Hedge Hogs (with 3–count ’em!–updates)

May 14th, 2012 at 8:59 am

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.

Three Updates:

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.

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11 comments in reply to "Hedge Hogs (with 3–count ’em!–updates)"

  1. Robert G Williams says:

    JP Morgan Chase and its likes (the too-big-to-fail banks) shouldn’t be allowed to act like hedge funds (even though the offending transactions don’t look much like hedges against risk).

    I keep seeing comments from various commentators on various websites to the effect that JPMC should be able to do what it likes with its “own” money. But truth be told, this is shareholders’ money. What should really happen if JPMC has excess funds is the following: distribute those funds to the shareholders who can then choose to invest in riskier asset classes under their own decision regimens. If hedge fund investments are what they want, then let them make conscious decisions to invest in hedge funds, without any Federal (US taxpayer) guarantee of the investment.

    It seems to me that banks have been granted “franchises” and given preferential treatment to serve the needs of the nation’s economy and to facilitate the movement of funds between individuals/entities wanting to have a relatively safe haven for their excess liquidity (aka, depositors) and those needing to borrow those resources. Proprietary trading of the too-big-to-fail banks’ “own” funds has little place in this economic environment, especially after the debacle of the 2007-2008 financial crisis.

    Moreover, one would think after the fiasco of the 2007-2008 financial crisis, the too-big-to-fail banks would have learned a lesson about risk management — but, no, here we are again with JP Morgan Chase losing $2+ billion of their “own” money — and under the leadership of CEO Dimon who is one of those most vocal against limiting the banks’ proprietary trading under proposed regulation/legislation. (As an aside, the too-big-to-fail banks of vintage 2007-2008, including JPMC, are now even bigger than they were at the beginning of the financial crisis.)

    The shareholders, bondholders and managements of these too-big-to-fail banks should pay the price for “mistakes” such as JP Morgan Chase’s recent fiasco. However, the US taxpayer remains on the hook just as in the 2007-2008 financial crisis.

    It’s time we revisit the separation of real banking activity and everything else that banks want to do. This might eliminate, or at least restrain, much of the burden that is now placed on US taxpayers to correct the ” sloppy” and “stupid” decisions (CEO Dimon’s own adjectives) that have been made by the TBTF banks in the post-Glass-Steagall era.

  2. save_the_rustbelt says:

    Some reports indicate JPM was hedging against projected losses due to the mess in Europe.

    If so that may be a little different than the story about wild gambling.

    Lousy execution in either case.

  3. perplexed says:

    -“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.”

    But its not just the depositors’ money that’s insured by the government with TBTF’s, there’s an implicit (actually explicit now that its been shown to be true) guarantee that the bank’s bondholders and stockholders will be bailed out as well. This is free insurance to these casinos. No one else gets this form of corporate welfare except the TBTF’s. The Volker rule is not enough; we need to break them up or force them to pay the “market” rate for this “insurance” (which would result in their breaking up on their own to avoid paying for what they get for free now). Bragging rights that “our TBTF’s are larger and more dangerous than those of any other country” are not a public benefit, in fact they’re quite the opposite. There is no upside for the public in allowing this to continue; campaign contributions will just have to come from another source.

  4. Joe Marinaro says:

    “This was the law that stopped investment banks from gambling away people’s life savings for decades”

    Elizabeth Warren’s comment begs a follow up question as to an example of this actually happening.

    I still have a hard time seeing Senator Levin wailing about banks being too big to fail when he desperately sought, and received a bailout from the taxpayers for his state’s auto industry. Clearly GM and Chrysler were/are “too big to fail”.

    Disney lost $200 million on John Carter yet no screaming there. Just a bad decision and a risky bet that failed.

    JPM made a bad hedge and compounded it with a worse hedge on the hedge then violated the cardinal rule of risk management by becoming the market. Left themselves a target for folks on the other side of the trade to take on. Clearly, as Dimon has stated this was an ill-conceived trade that was exacerbated by a failure to capture all of the potential downstream risks early enough to prevent the losses but it isn’t the end of the world.

    • perplexed says:

      “…an ill-conceived trade that was exacerbated by a failure to capture all of the potential downstream risks early enough to prevent the losses but it isn’t the end of the world.”

      No, not the end of the world, but if the American citizens that provide this free insurance are lucky enough, it could be the beginning of the end of TBTF banks! We need some bold action to help turn our “luck” around and stop us from being systematically at the losing end of these bets.

      • Joe Marinaro says:

        Just curious but which losing bets? GM? Chrysler?

        Treasury made billions on TARP repayment from banks and in fact some of the banks (JPM included) didn’t even want the money but were told to take it so as not to stigmatize other banks that did need the money.

        Treasury will lose billions on the GM and Chrysler bailouts and clearly they are viewed as too big to fail.

        This was a bad trade. Badly conceived, badly executed and with a terribly flawed risk management oversight. No excuses. Things need to change but this is a JPM issue. No taxpayer monies were lost. Owners have taken a hit (shareholders) and that is a risk they assume. They may very well have a right to be pissed at the poor management of the trade but it is their issue.

        • perplexed says:

          “…but this is a JPM issue. No taxpayer monies were lost.”

          It will only be a JPM issue when they are broken up & no longer TBTF, until then its very much a public issue. Public funds ultimately guarantee these bets and we have no way of even knowing the exposure. Taxpayer money is at risk the entire time without compensation or any possibility of gain. Heads they win, tails we all lose. Investors can make these same bets through private hedge funds; they just have to pay higher borrowing costs due to the lack of implicit guarantees.

          Are you really suggesting that somehow auto bailouts make this OK?

          • Joe Marinaro says:

            No on the auto bailouts. Just that it is duplicitous of Sen Levin to be upset about the bank bailouts that ultimately were profitable when the bailouts for the auto companies in his state will cost the taxpayers billions get no mention from him.

          • DutyOfYouth says:

            BTW, Joe,

            The auto bailouts were initially approved by George Bush II.

            Also, the US government already has a profit on the “auto bailouts” (which were actually “loans”) based upon repayments already received and the public market value of securities received. [You DO believe in efficient markets, right Joe?]

            Anyway, not only has the US Govt & US taxpayer received a direct cash/investment profit, we have received ENORMOUS additional financial (& social) benefits not the least of which is that we AVOIDED having to spend billions of taxpayer dollars on unemployment benefits to the hundreds of thousands (if not millions) of people who would have lost their jobs at the auto companies and in their supply chain if GM/Chrysler had gone bankrupt (which would also have bankrupted Ford by all reasonable accounts).

            Any more craziness that you need me to dispell? No? Then take another Zanax and go to sleep.

  5. DutyOfYouth says:

    Joe – you are obviously a shill.

    Your comparisons are not even close to reality.

    Disney could go bankrupt with 1,000 John Carters (or Ishtars), and it would not cost the US taxpayer a penny.

    On the other hand, between FDIC insurance (provided by the federal govt) and the FED’s Discount Window, the US taxpayer could be on the hook for essentially unlimited losses if a Federally Chartered Bank goes bankrupt for ANY reason.

    The simplest and most efficient (and most “capitalistic”) way to fix this problem (risk) is to reinstate the Glass-Stegal law to separate the investment banking (i.e. gambling) side of JPM from its retail banking side.

    If JPM wants, they can spin one side off and trade their stock as “paired units” under a common parent; so it could all be done on paper. If the investment banking arm went bankrupt, the bond holders & creditors on that side would take the losses, and the retail banking side (& thus the US govt/taxpayer) would be unharmed.

    In the above case, even the stockholders would be better off because at least one of the stocks in their “paired unit” would still be worth something.