Sunday, May 13, 2012

Shine on you crazy Dimon

JP Morgan has taken a $2 billion loss on derivatives trading. As I've tweeted, that's around .1% of their assets and 1% of their equity, so on the surface it's hard to see what the fuss is about.

Over at Bloomberg, I found a clue:

It’s not often that a huge company calls an emergency teleconference on short notice to discuss an intra-quarter trading loss that’s equivalent to only 1 percent of shareholder equity. So when a Deutsche Bank AG stock analyst named Matt O’Connor asked Dimon why the company had disclosed it at all, the answer was bound to be revealing. “It could get worse, and it’s going to go on for a little bit unfortunately,” Dimon replied. The meaning was clear. Worse could mean disastrous.

So maybe the $2 billion is just the tip of the iceberg? Still it would have to be a very big iceberg to cause much worry about systemic risk and taxpayer involvement, wouldn't it? Maybe it is a very very big iceberg. That would be bad.

The other open question is what exactly were they doing, hedging or betting?

A classic hedge involves taking a position in the derivatives market that is opposite to your position in the "real world" to achieve certainty about future costs or revenues. If you are hedging to avoid a decline in price of an asset you own, and the price of that asset goes up, you will in all likelihood suffer a loss in the derivative that offsets the gain in the "real world". It's unlikely, though that JP Morgan would report such an outcome as an overall loss.

Even if you set up your hedge correctly, if the correlation between the "real world" asset and the derivative asset is not perfectly predictable, you can suffer an overall loss in your hedge. This is basis risk.

Maybe that is what JP Morgan is reporting; a good hedge gone bad due to basis risk.

My man at Bloomberg doesn't think so though:

Here’s what little Dimon said of the trades in question: “The synthetic credit portfolio was a strategy to hedge the firm’s overall credit exposure, which is our largest risk overall in this stressed credit environment. We’re reducing that hedge. But in hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored. The portfolio has proven to be riskier, more volatile and less effective as an economic hedge than we thought.” 

There is a tantalizing clue in this language. Read the statement carefully and you can see this wasn’t a bona fide hedge. That means it probably was no different, in substance, than a speculative wager. The definition of an “economic hedge,” literally, is an investment that doesn’t qualify for hedge accounting, meaning its effectiveness at offsetting a given risk isn’t sufficiently reliable. Otherwise the wiggle word “economic” wouldn’t be needed.

This made me happy, as I learned a new term, "economic hedge" that apparently can be a synonym for "shitty hedge" or used as a fig leaf for a speculative bet.

In general, I think we want banks and businesses to hedge risk. Structured finance is not an unmitigated bad. And I think we need to recognize that even a well-executed hedge can produce losses, so we can't judge the quality of a hedge purely by its ex-post outcome. On the other hand, in this environment, banks and firms have incentives to misrepresent failed speculation as a problematic hedge and regulators need to be sensitive to that.

The question is whether it's possible to write a rule that distinguishes clean hedges from "economic hedges", especially when you realize that for many real world assets a clean hedging instrument may not even exist.

If it's not possible (and I don't think it is), then should we make banks pay for insurance against the creation of systemic risk? If so, isn't pricing that insurance going to have the same issues as writing the rule?

Or maybe we should put size caps on banks so that one bank's behavior, no matter how shitty, cannot cause systemic risk. But does it matter for systemic risk if one big bank makes bad "economic hedges" or 3 smaller banks each make the same bad bets?

I just don't see a simple rule or magic bullet that gets us out of harms way that doesn't also throw the structured finance baby out with the "economic hedge" bathwater.


Norman said...

This sounds like an argument for tighter leverage restrictions: if we can't distinguish a firm's own risk from the systemic risk we'd like to hedge against, then maybe we should reduce the amount of risk overall.

It's still not a silver bullet, and I may be misunderstanding the argument. But if we really can't effectively price insurance or write rules, perhaps it's the best from among bad options?

On a somewhat related note, what do you think of Arnold Kling's argument that while many small banks aren't really less risky than a few large ones, they are less likely to capture their regulatory agencies?

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