By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010). Jointly posted with Roubini Global Economics
Having benefitted from risk management failures of others such as investment bank Bear Stearns and hedge fund Amaranth, JP Morgan (“JPM”) appears to have made an “egregious” and “self inflicted” hedging error. The bank would have done well to reflect on John Donne’s meditation: “send not to know for whom the bell tolls it tolls for thee”.
A US$2 billion Banana Skin …
The losses indicated are US$2 billion and may be higher. JPM’s share price fell around 9% (a loss of US$14 billion in market value) when the new was announced via a hastily arranged news conference. The bank also lost considerably more in reputation and franchise value.
The episode has all the usual trappings of a salacious trading disaster. Competitors had christened Bruno Iksil, one of the traders responsible – Lord Voldemort (after the Harry Potter villain). The position, which has been common knowledge in the market since early 2012 at least, was dubbed “the London whale”. After the losses were announced, the usual journalistic liberties have been taken – the whale has “beached” or “been harpooned”. A sub-editor gleefully coined the headline “Dimon is a Whale of a Hedge Fund Manager”.
But the losses raise serious issues. As they do not relate to the usual “rogue trading” incident which is typically dismissed as impossible to detect or control, the episode provides insights into the problems of modern high finance, bank strategies and regulation of markets.
Details are sketchy. The losses relate to a position taken to “hedge” a US$300+ billion investment portfolio managed by JPM’s Central Investment Office (“CIO”) overseen by staff including experienced hedge fund investment managers. The portfolio has increased in size from $76 billion in 2007 to $356 billion in 2011.
The objective of the CIO is hedging JPM’s loan portfolio and investing excess funds. During a 13 April 2012, conference call, Jamie Dimon, the CEO of JPM referred to the unit as a “sophisticated” guardian of the bank’s funds.
In its statement, the bank advised investors that: “Since March 31, 2012, CIO has had significant mark-to-market losses in its synthetic credit portfolio, and this portfolio has proven to be riskier, more volatile and less effective as an economic hedge than the Firm previously believed.”
The large investment portfolio is the result of banks needing to maintain high levels of liquidity, dictated by both volatile market conditions and also regulatory pressures to maintain larger cash buffers against contingencies. Broader monetary policies, such as quantitative easing, has also increased cash held by banks, which must be deployed profitably. Regulatory moves to prevent banks from trading on their own account –the “Volcker” rule- has encouraged the migration of trading to other areas of the bank, such as liquidity management and portfolio risk management hedging.
Faced with weak revenues in its core operations and low interest rates on cash or secure short term investment, JPM may have been under pressure to increase returns on this portfolio. The bank appears to have invested in a variety of securities including mortgage backed securities and corporate debt to generate returns above the firm’s cost of capital.
In 2011, the CIO portfolio contributed $411 million to JPM’s earnings, below its contributions of $1.5 billion in 2008 and $3.7 billion in 2009. JPM’s disclosures show that the unit took significant risk. Based on a common measure known as VaR (Value at Risk), the potential statistical loss for a single day was $57 million in 2011, similar to the $58 million of average risk in the bank’s larger investment bank and trading business.
The Art of Topiary…
The losses relate to an attempt to hedge the exposure on this portfolio.
As hedging would reduce returns, the strategy adopted appears to have been to buy insurance against default in the short term (to end 2012) and finance the hedge by selling insurance against default in the medium term (to end 2017). The structure took advantage of the difference in pricing of insurance between the two maturities of around 0.60-0.70% per annum. The strategic view was that risk would increase in the near term but abate in the longer term.
The choice of hedge instrument was an older “off-the-run” credit index -the CDX NA.IG (“North American Investment Grade”) Series 9. In all probability, the choice was driven by economic considerations. The constitution of the index may have provided a better match to the exact risk in JPM’s books. The pricing of the index may have been more favourable than more recent “on-the-run” index. The relative liquidity of alternative hedging instruments would have been a factor.
