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Who’s Right, The Market Or The Fed?

Latest Fed guidance Expect 10, 0.25% rate hikes by December 2018. “Economic recovery” is underway and will continue at a moderate pace. Interest rates will “normalize” by 2019. (Where the Fed sees rates and when, 2 minutes 6 seconds) Source Federal Reserve 35+ trillion in open position face value tells us Expect a maximum of 3, 0.25% rate hikes by December 2018 Rates will not “normalize” this decade True economic recovery will take far longer than the most pessimistic of Fed guesstimates. A-C on the chart below shows the market’s expectations for rate hikes A) In January 2013 the market was pricing in 6, 0.25% rate hikes between June 2016 and December 2018 with the spread between the two deliveries (GEM16) and (GEZ18) at 1.50, position value 3,750.00 USD B) By November 2013, optimism for US economic recovery and rate normalization peaked with the market pricing in 10, 0.25% rate hikes between Jun. 16 (GEM16) and Dec. 18 (GEZ18) at 2.50, position value 6,750.00 USD C) Current rate hike expectations have dropped to less than 3, 0.25% hikes by Dec 18, with the spread at 0.6250, position value 1,562.50 USD D) If the market had faith in the Fed’s projections the spread between the Jun. 16 (GEM16) and Dec. 18 (GEZ18) deliveries would be 2.50 reflecting the Fed’s expected 10, 0.25% rate hikes by Dec. 18, position value 6,250 USD. Click to enlarge How to calculate the market’s expectations to 0.01% through March 2026. Use the quotes on this Exchange page To convert the contact delivery price into rate it represents take 100.00 – contract price = the rate. Example, 100.00 – the December 2016 contract price of 99.17 = an expected 3 month rate of 0.83% by Dec 18. To calculate expected rate increases between delivery months take the nearby delivery minus the forward delivery equals the expected rate change between delivery months. Example, June 2016 delivery trading at 99.3350 – December 2016 at 99.1700 = the expected increase in rates between June 2016 and December 2016 = 0.1650%. What U.S. price action tells us. The market’s perception of economic recovery is far worse than the Fed’s. Rates will not “normalize” during this decade. Fed and US fiscal policy makers creditability with the market is at a new low Eurozone market expectations are worse. A) In January 2013 the Eurozone expected an increase in the 3 month Euro Interbank Offered Rate (EuriBor) between Jun. 16 (IMM16) and Dec. 18 (IMZ18) of 0.6000%, position value 1,500.00 EUR B) By November 2013 optimism for Eurozone economic recovery and rate normalization peaked with an expected increase in the EuriBor rate between Jun. 16 (IMM16) and Dec. 18 (IMZ18) of 1.10%, position value 2,750.00 EUR C) Currently optimism for Eurozone economic recovery and rate normalization has hit a new low with an expected increase in the EuriBor rate between Jun. 16 (IMM16) and Dec. 18 (IMZ18) at 0.10%, position value 250 EUR. Click to enlarge Converting the contact price into rate increase/decrease works the same as the US. Use the quotes on this Exchange page to calculate today’s Eurozone rate expectations to the 0.01 through March 2022 3 Month Eurozone price action tells us The EuriBor rate is expected to move 0.0350% lower during 2016 The market sees only a 0.0700% rate increase between now and December 2018 The EuriBor rate will remain negative through December 2019 Eurozone rates will not “normalize” this decade United Kingdom, nearly the same A) In January 2013 the UK market expected an increase in UK 3 month rates between Jun. 16 (LZ16) and Dec. 18 (LZ18) of 1.20%, position value 3,000.00 GBP. B) By January 2014 optimism peaked with the market pricing in a 1.60% increase, position value 4,125.00 GBP. C) Currently UK price action says only a 0.30% increase, position value 750.00 GBP. Using the quotes on this exchange page conversions and expected increase/decrease work the same as the U.S. and Eurozone. Click to enlarge Global Stock markets Let’s skip all the subjective fundamental economic over analysis and