month, it has done surprisingly well since purchasing the debt last November of Lee Enterprises, another troubled newspaper publisher, from Goldman Sachs.

Buffett may have a soft spot for newspapers. But when it comes to investing, he’s no sentimentalist.

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