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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.
What??
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:
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..
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Much to Jamie Dimon's chagrin, we will never see those headlines.
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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.
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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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Bruce, agree and disagree.
This behemoth has, in round numbers, 700bn in their loan book and 1tr of investments, and add up the rest 2.3tr of assets it needs to fund. That's a crapload. If you then tear apart the asset side, you can slice and dice it every which way to Kansas.
If anyone can accurately hedge this, I would love to see it be done. I expect three things to happen when we talk about these numbers:
1) whatever you hedge in the big portfolios, you will move the market, it's guaranteed. And you are up against Citi, BAC, DB, HSBC doing the same, also with funding in the 2.2-3 trillion range (albeit their funding mix, especially HSBC and DB are quite different, and C has more currency impact than JPM)
2) You will take a position, aka a bet, or speculation, if you think with "reasonable accuracy" you should (e.g., carry trade on overnight versus the 10yr).
3) You will make money, and you will lose money.
So in defense of JPM, they fucked up but with 180bn in capital, absorbing it is doable. There is a lot of hoopla, but to lose say even 5bn on a 2.3trillion book is not the end of the world.
Not in defense of JPM, there are several structural problems with this:
- their funding book is too complex, and so is the rest of the TBTF's. I may think HSBC has the "easiest" due to the quite predictable business they have lending to middle market companies and private individuals.
JPM and TBTF complexity creates by itself significant tail risk, i.e., unknown unkowns.
- their book is too big. When you can move the markets by the "unintentional" act of trying to match assets and liabilities, then something is wrong.
- Their "need" to take positions, even a low percent of the total book, means big numbers, which adds to tail risk and market "making".
If the TBTF banks were broken into smaller units, would any of these risks go away? Probably, if you carve out the pure commercial side of the bank, and find a way to limit position taking - which I am not so sure how it would be
done (e.g., can you not allow banks to do a carry trade? maybe). One thing for sure, JPM will finally drop VaR, which is a good thing.
Interesting post. The argument the TBTF banks use for being allowed to continue to exist is that in a global economy a bank needs huge size and capital to be competitive. If this size, however, creates intractable hedging problems and market-moving hedging requirements, then it all becomes a Catch-22. As big as one needs to be to attract a customer base, is too big to manage with acceptable risk.
We don't need big banks - we need smart banks. I would argue that breaking up into MANY smaller pieces would benefit the bank in question as well as the economy. The smaller investment bank would have smaller book and by hedging smarter would make more money then one huge, moronic CIO of big bank.
These big banks are dinosaurs of the past era. They need to be broken up in order to generate more profits and to protect our societies.
Nothing a little good old-fashioned Capitalism wouldn't cure. Banks, like most other companies, could succeed or fail based on their performance and the quality of their management. Bad ones would fail, and the good ones, the ones that were prudently managing their risks (and maybe even looking after their customers), would benefit. What we have instead is a grotesque mix of crony capitalism, moral hazard, and continuing taxpayer impoverishment.
One point of difference with this article: this will have no effect at all on JPM's relationship with Obama. If you can't recognize that simple fact then you're blinding yourself to a key point in understanding the last 3 1/2 years.
There was a time when Paine Webber Nikkei Put warrants were an almost perfect hedge to the Dow ... go figure.
As for JPM, I'm starting to be sympathetic to the arguments of the folks who say this gives them a good cover to put people off the scent of the $1B they (allegedly) absconded with from MFG.
I do remember sitting on the trading floor at 390 Greenwich and hearing people talk about Dimon as if he was a god descended from heaven, but in those days he was on the leash of Sandy Weill, who was the real brains of the operation.
Thanks Bruce.
So ina few weeks we can see Bendonkey saving JPM and everything will be back ot normal and biz as usual. Wow, must love the banking industry. Now why in the hell is Glass Steagla act not brought back instead you have pole smokers such as Frank and Dodd who are as corrpt as one can get have bills passed, ah now I get it, to save their buddies.
I will wait for the full display of the "trade" in question.
I doubt if it was a hedge.
To be a hedge, JPM would have had to have $100 BIL in offsetting exposure to Euro interest rates, or whatever the underlying CDS was meant to offset.