look at the big picture price action. Price action is telling us uncertainty and doubt about economic recovery has now spread into the global equity markets. S&P 500 traded at the CME On the 16 year S&P chart below note the current volatility relative to the overall rate of change, the monthly moving average (green) has been violated, the majority of the price action is now below the average. Does this market still look like it’s in a healthy uptrend to you? Click to enlarge DAX traded at EUREX Increased volatility relative to the overall rate of change, the DAX has broken below the monthly moving average (green), the majority of the price action is now below the average with the long term trend appearing to be shifting from up to down. Click to enlarge Nikkei 225 traded at JPX Increased volatility, the market has broken below the monthly moving average (green), the majority of price action now remains below the average, the long term shifting from up to down. Click to enlarge Survival Put opinions aside, trade with the trend long or short. Learn new markets and strategies. Trade whatever market/sector has the highest return on risk Define risk on trades and for the duration of the trading period without wasting precious investment capital on option time premium to hedge risk. One example of defined risk trade using the Euro Stoxx 50 traded at EUREX Looking at the chart below is it really that hard to identify the current daily trend using the moving average (green) ? We’ve seen the break below the daily moving average and now majority of price action below the average. Click to enlarge On the weekly, a break below the weekly moving average (green) with the majority of the price action below the average. Click to enlarge Monthly, break below the monthly average (green), majority of the price action below the average. Click to enlarge The daily, weekly and monthly charts tell me short Common technical indicators say the same Click to enlarge Eurozone rate expectations sum up the economic fundamentals. The EuriBor is pricing in lower rates during 2016 with the EuriBor moving from the current negative 0.2550% to negative 0.2900% by December 2016. EuriBor traders are telling us loud and clear true economic recovery isn’t expected for the Eurozone in 2016. Structuring a defined risk trade shorting the Euro Stoxx 50 A) Short the Euro Stoxx 50 at 3,000, position value 30,000 EUR B) Write the 2,800 put collecting premium C) Using the collected premium purchase the 3,200 call to hedge risk. Click to enlarge Trade Summary Risk is defined on the trade and for the duration of the trading period This trade cannot be stopped out regardless of market volatility, the only thing needed to be profitable is anticipating the market’s overall direction correctly. The trade can be liquidated at any time , you do not need to hold the position to expiration. The only way the 3,000 short can be pulled away is at a 2,800 generating a gross profit of 2,000 EUR. If the market reverses and rallies to 3,800 losses above 3,200 are hedged by the 3,200 call with gross losses limited to 2,000 EUR. If the market stays the same and you’ve structured your trade correctly you should break even as you’ve collected as much time premium on the 2,800 put write against your 3,000 short as you’ve paid out for the 3,200 call to hedge. Effective “option collar” strategies are not limited to the international futures markets they can be employed in any market that has underlying option liquidity. Examples Baxter International Inc ( BAX ) – NYSE, Bank of America Corporation ( BAC ) – NYSE, General Electric Company ( GE ) – NYSE, SPDR S&P 500 Trust ETF ( SPY ) – NYSEARCA, iShares MSCI Emerging Markets ETF ( EEM ) – NYSEARCA, SPDR S&P Metals and Mining ETF ( XME ) – NYSEARCA, Pfizer Inc. ( PFE ) – NYSE, Apple Inc. ( AAPL ) – NASDAQ, SPDR Gold Trust ETF ( GLD ) – NYSEARCA, iPath S&P 500 VIX Short-Term Futures ETN ( VXX ) – NYSEARCA, Market Vectors Gold Miners ETF ( GDX ) – NYSEARCA, Ford Motor Company ( F ) – NYSE, Financial Select Sector SPDR ETF ( XLF ) – NYSEARCA, iShares