A Defense of the Morg
Man-o man did the Morg screw up! Let me count some of the ways:
- It announced a $2B loss, but everyone in the market knows its trading book, so the losses have nowhere to go but up.
- Investors took JPM’s stock behind the woodshed and beat it with a stick. The one-day damage resulted in a $14.5B (9.5%) drop in the market cap for the company.
- The SEC, the Fed, and the UK's FSA have all initiated investigations into what went wrong. This insures that this story is going to remain on the front pages for at least another month.
- The timing of this debacle could not have been worse. Any chance that the big banks had of creating some wiggle room on the Volker Rule has been lost. Over time, the tighter regulations that will certainly follow will cost JPM multiples of the loss the have incurred so far. The other big banks have the same problem. The CEOs (and the shareholders) of the big banks must hate Jamie Dimon.
- Dimon will lose one of his best friends, Obama. There is no way the White House can look the other way on regulating the banks anymore. This is an election year, so red meat is needed to get votes. JPM/Dimon has served itself up as a roast beef and is just waiting for folks to start slicing it up.
- By far and away the worst aspect of the story is that the big brass at JPM did not have a clue as to how risky their “hedges” were. The big shots thought that the bank was reducing risk, actually it added (substantially) to the risk it was facing.
It’s possible that I’m the only person in the world (other than Dimon and the JPM Board) who has any sympathy for poor old Morg.
As of today, I’m operating under the assumption that the losses at JPM are the result of hedges that went bad. The original intent was to minimize risk, the result was exactly the opposite. This was not about some rogue trader that hid the risk that was being taken, senior management was (sort of) aware of the “hedging” trades that were put on by the bad folks in London.
Hedging risk is a very complicated business these days. There are two ways of reducing risk, (1) sell everything and go out of business, or (2) do what you can to manage risk, and at the same time recognize that there really are no effective hedges.
It is very difficult to reduce risk without taking on derivative exposure. That is the way of of our financial system. To make this point I’ll describe what I did on Friday.
Two weeks ago I reported in this blog that I had bought a one-month put option on the EURUSD. The option is at a strike price of 1.3210 (spot price at the time of execution). As of this past Friday night I’m three big figures into the money on this position. For me, this is the equivalent of a double in baseball. I’ve not hit many doubles of late, so the thought crossed my mind that I ought to take some chips off of the table.
To be honest, I was troubled with the price action of the EURUSD in the latter part of the week. Yes, the Euro cross closed on the lows, but to me the price action looks sticky. I’ve only got two weeks left on this option, I know from past experience that under 1.30 the damn Euro has found demand in the past.
It’s my best guess that the news flow out of Europe is going to get worse over the next fortnight. There is a reasonable chance that things go wrong and we see another big price adjustment in the EURUSD. To my eyes it looks like there is a good possibility for a move to 1.2500. If that happens my “double” will turn into a home run. I could use a home run (who couldn’t).
I pondered this on Friday. What to do? How does one reduce risk, and at the same time stay in the game? I chose a hedging strategy that is not unlike what the Morg did to protect its book. I took a derivative position against my short EURUSD position; I bought USDYEN.
I’ll take all the criticism that readers can dish out on this trade idea. I can understand if someone were to say, "It was the ‘wrong’ thing to do".
In a number of ways I added to the risks that I was taking. There is no certainty that my new Yen position will act as a hedge against the existing EURUSD short. I have substantially increased my market exposure overall. I now have two long dollar positions. If some event happens and the result is a new market mood that translates into a “Sell the dollar across the board” mentality I will get my head handed to me.
The flip side is that there is empirical evidence from the market that when EURUSD goes lower, USDYEN also moves lower. That’s just the way it is. So if the Euro does find some stability in the next few weeks that results in a higher EURUSD I will give back some (all?) of the gains that I have in the option position, but it's damn near a sure thing that if that happens, USDYEN will move significantly higher. So I do have a hedge on.
Part of my thinking here is that at 79.90 the USDYEN is a buy. Yes, the position should be a hedge against the EURUSD short, but it also could end up a win-win for me. The EURUSD could weaken and I get fatter while the USDYEN could be flat. So I’m speculating with my hedges. I know that. This is exactly what JPM did with its hedging activity. It chose to put on a derivative short, against a book long. Call this “aggressive hedging”.
A big question for me was how much do I short the Yen to offset the short EURUSD exposure? There is no answer to this. There is no formula to look to. I’m “hedging” in two different markets; there is no certainty that there is a correlation between the two. If I have $1 short EURUSD, how long USDYEN should I be to create an effective hedge? Is it 1 – 1? 0.5 – 1? 2 – 1? This is not science, it’s guess work.
I think that JPM screwed up this critical calculation. They bought some protection in a market that they thought was correlated. It turns out the were right, but they bought too much protection so the hedge losses ended up being greater than the gains from the underlying portfolio. If JPM had hedged with a much smaller exposure to CDX.NA.IG.9 (the derivative contract that done JPM in) the headlines would have been different. We might have gotten these instead:
Much to Jamie Dimon's chagrin, we will never see those headlines.
I wouldn’t be surprised if most readers thought I was nuts. Hedging one exposure with a derivative position in a different market is not de-risking, it is adding to risk. But in the complex world we live in there really are no hedges that work. Everything is connected, every price is a derivative of something else. Everything is negatively or positively correlated. Right?
I watched Senator Carl Levin on TV Friday. He crapped all over JPM/Dimon. He wants the Morg out of the spec side of the banking equation. If the good Senator reads this blog, he would think I’m nuts, he would also make me the poster boy of why guys like me should be shut down. (I’ll be sure to send him a link)
It might just be that this ends up with Levin getting his way. More regulations, a transaction tax, or a very high tax rate on short-term capital gains seem likely as a consequence. Maybe that is how this should resolve itself. Kill the beast.
The risks are out there folks. Chasing small fry like me, and “Whales” like JPM into the bushes does not take the risks away. It magnifies them. For example:
- Since the start of May we’ve had a minor correcting in the stock markets. Hardly a ripple. But the Wilshire 5000 is down by $600 billion. Apple’s stock value has risen by $47B and then fallen by the same $47B in the last thirteen trading days.
- The market value of US government bonds has soared the past two weeks. At this point every high-grade bond in existence is trading at a premium. The funny thing is that every cent of that market premium has to go to zero.
- The Euro is down by a lousy 2.5%, but a different way to look at it is that the value of Euro denominated assets fell by more than a Trillion dollars on a relative basis. I doubt that one in a thousand even noticed the change.
I don’t think that anyone who lives on the grid is free of macro, derivative or tail risk. They might think they are, but they are not. The upcoming effort to curtail the risk takers may make many “feel” good. I think those same folks will regret it when the specs get put in a pen.
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