The choice may also have been motivated by the desire to mask the bank’s trading activities from other market participants to allow the position to be established without moving market prices. The particular contract, originally issued in 2007, was extensively used in a variety of structured products. This meant that trades could be disguised as hedging existing products or client positions rather than on JPM’s own account.
It is possible that the hedge could have been “juiced up”, that is, leveraged, by trading in different instruments such as the tranched version of the index to increase sensitivity to changes in market credit spreads.
With the benefit of hindsight, the trades seem to be no more than what Lord Voldemort might view as “school-boy spells you have up your sleeve!”
In the conference call announcing the loss, Mr. Dimon explained that the CIO portfolio was a hedge for the bank’s balance-sheet risk. He stated: “It actually did quite well. It was there to deliver a positive result in a credit-stressed environment. And we feel we can do that and make some net income”.
It is questionable whether the CIO portfolio or the problematic positions could be regarded as a true hedge. It is complex and relies on the correlation between the bank’s underlying positions and trades. The effectiveness of the hedge also relies on the changes in credit pricing for different maturities. The simplest way to reduce risk would have been to sell off existing positions or offset the positions exactly.
The bank’s assertion that the entire set of transactions was both a hedge and a source of earnings is confusing. The bank should have heeded the warning of the seventeenth-century French author François de La Rochefoucauld: “We are so accustomed to disguise ourselves to others that in the end we become disguised to ourselves.”
Given JPM vaunted risk management credentials and boasts of a “fortress like” balance sheet, it is surprising that the problems of the hedge were not identified earlier. In general, most banks stress test hedges to ensure their efficacy prior to implementation and monitor them closely.
While the US$2 billion loss is grievous, the bank’s restatement of its VaR risk from $67 million to $129 million (an increase of 93%) and reinstatement of an older risk model is also significant, suggesting a failure of risk modeling.
During the conference call, Mr. Dimon conceded that the trades were “flawed, complex, volatile, poorly reviewed and poorly monitored … there are many errors, sloppiness and bad judgment”.
The episode also points to failures on the part of parties other than JPM.
Banks are now obliged to report positions and trades, especially certain credit derivatives. This information is available to regulators in considerable detail. Given that the hedge appears to have been large in size (estimates range from ten to hundreds of billions), regulators should have been aware of the positions. It is not clear whether they knew and what discussions if any ensued with the bank.
External auditors and equity analysts who cover the bank also did not pick up the potential problems. Like regulators, they perhaps relied on assurances from the bank’s management, without performing the required independent analysis.
The losses are complicated by Mr. Dimon’s vocal opposition to some aspects of the re-regulation of financial institutions, especially Volcker Rule which seeking to restrict proprietary trading of banks. Given the fact that JPM survived the financial crisis relatively well and his personal high standing within President Obama’s administration (he was considered a potential Treasury secretary), Mr. Dimon has held the moral high ground in arguing for less stringent regulations.
In the bank’s annual report, Mr. Dimon wrote: “If the intent of the Volcker Rule was to eliminate pure proprietary trading and to ensure that market making is done in a way that won’t jeopardize a financial institution, we agree….We, however, do disagree with some of the proposed specifics because we think they could have huge negative unintended consequences for American competitiveness and economic growth”.
Banks have sought a weaker version of the Volcker Rule with broad remit to undertake “portfolio hedging”. This would allow banks to view an investment portfolio in its entirety and enter transaction to offset the risks of the entire portfolio, without the necessity of hedging securities or positions on an individual basis as would be required by a narrow definition of hedging. Banks argued that this exemption is essential to allow flexibility in managing risk within a large financial institution.
The JPM episode has helped re-open the debate. During his conference call, Mr. Dimon ruefully observed the bank’s US$2 billion loss “plays right into the hands of a bunch of pundits out there”.
Legislators and regulators now argue that the rules for portfolio hedging are too wide and effectively impossible to police effectively. In addition, the statutory basis may not support the rule. The legislative intent was intended only to exempt risk-mitigating hedging activity, specifically hedging positions that reduce a bank’s risk. Interestingly, drafters of the portfolio hedging exemption recognized the potential problems, seeking comment on whether portfolio hedging created “the potential for abuse of the hedging exemption” or made it difficult to distinguish between hedging or prohibited trading.
