A number of commenters make an interesting point, one I’ve thought about myself. This “hedge” that lost all those billions for JPMorgan…it doesn’t sound like a hedge…it sounds like a gamble and such gambles shouldn’t be allowed, especially on accounts ultimately backed by taxpayers (see discussion of underlying case here).*
First off, all hedges are gambles in the sense that they are bets that an interest rate or the price of an index will move in a certain direction. What makes them hedges is that the direction of the bet is usually the opposite of the direction of another bet. If that sounds confusing, just think of it this way: if you lose money on bet #1, the hedge should help you gain money on bet #2. On a beautiful day, I leave the house in short sleeves. But I hedge against rain by carrying an umbrella.
Where the commenters have it right is that hedging goes way beyond this simple relationship and in that sense, I agree, it often goes beyond hedging as the concept is understood. And the JP case of hedge #2 as described in the link above sounds like a good example of that.
I will say that the culture of financial markets and hedge funds does not recognize this difference at all. I was recently in an investment meeting regarding funds for an organization of which I was a member. The investment adviser was explaining how a hedge of a hedge of hedge had lost money for us. I asked, “So, where’s the hedging in that?”
He looked at me like I was an alien and kindly tried to explain that this isn’t really how hedging works in contemporary finance. ”It’s really a misnomer,” was his ultimate point.
A simple Volcker rule which prohibited trading of depository (and thus back by the USG) banks’ own accounts–their profits–would clearly help here. I know…devil in the details and all that. But the JP case should remind us that it’s not that hard to identify the multiple-level hedges that seem more of a profit play than a hedge play.
*On a related note, a commenter asked if Glass-Steagall (GS) would have prevented JP’s loss. Here’s my reply:
GS wouldn’t have prevented an investment bank from betting its money on derivatives like this, but it would have hived off the investment bank from the depository bank, thus reducing bailout risk. The fact that bank deposits are insured by the FDIC means that if the depository (as opposed to investment) bank loses enough on its bets, the taxpayer ends up on the hook since the FDIC is backed by the US gov’t. JP/Chase is a bank-holding company with depository banks as subsidiaries so we need a Volcker rule to play a similar role to GS here.
1) This NYT piece provides useful amplification of the points above. Apparently JP was lobying for an exemption to the Volcker rule for a type of hedging called “portfolio hedging,” which the Times describes as “…a strategy that essentially allows banks to view an investment portfolio as a whole and take actions to offset the risks of the entire portfolio. That contrasts with the traditional definition of hedging, which matches an individual security or trading position with an inversely related investment — so when one goes up, the other goes down.”
Such a broad exemption would allow the very type of multiple hedging that generated the loss, versus the simpler vanilla version described above.
2) From ThinkProgress re MA Senate candidate Liz Warren:
In an email today, Warren called on Congress to reinstate Glass-Steagall:
I’m calling on Congress to put Wall Street reform back on the agenda and to begin by passing a new Glass-Steagall Act. This was the law that stopped investment banks from gambling away people’s life savings for decades — until Wall Street successfully lobbied to have it repealed in 1999.
A new Glass-Steagall would separate high-risk investment banks from more traditional banking. It would allow Wall Street to take risks, but not by dipping into the life savings and retirement accounts of regular people.
3) Excellent piece on this when-does-a-hedge-stop-looking-like-a-hedge angle in the LAT:
Dimon continues to explain this trade away as a “hedge.” It may not have been anything of the kind. First of all, a hedge reduces risk: If one investment might lose a lot of money if markets move in one direction, you create a hedge that will make money under those circumstances so your losses are limited.
Yet JPMorgan already is massively long corporate debt as a result of its normal course of business, which is lending money to corporations. A “hedge” that replicates that same position isn’t a hedge at all. There’s evidence that the department where the Whale worked was, in fact, replicating Morgan’s real-life business of lending to corporations, but using fancy derivatives to do so — creating a “synthetic” bank, as traders would say, without actually lending to corporate customers as real banks do.
If that’s true, the question is why? To put it another way, if JPMorgan had $350 billion sitting around idle (the sum the Whale’s department appeared to have to play with), why not use it to do something that helps the economy — such as, you know, lending it to businesses? Instead, JPMorgan used the money to buy chips to play in the derivatives casino, which doesn’t help the economy one bit.