China Large-Cap ETF ( FXI ) – NYSEARCA, Shares Russell 2000 ETF ( IWM ) – NYSEARCA, Let’s take a look how at how a “collared” position protected me in Apple AAPL I’m sure I wasn’t the only one caught long Apple AAPL at 130 USD in July 2015 I made the mistake of getting too attached to being long this stock from 75.00 USD and stayed long in July 2015 at 130.00 USD despite the daily trend telling me it was questionable. Click to enlarge The weekly was shaky Click to enlarge The monthly still up with only a few “bumps” against the moving average and no sustained price action below the average. Click to enlarge The technical indicators were deteriorating Click to enlarge Rather than reverse to short or liquidate my Apple position I maintained my long hedging it up with a collar shown A-C on the chart below. A) At the time I put down the collar AAPL was at 129.62 USD B) I wrote the 140.00 1 month call against my long C) Using the collected premium I purchased the 120.00 put Click to enlarge Price action got ugly quick, the market broke eventually taking out 110.00 USD, disappointing but tolerable as I had my 120.00 put hedge in place negating any losses below 120.00. I delivered my long at 120.00, had I not “collared” this position it could have been far worse, AAPL eventually violated 95.00 USD on the run lower and has not seen a sustained move above 120.00 since. Click to enlarge This Apple trade was yet another refresher course for me not to get too “attached” to a stock, to pay attention to price action and not fight market momentum. If you’re attached to your long shares or index positions (as I was too apple) you too might want to take a good hard look at the current price action and start “collaring up” positions to prevent a financial character builder. I don’t think anyone knows for sure where the high will be for the S&P 500 and Global Equity Markets. Click to enlarge What we do know for sure is when the S&P 500 and Global equity markets break the financial impact can be worse than a divorce and five kids in private school. Click to enlarge Using “collars” to control risk on directional trades has cut my stress level for these trades by 70%. ——————————————————————————- Additional information and definitions Trading intra-market rate spreads If you believe Fed creditability and “economic recovery” will continue to deteriorate you’d short the GEZ16 futures contract and go long the GEZ18 expecting the market to go from pricing in 2, 0.25% hikes between Dec. 16 and Dec. 18 to 0, 0.25% hikes or for the spread to potentially invert (-0.10) like it has in Europe and Asia. Each 0.01 contraction in the spread price from the current 0.50 = +25.00 USD and each 0.01 expansion -25.00 USD. If you believe the market is being more pessimistic than justified about economic recovery and, the Fed is more right about the rates they set than wrong, you’d go long the GEZ16 and short the GEZ18 expecting the spread to widen from the 0.50 (2, 0.25% rate hikes) to 1.00 (4, 0.25% hikes) and be more in line with the Fed’s expected 8, 0.25% hikes , spread = 2.00. Each 0.01 expansion in the spread from 0.50 = +25.00 USD, each 0.01 contraction = -25.00 USD Click to enlarge Eurozone intra-market rate spreads work the same as the US, if you think Eurozone economy will weaken further you’d short the IMZ16 and go long the IMZ18 expecting the spread to contract, if you believe the Eurozone is in better shape than what the market is telling us you’d go long the IMZ16 and short the IMZ18 expecting the spread to widen, each 0.01 = 25.00 EUR. Click to enlarge Difference between intra-market and inter-market spreads Inter-market spreads trade different contract markets for example, WTI against Brent crude oil, long 1,000 barrels of Brent QAN16 , short 1,000 barrels of WTI CLN16 expecting the spread to widen from 0.00, each 0.01 = 10.00 USD. Click to enlarge Platinum versus Gold is also a Inter-market spread example, long 2, 50 troy ounce Platinum contracts PLN16 , short 1, 100 troy ounce gold contract GCM16 expecting platinum to gain back lost ground against