In a recent Congressional hearing, Former Fed Chairman Paul Volcker, who helped shape the eponymous provision, questioned whether the volume of derivatives traded was “all directed toward some explicit protection against some explicit risk”.
The pundits have been quick to suggest that the losses point to the need for more stringent regulations. But it is not clear that a prohibition on proprietary trading would have prevented the losses.
In practice, without deep and intimate knowledge of the institution and it activities it is difficult to differentiate between legitimate investment and trading of a firm’s surplus cash resources or investment capital.
It is also difficult sometimes to distinguish between hedging and speculation. The JPM positions which caused the problems were predicated on certain market movements – a flattening of the credit margin term structure- which did not occur.
Hedging individual positions is impractical and would be expensive. It would push up the cost of credit to borrowers significantly. All hedging also entail risks. At a minimum, it assumes that the counterparty performs on its hedge. But inability to legitimately hedge also escalates risk of financial institutions. Ultimately no hedging is perfect or as author Frank Partnoy told Bloomberg: “The only perfect hedge is in a Japanese garden”.
Additional regulation assumes that the appropriate rules can be drafted and policed. Experience suggests that it will not prevent future problems.
Bankers and regulators have always been seduced by an elegant vision of a scientific and mathematically precise vision of risk. As the English author G.K. Chesterton wrote: “The real trouble with this world [is that]…. It looks just a little more mathematical and regular than it is; its exactitude is obvious but its inexactitude is hidden; its wildness lies in wait.”
JPM indicated that it is trying to unwind its positions. Given the size, the level of losses may increase as markets may move against the bank as it tries to liquidate its position.
But JPM should survive this loss. The bank was quick to point out that the US$2 billion loss was offset by profits in other parts of the portfolio. According to the bank: “As of March 31, 2012, the value of CIO’s total [available for sale] securities portfolio exceeded its cost by approximately $8 billion.
The fate of specific actors is more difficult to predict. Mr. Dimon’s language in describing the losses was expressive:
“… Errors, sloppiness, and bad judgment… Badly executed, badly monitored. I’m not going to repeat it 800 times…“I know it was done with the intention to hedge tail risk… it was unbelievably ineffective…”
He seemed to be trying to distance himself and the bank’s Board of Directors from the failures praising the expertise of the individuals involved: “We added different types of people, talented people and stuff like that”. He was at pains to point out that the CIO until had been very successful to date.
But human sacrifices will be needed. The question is whether it reaches the executive suite or can be limited to foot soldiers. Mr. Dimon has admitted his credibility is at stake, though not necessarily his job.
What complicates Mr. Dimon’s position is that as recently as 13 April 2012, he indicated that the CIO positions were not problematic, dismissing the issue as “a complete tempest in a teapot”. After the losses were announced, Mr. Dimon admitted on US television that he was “dead wrong” to have dismissed questions about the issue.
Just Watch This Space…
The episode raises deeper concerns, beyond the issues at JPM.
How many other such problems in other firms remain undiscovered? JPM is a major player in credit derivatives and by no means the worst managed or the most aggressive in risk taking. If it curtails its activities then the loss of liquidity may affect other players and result in unrelated losses.
How has earnings pressure in banks affected their risk taking? Clearly, the large cash holdings of banks and the need to generate adequate returns for shareholders is encouraging risk taking.
How does regulatory initiatives and monetary policy action affect bank risk taking? Central bank policies are adding to the problem of banks in terms of large cash balances which must be then invested at a profit. The implementation of the Volcker rule may have had unintended consequences. It encouraged moving risk taking activities from trading desks where the apparatus of risk management may be marginally better established to other parts of banks where there is less scrutiny.
The most important question remains whether any specific action short of banning specific instruments and activities can prevent such episodes in the future. It seems as Lord Voldemort observed in Harry Potter and the Deathly Hallows Part 2: “They never learn. Such a pity”.