I think it was NOT a hedge, but was a bet that grew and grew as the compulsives saw that they could drive the market, and that they did, until others realized that JPM was the "market".
Yet another reason why a market needs many, arms length bidders/sellers to be a true "market".
Five major banks holding 80% of the trillion dollare derivatives is NOT a market.
It is a sham series of "wink and a nod" paper bets that allow them all to book phantom profits, bonuses, etc. Contrived daisy chain. If bets sour a little, offload to customer. If bets explode, offload to taxpayer.
That is not banking.
That's my opinion.
Ironic how VaR was originally a JPM white paper released to the public without its 'proprietary' vol model. Picked up by the shameless software peddlers like RiskMetrics and the rest is history. Yeah I was there with my own 'predictive vol' model at the time.
Best of luck with your bet Bruce.
If you distill things down, you and the J.P are gambling.
"Hedging" is just another word for gambling.
Putting a bet on the black even and the red odd in roulette.
Buying "insurance" while doubling down on your 21.
Betting on both the "pass" and "don't pass" line in craps.
"But...but...but..." people might say...
I know, it's "complicated" and it's "necessary".
Yeah sure, just like betting the horse races and other sports betting - that eventually leads to thrown outcomes and dead people.
There really is no defense of gambling with people's deposits, savings, mortgage payments, taxes, and national economies.
I am gambling. So was JPM. I say to do nothing is also gambling.
What has the buy and hold done for investors over the past ten years? Not much.
If you buy high grade bonds you get a negative return. No fun in that either.
The Fed has forced me to be a gambler. It is not by choice that I do that. Where is the alternative but to take risk? So you take a risk and offset it with another risk. Doing nothing is also a risk.
Bruce - there is huuuuge difference between hedging (like yours) and momentum trading that corners the market (like JPM). Sorry, but you are comparing apples to oranges. There is nothing wrong with hedging strategies. I have problem with cornering the market - and someone needs to go to jail for doing it or allowing it to happen as a regulator.
This rogue behavior happens all over the markets. I can clearly see the big players cornering the equity market, FX, etc. The cockroaches are all over the capital markets. This is criminal IMHO but we have regulatory capture in DC so nothing good will happen.
Not arguing with you at all, but what has the buy and hold done for investors over the past ten years?
Somewhere between 50%(SP) & 120%(Nasdaq) not counting dividends.
now adjust for inflation.....not so pretty, eh?
Absolutely right. Doing nothing is also a risk. And we thank you, Dr. Bernanke, for that.
After netting out inflation the aggregate of all financial bets are limited to the growth of the economy. If money was invested in real assets, then and only then would the sum of all bets pay off. Even then it is a gamble.
Gamblers (er, Investment Bankers) bet (er, hedge) believing they are smarter than the game. If you win, your counterparty loses.
Looks like Bankrupt Governments will be called to belly up to the bar again.
'The Fed has forced me to be a gambler. It is not by choice that I do that. Where is the alternative but to take risk?'
Don't take this the wrong way but you might be plagued by a rigid Action Bias. It's a poor argument you're making, maybe just admitting the rentier model is a dying one is the beginning of something not the end.
Good 'luck'.
http://www.economicpolicyjournal.com/2012/05/jpmorgan-markets-moved-in-w...
Bruce,
JPM's loss is not due to the difficulty of hedging. The loss is related to clueless creation of a position so massive that it's size relative to the market has trapped them. In short, they were greedy clueless morons. This 2B loss is only the beginning and they indicated they will hide the mounting losses by going to mark to maturity. The silver market will be JPM's next blowup.
Relates to what Doug Noland published on Friday re J P Morgan (from the PrudentBear Credit Bubble Bulletin):
« But I just don’t believe it is mere coincidence that JPMorgan dropped its bombshell $2bn loss announcement in the middle of market worries regarding Greece, Spain, the euro and European bank stability.
... It would make sense to me that JPMorgan has been comfortable building massive risk exposures throughout various markets, anticipating a relatively sanguine “risk on” landscape.
... developments in Europe, throughout global markets and with the global leveraged players had recently made them much less confident in previous assumptions. It would make sense if they’ve decided to start hunkering down.