gold, each 0.10 = 10.00 USD. Click to enlarge The intra-market rate spreads mentioned in this report are trading the same contact market but different delivery dates , for example short 1 Jun. 16 US 3 month deposit GEM16 long 1 Jun. 21 3 month deposit contract GEM21 expecting the spread to widen, each 0.01 = 25.00 USD. Definitions 3 month rates or Eurodollar deposits are time deposits denominated in U.S. dollars at banks outside the United States. (There is no connection with the euro currency ). The term was originally coined for U.S. dollars deposited in European banks, but it’s expanded over the years to its present definition-a U.S. dollar-denominated deposit in any non US bank for example Tokyo or Beijing would be deemed a Eurodollar deposit. Futures open interest (contracts outstanding exceeds 10 trillion, Euribor is short for Euro Interbank Offered Rate. The Euribor rates are based on the average interest rates at which a large panel of European banks borrow funds from one another. The Euribor rate is considered to be the most important reference rates in the European money market. The interest rates do provide the basis for the price and interest rates of all kinds of financial products like interest rate swaps, interest rate futures, saving accounts and mortgages. Short Sterling prices are based on the British Bankers Association London Interbank Offered Rate (LIBOR) for three month sterling deposits in units of 500,000.00 GBP. 3-Month Sterling Futures are traded on the London International Financial Futures and Options Exchange, part of NYSE Euronext. Each contract is for Interest rate on three month deposit of £500,000 of 3-month Sterling. The Standard & Poor’s 500 , often abbreviated as the S&P 500, or just “the S&P”, is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 index components and their weightings are determined by S&P Dow Jones Indices. It differs from other U.S. stock market indices, such as the Dow Jones Industrial Average or the Nasdaq Composite index, because of its diverse constituency and weighting methodology. The “Composite Index”, as the S&P 500 was first called when it introduced its first stock index in 1923, began tracking a small number of stocks. 3 years later in 1926, the Composite Index expanded to 90 stocks and then in 1957 it expanded to its current 500. S&P 500 futures trading began in 1988 , e-mini contract 1997. The DAX ( Deutscher Aktienindex (German stock index)) is a blue chip stock market index consisting of the 30 major German companies trading on the Frankfurt Stock Exchange. Prices are taken from the Xetra trading venue. According to Deutsche Börse, the operator of Xetra, DAX measures the performance of the Prime Standard’s 30 largest German companies in terms of order book volume and market capitalization It is the equivalent of the FT 30 and the Dow Jones Industrial Average. The Nikkei 225 , the Nikkei Stock Average is a stock market index for the Tokyo Stock Exchange ((NYSE: TSE )). It has been calculated daily by the Nihon Keizai Shimbun (Nikkei) newspaper since 1950. It is a price-weighted index (the unit is yen), and the components are reviewed once a year. Currently, the Nikkei is the most widely quoted average of Japanese equities, similar to the Dow Jones Industrial Average. The Nikkei 225 Futures , introduced at Singapore Exchange (SGX) in 1986, the Osaka Securities Exchange (OSE) in 1988, Chicago Mercantile Exchange ((NASDAQ: CME )) in 1990, is now an internationally recognized futures index. The EURO STOXX 50 is a stock index future of Eurozone stocks designed by STOXX, an index provider owned by Deutsche Börse Group and SIX Group. Its goal is “to provide a blue-chip representation of Supersector leaders in the Eurozone”. It is made up of fifty of the largest and most liquid stocks. The index futures and options on the EURO STOXX 50, traded on Eurex, are among the most liquid futures contracts in the world Disclosure: I am/we are long AND SHORT POSITIONS IN THIS REPORT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Time For Investment Grade Corporate Bond ETFs?

