Tuesday, June 5

2B Or Nought 2B

A background in Economics and early years trading Commodities mean that stock markets hold me in an enduring thrall. I mostly restrict my passion to delivery trades though; F&O action is rare. Equally, those that I talk equities with are folks that classify more as investors than traders. This means that even margin trading is around the fringes of my stockpicking existence.

I was, however, greatly intrigued with JP Morgan Chase's losses on account of derivatives trade last quarter. For one, the amount involved is an obscene $2B (I admit that my imagination runs short when faced with such astronomical sums - for reasons not entirely unrelated to my humble circumstances)! I am told too, that there are many who believe the actual hole to be at least twice that ungodly number.

Of course, markets are replete with instances of mindnumbing losses. I was in College when Nick 'I'm Sorry' Leeson brought down Barings - he was neither the first, nor the last. This begets the question as to how organizations of considerable repute come to such massive grief. Equally, it is not easy to reconcile this with the high quality of their internal talent (case in point: Jamie Dimon was easily a star in an industry under intense recent public scrutiny; or at least till now). We also ought to know if 'mere' avarice is at play, or process or technology failures to detect and correct the situation too.

For starters, let us rule out that the core issue is Options as a financial product itself. Arguing this is like blaming steel for knife-wounds in a ghetto crime. With that out of the way, the picture is no less instructive. At the core of the mess are mismanaged hedges at JPMC's London Treasury. The sequence appears thus:

Like any commercial bank, JPMC had to optimize returns (investing in high quality, long term bonds) vs liquidity (via overnight money market, paying near zero interest in a post-QE world) from funds placed under its charge. Too much liquidity would lower the spread between what the bank got from investments and what it paid depositors; too little would risk it running out of cash. Bond investments need protection too, since their prices vary with interest rate (inversely; if rate moves up, bond prices go down for effective yield to be in line). For a bank, this would be double whammy - their investment erodes in value, and they have to cough up a larger 'share' of returns due to increased interest rates. Naturally, banks hedge such exposures, including through Credit Default Swaps (CDSs are bankruptcy-protection instruments).

By all accounts, JPMC's Treasury at London was running huge positions. This forced them to trade massively in a relatively small, illiquid CDS market as a hedge strategy. This created price skews that drew hedge funds (and others) seeking arbitrage opportunities. Continued aggression from 'London Whale', however, meant that the distortions grew larger (valuations changed an-unheard-of 50% in three months). Pressure on CDS market players mounted - the game was too expensive and prolonged. They were angry, but could do little in an unregulated market with the Whale running amok.

If this was bad, it soon turned worse. Perhaps realizing the limitations of the original CDS market hedge strategy, Whale & Co devised new plans. Defying logic, they got into related but riskier instruments, with further exposure to volatility. Hedge funds started to sense the desperation and waited for the nut to crack.

Meanwhile, within JPMC too this had rung alarm bells. Reinforcements from the core i-banking unit were sent to London Treasury. It did not take them long to figure out how untenable and inherently risky JPMC's position was. They wanted out; and thus presented the perfect revenge opportunity to hedge funds and CDS market punters. To liquidate the trades, these players wanted their price. $2B, or more, is this pound of flesh.

Given market dynamics, perhaps I am guilty of over-simplification (for more gory details, refer an excellent article on the Whale at Seeking Alpha ). Regardless, the episode throws up a few conclusions. The most critical is the need to regulate such specialized (and illiquid) markets. Another lesson is the limitations in deploying narrowly defined, fixed technical strategies to mitigate risk.

In an Occupy Wall St backdrop, however, it is worthwhile to note that this was not a case of i-banking excesses that have so fired up public imagination and invited lawmaker attention (in fact the scene of crime at Chase commercial bank Treasury in London, is far removed from JP Morgan i-bank). Of course, the starring role for CDSs is a true throwback to GFC 2008, but only partly so (teaches regulation at max).

Unless you own JPMC stock, therefore, the pall of gloom and hyper-suspicion is somewhat ill-founded. A sigh of relief too, may not be out of line. Until, of course, the next quake strikes.

6 comments:

Learner said...

Great read!

Anonymous said...

So you finally return to blogosphere, son -- good re-entry shot too -- but I got the feeling that there is another final-final future Profession that you seem to be headed towards -- Politics was always on the cards, now it is Professor too ;-)

How I wish I was around to see some of the old EcoSoc janata reacting to this -- but theres a price to pay for sunny California :-)

Waiting to hear what you say next!

-A

Aparna said...

Rockfeller's strategy of spreading globalisation or forcing nations to succumb to liberalisation through chaos has been implemented via multitentacle approach , and market manipulation through greed manipulation has been one such weapon that ultimately began backfiring. It was apparent in the U.S subprime crisis that triggered recession and the same is happening in the world of banking and stocks Ultimately-- the rakish urge to throw caution to the winds for short term gains has to be checked -PRONTO!!

Aparna said...

Rockfeller's strategy of spreading globalisation or forcing nations to succumb to liberalisation through chaos has been implemented via multitentacle approach , and market manipulation through greed manipulation has been one such weapon that ultimately began backfiring. It was apparent in the U.S subprime crisis that triggered recession and the same is happening in the world of banking and stocks Ultimately-- the rakish urge to throw caution to the winds for short term gains has to be checked -PRONTO!!

Anonymous said...

A gr8 insight, very aptly explained and a fantastic read...seems one's indulging in reading the Economic Times..obviously without paying the subscription fee..

Rahul said...

I agree with aparna's comment about greed playing a key part in this episode or for that matter in all such episodes, sometimes mixed with ego when a trader throws in all he has with an overconfidence that is actually recklessness. That is one more reason to support regulation and greater govt intervention in trading markets. Good policing is the only way to maintain order even in society.