... JPMorgan management was forced to respond to recent changes both in the marketplace and in prospects for the market risk/liquidity backdrop more generally. Recent developments and the abrupt return of de-risking/de-leveraging dynamics significantly changed the risk-profile of their positions and market insurance products more generally. They bet big on “risk on” but now must work to position for the likelihood of “risk off.”
... The clouds are darkening and much better to move before the heavy downpours commence ... »
http://prudentbear.com/index.php/creditbubblebulletinview?art_id=10662
Interesting post Bruce, thank God Rubber Scrota hasn't turned up this weekend yet.
Jim Willie over at Turd's podcast has some interesting suggestions , like the trade that went bad was probably interest rate derivatives after the 10 year Treasury rates went up over 2%. Also that the loss is more like 20 billion than 2 billion.
http://www.tfmetalsreport.com/podcast/3782/tfmr-podcast-19-jim-willie
The hilarity of course is "the guy's name is "the guy who will not be named."" I mean leave it to high finance to discover "The Harry Potter Method." ABSOLUTELY ridiculous. Once the Wall Street Journal and Bloomberg report on...ahem..."Voldemort"...you're already dead. Simply put Bruce to name only two options is beyond limiting. Here's one "third way": "just be small." Here's another: "maintain your sanity." Mutual Funds do this by simply closing the fund "because it got too big." There's always a believer as they say..."so long as you're willing to pay for that not a problem." Of COURSE trees can't grow to the moon. But in a world where money is defined PURELY by mankind's ability to acquire it "not only can it grow to the moon...you can fly up there really fast and go live there for a while...and make ever MORE money." I'm sorry...did someone say "the system is flawed"? REALLY? YA THINK?
Relax Bruce, it is all paper. Becoming more worthless by the day so long as the fraud remains unprosecuted.
When everything is a derivative effect of monetary policy, the myth of independent variables gets left on the corner with busfare.
Does the Volcker Rule allow for cutting off Dimon's horns?
This idea might be too stifling of a regulation but I like it.
It would be a good start.
Ok if everyone knows the book tell me. What are iksils biggest positions?
Greece 30-year and Green Mountain Coffee (It's the "G" strategy).
Bring back Bill "I hate my job" Harrison, who could not wait to put Dimon in the job.
Does anyone have a mod for the game Civilization where instrad of just farmers and warriors you can also build "stock traders?" The instructions would say that they are the way to unlimited wealth but then the game engine would work in such a way that they get rich and impoverish everyone else.
I am not so sure whay we should alot you, or Mr. Dimon, any food or other resources to engage in this type of activity.
In a game Europea Universalis I always played as Austria. Id offer loans to my neighbors and allies to fight their "enemies" until I was able to field a massive army and pay for it with the interest off the loans. Then I would take out each country one by one and no one would team up on me because my army was so huge.
They made a change to the game where if you declared war on someone they wouldnt pay you back what they owed yoi. That didnt really effect my strategy. Id just cycle the loans so they expired right before I declared war.
Then they made it so countries wouldnt borrow obscene amounts of money. I stopped playing after that. I had no idea how to win without playing banker.
Sounds like the Federal Reserve, oh wait. nevermind, I see what you did there.
The only proven mathmatical correlation known to man is continued free drinks & substantial ongoing losses at a crap table in Vega$.
... You mean the chicks aren't actually getting better looking when I drink more?
Don't worry, Bruce. The taxpayers are there to bail Jamie out.
"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."
Here's the thing Bruce, the vast, vast majority of "known" correlations being used by quants are built on such stretched margins of statistical correlation, that ingore such things as the now well known "fat-tails", AND IN ADDITION do not account for ALL the variables that work on ALL the objects and variables of a financial relationship, that they are rendered to less than gambling. Vegas KNOWS their math. Wall Street does NOT.
And that is the FUNDAMENTAL problem with Economics AND Financial Mathematics. Neither know all the variables in play in the system, NOR the ratio of correlation or inter-dependency.
Financial modeling is literally no different than the weather modeling BS passed off by the man-made global warming "science". It's all scientifically, mathematically BS.