Treasury bond yields are now at extremely low levels as investors are thronging this safe haven to beat global growth worries. Plus, monetary stimulus in various corners of the world and a still-dovish Fed have kept the yield low. The benchmark 10-year note yield was 1.71% as of May 13, 2016. Uncertainties are expected to remain in the marketplace for some more time because neither has oil recovered fully nor has any concrete solution been found yet for China, Japan and Eurozone. Yes, these economies are striving to boost growth, but sustained recovery is unlikely in the near term. In fact, the upheaval in global financial markets has forced the Fed to stay put so far this year even after raising the key interest rate for the first time after almost a decade. Many market watchers now expect the Fed to hike rates again in September and not in its next meeting in June. All these definitely point to lower Treasury yields, which is why Goldman Sachs cut its projection for 10-year US Treasury bond yields over the next few years. Many other banks also believe the same. Goldman Sachs now expects its year-end 10-year yield to be 2.4%, down from the 2.75% it projected in the first quarter. Bank of America Merrill Lynch pared down its forecast for the year-end 10-year yield to 2% from 2.65% at the beginning of the year. Morgan Stanley projects a lower 10-year yield at 1.75%, down from 2.7% when the year started. In short, yield-hungry investors intending to restrict their plays within the U.S. boundaries but not trying to expose themselves to the stock market uncertainties, would find investment grade corporate bonds compelling options. The investment grade U.S. corporate bond market has been on a decent path lately as these normally yield more than their Treasury cousins, with only a little rise in risk. Since corporate leverage is presently at its peak level in a decade (as per Goldman Sachs ), investors need to be aware of default risks. Now, default risk remains low if investors put their money into investment-grade bonds of some well-established companies. Further, if the global economic situation deteriorates and risk-off trade starts to prevail, high yield bonds will be hit harder than the investment grade bonds. Investors thus can take a look at below-mentioned investment-grade bond ETFs which offer solid yields and scope for decent capital gains. Investors should note that the below-mentioned ETFs yield higher than iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) (as 30-day SEC yield of TLT was 2.44% as of May 11, 2016) and returned slightly better than it in the last one-month period (as of May 13, 2016). TLT was up about 1.4% in the last one month (as of May 13, 2016). SPDR Barclays Long Term Corp Bond ETF (NYSEARCA: LWC ) This fund intends to mainly measure the performance of U.S. corporate bonds that have a maturity of greater than or equal to 10 years. The corporate bonds have a high investment grade rating as well. The ETF has a weighted average maturity of 23.84 years and a weighted average duration of 14.03 years. The ETF is an appropriate choice for investors seeking high yield. The ETF’s yield-to-maturity hovers around 4.46% (as of May 12, 2016). The fund returned about 2.8% in the last one month (as of May 13, 2016). It has a Zacks ETF Rank #3 (Hold) with a High risk outlook. iShares 10+ Year Credit Bond ETF (NYSEARCA: CLY ) The fund holds a basket of 1,710 investment grade long-term bonds having a 30-day SEC yield of 4.20% (as of May 11, 2016). The fund does a good job by spreading its assets well among various sectors. Consumer Non-Cyclical tops the list with 13.90% allocation, followed by 12.30% to Communications and 9.8% to Electric. CLY has a weighted average maturity of 23.29 years and an effective duration of 13.11 years. The fund charges 20 basis points as fees. The fund was up about 1.6% in the last one month (as of May 13, 2016) and has a Zacks ETF Rank #3 with a High risk outlook. Vanguard Long-Term Corporate Bond ETF (NASDAQ: VCLT ) The fund holds a basket of 1,661 high-quality corporate bonds having a yield-to-maturity of 4.4%. The fund puts 69% weight in the industrials sector followed by 17.9% in finance. VCLT has a weighted average maturity of 23.9 years and an effective duration of 14.0 years. The fund charges 10 basis points as fees. The fund gained about 2.3% in the last one month (as of May 13, 2016) and has a Zacks ETF Rank #3 with a High risk outlook. Original Post

Portfolio Construction In The Age Of Extraordinary Monetary Policy: Part I

