When is a “Hedge” A Risky Bet?

J.P. Morgan – Part Two 

By Shlomo Maital     

 

 Jamie Dimon

   Faithful reader Laura was right.  When I called the J.P. Morgan traders who caused huge losses “really smart”, she objected.  They’re just insiders, she said, dumb insiders.  The evidence comes from J.P. Morgan CEO Jamie Dimon himself.   “We were stupid,” he said yesterday. “We have egg on our face.”  If the boss himself calls himself and his traders stupid, who am I to argue?

    Dimon has led the charge against the Volker Law, which bans banks from speculative trading for its own account in derivatives.  Dimon, who until now has had huge weight in Congress, clearly believed the law would cut his bank’s obscene trading profits — first quarter 2012 net income “fell”, to “only” $5.4 b., a lot of it from ‘nostrum’ (bank’s own) trading profits.    Dimon has fiercely criticized Volcker himself, even though Volcker is one of the wisest most respected capital market authorities in the world. 

   But even if enacted the Volcker Law probably would not have stopped the disastrous trade that will lose J.P. Morgan far more than the published $2 b.  Why?  Well, because the trade was a ‘hedge’, designed to reduce risk.  How?  J.P. Morgan has massive holdings of govt. bonds and loans.  This is a ‘position’ fraught with risk.  If the bonds drop in price, J.P. Morgan loses.  So, you need to offset this position with a ‘hedge’, or opposite position, one that if bonds drop, you make offsetting profits. How?  By dealing in credit default swaps, or insurance.  If bonds drop, the CDI’s become more valuable; you lose on bonds, win on CDI’s.  Even the Volcker Law allows hedging.  But in practice, this was not a true hedge, because the hedge itself apparently ended up being larger than the position it was supposed to offset? Why? Because the trader who ran it, from London, got into a hole; as the ‘hedge’ lost money unexpectedly (bond markets got worse, rather than better), the trader kept expanding the hedge to manipulate the market and reduce the losses.   Smart traders saw the hole J.P. Morgan was in and shrewdly bet against it…     The real failure, and stupidity, was J.P. Morgan’s “back office” – the people who are supposed to monitor trades, evaluate risk and sound the alarm when the risk mounts.  This happens quite often. Back office people are easy prey for shrewd traders who know how to disguise their positions, especially in exotic derivatives that are really hard to value.  So Dimon was right – his bank does have egg on its face, his own face, because he failed to put in place a tough sharp effective back office.  Again, it’s not the first time.

       Bottom line:   Even if the Volcker Law passes, and bans banks from risky speculative derivatives trading, the banks will circumvent it like J.P. Morgan by ‘hedging’, only the hedges will be so big that they become speculative trades rather than risk-reducing actions.  There aren’t enough regulators in the world to control this.

       The system is broken.  The only real long-term cure is to enroll a new generation of traders, who understand that their primary responsibility is not to generate enormous profits (and bonuses for themselves) but to avoid crashing the system.  The chances of that happening?  Zero.

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