Any REAL HARD science would have long ago tossed out the formulas as unable to provide any true insight. Economics, the dismal science is filled with people of scum ethics willing to lie. That's why so much passed off as "quant" is nothing more than snake oil.
Mandelbrot tried to explain this abuse of higher math in his work (Mis)Behavior of Markets, but the financial world was having too much fun to listen AND MOST IMPORTANTLY, just like the man-made global warming BS, there were plenty of PhD's around willing to SELL THEIR INTELLECTUAL SOUL for the chance to use the field of markets and financial modeling as their test lab to test their quant theories.
The vast majority of MBA/masters/PhD financial math is utter BS. And it continues because the vast majority of leaders in the business world never received sufficient education in REAL mathematics [business math is utter BS] to understand what they are being sold by PhDs.
Throw in the throwing out of business ethics and you have EVERYTHING needed to explain how "we got here".
more to the point, in vegas, you have people trying to cheat the house and people trying to find ringers to throw sports games to rig the outcome.
on wall street, EVERY SECURITY , EVERY INDEX, EVERY STATISTICALLY DERIVED QUANITY can be targeted for manipulation ( at least temporarily ) by many layers of parties, with the largest most powerful parties ( the owners and managers of the exchanges, as wel as the fed who manages the treasury market) can manipulate virtually at will.
whales and giant squids can move bets, or have them moved back on themselves.
It's all about the "TB" in TBTF. JP Morg et al, needs to be broken up in to much smaller parts. It's just not the hedging, it's the "TB". We are being miss dirrected here.
Numbers are like people, if you torture them long enough they'll tell you whatever you want to hear.
Centurion, that's quite a smackdown.
I wrote about this about this last month.
http://azizonomics.com/2012/05/02/the-pseudoscience-of-economics/
Political economy originally was the term for studying production, buying, and selling, and their relations with law, custom, and government, as well as with the distribution of national income and wealth, including through the budget process. Political economy originated in moral philosophy. It developed in the 18th century as the study of the economies of states, polities, hence political economy.
In the late 19th century, the term economics came to replace political economy, coinciding with publication of an influential textbook by Alfred Marshall in 1890.
Earlier, William Stanley Jevons, a proponent of mathematical methods applied to the subject, advocated economics for brevity and with the hope of the term becoming "the recognized name of a science".
- Wikipedia
(In short, the "science" of economics is basically a smokescreen for the relations of wealth and power.)
Agreed, however economics as a science did not gain traction until the assertion that the mere application of the "scientific method" to a field of study anointed the study as valid science. In short they threw out the disciples of ensuring the data being observed was knowable and that knowledge of all the significant variables are required before a mathematical formula had any chance to be taken seriously.
The fact is most all "business major" math, at the undergraduate and MBA level, creates a legion of business men who think they know something because a formula, no matter how flawed, says X will occur Y times out of Z chances.
Surely I must be wrong. After all the US ranks what 18th in the world for science eduction, yet we are the leader in the world when it comes to applying math and science to business.
Can't make this sh1t up....
Make that first in applying the arts of swindling, extortion, and snake-oil peddling.
The deception by dropping the word “political”
is to pretend the politics have been removed
and the “invisible hand” of wealth and power is not guided by human conventions,
but pretended instead to be guided by immutable “scientific” law.
You mean the CASINO knows their math. Last i checked the City of Vegas had collapsed. "There's always the strip" as they say.
"Business Ethics"...is that like "Virgin Hooker"?
Thats why those types of plays cannot be accounted as true hedges and why jamie the gaping asshole dimon called it an "economic hedge" which has no legal definition
Economic hedge is just another term for prop trading by banks. But of course they are not allowed to do that anymore. Oh regulators? Where are you?
You're right about the math not being a hard science. Practitioners usually over-interpret the numbers and the ability of the models to capture reality. The best we'll ever be able to do is make good "guesses" about whether the odds are for us or against us. The rest of the issue is allowing us the freedom to fail if we're too dumb to avoid the gambler's ruin problem.
Math?
Who fuckin' needs math?
The most you need is arithmetic, to add and subtract shit, and the (in essence) binary equation: PrintCurrency/NotPrintCurrency = ShortCurrency/LongCurrency.
Calculus for (Newtonian) physics being a possible exception?