The news about Jamie Dimon’s JP Morgan losing over $2B has caused quite a debate. The point I’d like to address, is whether or not JPM was “gambling”. You see, on CNBC this week, Maria Bartiromo tried to make fun of Senator Harry Reid who intimated that JPM was gambling and should just move to Nevada. During her comments she also tried to make the point that (and I’m paraphrasing) “do we want to outlaw risk taking?” JPM’s misteps are being debated in entirely the wrong context.
To the question at hand, was JPM “gambling” or was this merely “hedging” gone awry? It helps to understand what a hedge is and why it might be used. Any business faces a variety of risks. Banks, in particular, face risks associated with the credit quality of the general economy. For an institution of JPM’s size, if the economy weakens, defaults are likely to rise or the bank is likely to need to increase reserves against potential losses. It’s obvious why a bank might attempt to hedge such risks.
Reportedly, JPM started out doing this last fall. They bought credit default derivatives (yes, the instrument that sunk AIG) as protection against weakening credit. This instrument carried protection on over 100 companies. Fine. Sometime early this year, JPM began to unwind this trade and reverse it. This was done not by selling the protection they had, but by selling…hold on…forget about the complexities of the trade itself. The only important thing here is that the so called hedge was “traded” and not held as a hedge. All of us carry insurance on our homes and cars. Do we change the amount of hedging against potential disasters? Imagine if every spring you decided just how much fire insurance to have. Maybe this season is particularly dry, would you buy $1 million coverage on your $500,000 home? Would you go naked next year if spring were wetter than normal? In other words, JPM was not behaving as if it were hedging risks- it was trying to outsmart the insurance it already had.
Yes, that last sentence of the previous paragraph is key. JPM was hedging risks it gets paid to take. Banking is a business of getting paid to take risk. A bank borrows deposits cheaply and lends them at much higher rates. The bank, in exchange for turning demand deposits (overnight money) into long-term, economic growth generating, loans and investments gets to keep the difference. From time to time, profits will fall- that’s why they get paid to do this in the first place and why banks hold reserves! So, why would JPM try to hedge its risk through derivatives instead of simply being a better banker? Why not just increase reserves or sell some loans? Furthermore, banks have a built-in “natural” hedge in the form of interest rates. Most banks profitability increases when interest rates fall, which they are likely to do when an economy weakens (admittedly, we’re already at zero, but the so-called hedging activity is not new to this cycle).
So why does JPM (and its brethren) decide to use derivatives to “hedge”? Because those natural measures would impact reported results. Traders always think they are smarter and quicker than the rest of the world, why not use sophisticated derivates to hold the books steady despite what happens to the underlying assets? This trade was not a hedge- it was a bet or “gamble”. They traded known and widely understood risks and tools for esoteric and hidden risks. This is exactly what we don’t need at systemically important institutions.
Another reason this “hedge” was nothing of the sort: a hedge is supposed to be offset by an underlying asset. If you are worried about the house burning down and the insurance pays, it’s because you lost your house. Net financial loss to your balance sheet is close to zero. If JPM was hedging, then which asset went up while the hedge lost? Hedges do not generate $2 billion net losses. We can’t blame simple execution errors either, for if banks of the size and sophistication of JPM can simply get the trade wrong, then no organization with systematic importance can be allowed to take such risks.
Oh, and another reason it wasn’t a hedge: trades so large that they distort the market itself are not hedges. JPM’s trades were so large, they distorted the credit indexes they were based on! There is no hedge if you “are the market”. I’m reminded of a Wall Street tale told to me by a retired trader I know. Back in the 70s or thereabouts, there were five Wall St hotshots that used to gather at a bar on the east side after work. In those days (not unlike now), wine and dining clients was a regular occurance and these guys often gathered at this particular bar to swap stories afterwards, talk shop, commiserate and exagerate. One day they got the bright idea to buy the bar since they spent so much time and money there. A few months later, they discovered the bar was losing money. The culprit was them: they were their own biggest customers. It’s not a hedge if you are the bar.
This morning’s WSJ has a great article on how the “London Whale”‘s trade unfolded. It details how Mr. Iksil (aka the “London Whale”) was “trying to wipe everyone [on the other side of the trade ] out”. In fact, his other nickname is the “Caveman” for “pursuing trades that rivals sometimes thought were overly aggressive but often led to huge profits.” Then the kicker: after making huge profits on the risk trade last fall, Mr. Iksil reversed the trade which eventually led to the recent large loss. Details on the reversal are sketchy, but if you are hedging, why reverse the trade? Do you decide not just to drop your fire insurance, but to start selling insurance in a wet year instead? It could be “reversed” to a position of net zero, but it wasn’t. It was turned into a bullish bet on the same companies. The risk to bank’s fundamental business hadn’t changed, but trade did a 180! How on earth is that a “hedge”?
Back to Maria and those that claim “do we really want to discourage risk taking?” I suppose the answer lies in a Clintonian definition of “risk”. If we mean risk as in taking deposits and making loans or investing in venture capital, the answer is of course no. If by “risk” we mean gambling with derivatives that serve no genuine banking function, then the answer is emphatically yes! And if investment banks are to gamble “with their own money”, then why should they have access to the Fed window and implicit backstops from the Treasury? Why shouldn’t their leverage be limited? Remember that derivates are enormously levered devices that keep the actual leverage off the books. Bring back Glass-Steagall!