Why This Series? This will be the beginning of a multi-article series that seeks to assess the Fed’s monetary policy and its effect on markets, and thus how we should invest going forward. My objective in writing this series is to make the case for why the traditional models of asset allocation will not provide the same results going forward as they have in the past, and thus a new approach is necessary. I form this conclusion by analyzing the data, and exploring the economic environment that investors find themselves in, as well as the unprecedented level of global central bank action and how this will affect the process of portfolio construction to meet the goals of the future. The series will have a particular focus on engineering the best portfolio possible by incorporating cutting edge academic research into the portfolio construction process. The series will consist of five pieces which together represent an in-depth discussion about the Fed, the economy, and how to invest in the new normal. The 2008 Financial Crisis and The Fed’s Response The 2008 financial crisis was the worst since the Great Depression of 1929, and by some measures, it was worse. In 2008, the S&P 500 fell by over 37.02% as the financial crisis took hold, figures four, five, and six below illustrate the take no prisoners effect of a violent market drop. The crisis was caused by a combination of government induced lending to unqualified borrowers, brought on by the community reinvestment act (12 U.S.C. 2901), as well as Wall Street speculation on real estate prices. Wall Street banks packaged Mortgage Backed Securities (MBS) rated AAA with subprime debt in various groups called tranches. These tranches of debt, then went bad when the subprime loans were deemed worthless. Wall Street packaged Collateralized Debt Obligations (CDO), which are pools of securities packaged together for sale to investors. The senior tranches of this debt are generally safer and have higher credit quality, while junior tranches are generally made up of riskier securities with higher yields. The challenge during the crisis was that Wall Street was packaging these CDOs with more and more risky debt and less and less of the AAA debt. On top of this, they created securities known as Synthetic CDOs, which use derivatives and other securities to obtain their investment goals without owning the assets of a CDO. The following chart depicts the creation of a Synthetic CDO in detail. Source: Financial Crisis Inquiry Commission When these junior tranches went bad, the House of Cards came down and brought trillions in consumer real estate and equity market wealth with it. Banks were most seriously hit with billions in worthless securities on the books. In response, the government took action to combine failing banks to create even larger financial institutions, and initiated new regulations under Dodd-Frank. The reality, however, is that this bill does little to increase the safety of our financial institutions, and only provides the illusion of safety with increased capital requirements. A Quantitative Analysis of Risk In conducting a quantitative analysis of the risks within financial services firms, there are multiple avenues to be considered. In terms of fair value accounting, IFRS 13 and FASB 157 are the two methodological statements for application. As we are going to focus the analysis on U.S. banks, I will limit the scope of this writing to U.S. GAAP application, and leave concerns from IFRS out of the discussion. Currently, U.S. GAAP only requires netting of derivatives exposure, providing investors with only a part of the overall exposure of any financial institution. Two additional pieces are required to more accurately understand the risks from derivative securities. First is the PFE, the potential future exposure, largely calculated through counter party risk. The second piece is the CVA (Credit Value Adjustment), this adjusts for the deterioration in credit quality of counter parties. It is important to note, however, that the CVA has no standardized method of calculation, adding another layer of uncertainty in arriving at a dependable quantifiable value of the derivatives exposure. (For additional exploration-Ernst & Young laid out this point well in this piece .) One additional layer of exposure is found in the Level 3 section of the valuation hierarchy. According to FASB 157, assets can be valued according to a hierarchy. Level 1 represents securities where readily available markets are available, and thus observable pricing exists. Level 2 are securities where inputs are observable either directly or indirectly, such as in markets that are thinly traded or where observable inputs can be estimated based on the prices of similar assets. Level 3 assets are assets where no observable market prices are available. In such a scenario, banks are allowed to use various methodologies to determine the prices of these assets. In my opinion, the challenge with these Level 3 values is that they are given a certain value simply because the banks say that is what they are worth. With no observable inputs, it is hard to put much confidence in the stated prices of these assets without a more dependable model for price discovery. It is important to note that the challenges with Level 3 assets extend beyond the world of bank balance sheets. The May 4, 2015 issue of Barron’s includes a very interesting exploration of the subject on page 31, as it relates to bond mutual fund financial statements. The article discusses a specific fund currently under investigation, but also deals with the issues of Level 3 securities on the books of many mutual funds. The story quotes the independent auditor of the specific fund in question in its most recent