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JP Morgan: Financial Weapons of Mass Destruction

  • Written by Syndicated Publisher 1 Comment1 Comment Comments
    May 22, 2012
    Many commentators have surmised that hedging activity has significantly added to the riskiness of banks. That is the basis of the Volker Rule; to stop banks from gambling on finance with taxpayer insured deposits. What needs to be explained , however, is why hedging is so inherently risky.
    In his Mea Culpa over JP Morgan’s recent trading loss, CEO Jamie Dimon blamed inadequate supervision and judgment. But I believe there are irreducible risks inherent in hedging that cannot be mitigated by competent oversight; they are related, firstly, to our inability to enumerate all possible future states of the world and, secondly, to the unpredictable impact that trading in financial instruments – particularly newly invented contracts – has on altering pre-existing relationships between financial variables.
    Former US Defense Secretary Donald Rumsfeld described the first factor as “unknown unknowns”. Things happen all the time that were unimaginable before their occurrence. Everyone knows this – it is the reason we desire to hold liquid assets- but the economic models that underpin financial trading strategies do not recognize it. The implication is that there is no perfect hedge. Think of the impact of last year’s Fukushima disaster on Japanese energy trading strategies. I’ll bet nobody hedged that risk.
    The second factor has been prominent in recent financial history. The development of the mortgage securitization market unified the housing credit market –underwriting standards, loan pricing and availability of credit – thereby increasing the correlation between home price movements across US metropolitan areas, an effect that undermined a key assumption of mortgage hedging models and contributed greatly to the mortgage market meltdown. It has been speculated that JP Morgan’s recent large trading activities in an exotic credit default swap may have affected its price so as to reduce its relationship to the variables it was attempting to hedge.Actually, JP Morgan’s travails uncannily exemplify both factors: Based on what is currently known, in late 2011 JP Morgan devised a strategy to hedge the corporate credit risks in its portfolio by shorting a credit derivatives index called IG.9, while paying for its short positions by selling some amount of credit protection. A novel event – the ECB’s LTRO injection of capital into the Eurozone banking system  – caused the hedge to go awry. Then Morgan’s attempt to recover by doubling down on its position distorted prices until it finally became unsustainable and collapsed. An article in the Financial Times explained how JP Morgan’s  hedging strategy apparently went awry:”For a while it [the hedging strategy] worked well…But then in December, the European Central Bank unleashed a tidal wave of liquidity into markets, triggering what some analysts called the “mother of all credit rallies”. The two legs of JP Morgan’s trade did not move according to the relationship the bank had expected, however, meaning the position became imperfectly hedged. The bank continued to write swaps on the IG.9, causing a pricing distortion…But the trade was growing more unwieldy as credit markets took a turn for the worse in April…With the size of JP Morgan’s long leg continuing to build, it eventually overwhelmed the market. The last legs of the trade could not be balanced (‘How a storm in a teapot became a tidal wave’, FT May 17, 2012).
    The doubling down behavior and the high degree of leverage caused the bank to lose a huge amount of money very quickly. These were not the results of a rouge trader or a risk junkie. Rather, it was the outcome of a conservative risk balancing operation led by some of the most respected and experienced risk managers on Wall Street.If we recognize the slender foundation upon which rest all our predictions about the future, including those concerning relationships between events, and the near certainty of novel events occurring, then at least we can proceed on sounder footing.

    Images: Flickr (licence attribution)

    About The Author – Luc Vallée

    Currently President of The Independent Market Observer. Chief Economist and Vice-President at the Caisse de dépôt from 2001 to 2008. Chief Financial Officer and Vice-President, Corporate Strategy for Mediagrif Interactive Technologies from 1999 to 2001 – MDF.TO. Deputy Treasurer at Canadian National Railways, 1997-1999. Associate Professor of Applied Economics at l’École des Hautes Études Commerciales (HEC) in Montréal, 1989-96. Consultant for the World Bank, the Canadian government, the Quebec government and the City of Montreal. Deputy director of the Center for International Studies, 1993-1996. Adviser to the investment banking division of Société Générale in Canada, 1996. President of ASDEQ in 2005-06. Member of the National Statistics Council of Statistics Canada, 2008-now. Ph.D. (1989) in economics from the Massachusetts Institute of Technology.


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