annual report as stating the following in relation to Level 3 assets: “These estimated values may differ significantly from the values that would have been used had a ready market for the investments existed, and the differences could be material.” The article also warns investors that during a crisis many assets classified as Level 2 can quickly become Level 3. I would echo this view in relation to bank balance sheets, as we learned during 2008 many of these arcane securities buried deep within bank balance sheets may carry a material variance between stated value and real market value.” Analyzing Level 3 in the Largest Banks Bank of America (NYSE: BAC ) As you can see from this analysis from page 241 of Bank of America’s annual report (2014), Level 3 assets represent 3.37% of the total assets after netting. The company is holding over 1,592,332M in total Level 1, 2, and 3 assets before netting with Level 2 making up 86.7%. I give BAC management a great deal of credit for maintaining a low value of Level 3 assets, but I believe the high value of Level 2 assets may expose investors to unquantifiable, and possibly material risks, in a financial crisis as there is no way of knowing how much of Level 2 would become Level 3 in such a scenario. Additionally, according to the OCC’s Quarterly Report on Bank Trading and Derivatives Activities for the 4th quarter of 2014 , BAC had total credit to capital exposure of 93%, and 85% as of the fourth quarter of 2015. Wells Fargo (NYSE: WFC ) Note 17 and Table 65 of the 2014 Annual Report, illustrates an exposure of 2% for investors to Level 3 securities. WFC is holding the majority of its assets at level 2, representing 94% of assets after netting. Additionally, according to the 4th quarter OCC report on Bank Trading and Derivatives Activities, WFC has total credit to capital of 22%, and 31% for the fourth quarter of 2015. JPMorgan Chase (NYSE: JPM ) Page 163 of the Annual Report indicates total Level 3 assets as a percentage of total assets measured at fair value of over 7.2%, which appears to be rather high when compared to peers. Additionally, according to the 4th quarter OCC report on Bank Trading and Derivatives Activities, JPM has total credit to capital of 177%, and 209% for the fourth quarter 2015. Note 3 of JPM’s annual report lays out the detail for fair value accounting for the firm. Citigroup (NYSE: C ) Page 262 of the 2014 Annual Report shows total Level 3 exposure of 2.42%. Additionally, Citi had a credit to capital ratio in 2014 of 172%, and 166% in the fourth quarter of 2015. Before netting exposure, Citi is holding close to a trillion dollars in derivatives at $892,760M. After netting of $824,803M occurs, this number is reduced to $67,957M, and this total includes Levels 1, 2, and 3 securities. The total Level 3 exposure after netting is $11,269M which is 16.58% of the net exposure of $67,957M, and 2.42% of total investments in Levels 1, 2, and 3 of $302,901M. What would be worrisome to me if I were a Citi shareholder is that the vast majority of the assets in the hierarchy are recorded in Level 2. The question is how much of Level 2 would become Level 3 in a crisis? It is important to note that many of these risks are mainly material to the investment thesis if we were to have another financial crisis. Level 3 assets are not a day-to-day concern for investors, generally speaking. That being said, they would be material should another crisis befall us. As nothing has been done to address the root cause of too big to fail, we now have larger financial institutions with more complex securities on the books, and another financial crisis may be inevitable. The Fed Response to the Crisis The Federal Reserve acted quickly instituting, what could be best characterized as an unprecedented experiment in monetary policy. The Fed put these extraordinary monetary policy measures in place to unfreeze markets and induce risk taking in the economy. They did this by implementing a combination of Large Scale Asset Purchases (LSAP) as well as Zero Interest Rate Policy (ZIRP). The combination of these policies were introduced to drive down the risk premium for long-term bonds (BRP), and drive up the risk premium for equities (ERP). While Ben Bernanke , the Fed Chair at the time defends his actions in monetary policy, the effects of these policies, which I will explore in the next article, are muddled at best and a down right failure at worst. The Fed’s objective in instituting this monetary policy was to drive up the prices of equity securities with the hopes of creating a real wealth effect. At the same time, the Fed hoped to induce risk taking in the real economy by driving down interest rates. The idea was that the two-fold effect of driving down interest rates to the zero lower bound, and inducing a rising equity market would allow us to avoid the negative effects of the great depression. But many question whether this was simply a mechanism to delay rather than avoid the worst of the financial crisis. In part II, we will discuss the implications of these policies on asset prices. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor.