A degree in Economics and early years trading commodities mean that the markets hold me in an enduring thrall. I mostly restrict my passion to delivery trades, though; F&O action is rare. Equally, those with whom I talk equities classify more as investors than traders. This means margin speculation resides around the fringes of my stock-picking existence.
I was, however, greatly intrigued by JP Morgan Chase's massive derivative trading losses last quarter. For one, the initially reported figure was an obscene $2B (frankly, my imagination runs short when faced with such astronomical sums, for reasons not entirely unrelated to my humble circumstances)! Rumours abound, too, that the actual hole to be at least twice that ungodly number (phew).
Of course, financial markets are replete with instances of mind-numbing losses. I was in college when Nick "I'm Sorry" Leeson brought down Barings. He was neither the first nor last in a long line of market operators whose avarice or ambition — though rarely outright ineptitude — delivered similar rude shocks. Indeed, the trail of destruction in their wake invariably claimed more than a fair share of humble retail investors alongside the institutions themselves.
Naturally, it raises the question of how organizations of considerable repute come to such massive grief. These failures are difficult to reconcile with the high calibre of internal talent on display (for instance, Jamie Dimon himself has long been a star in an industry under intense public scrutiny). Equally, we ought to understand the process or technical inadequacies that led to a failure to detect and correct the exposure in time.
In the current instance, we can rule out derivatives themselves as the primary culprit. Targeting the financial instrument is like blaming steel for knife-wounds in street crime. That out of the way, the picture is no less turbid, with mismanaged hedges at JPMC's London Treasury at its core. The sequence unfolded as follows:
JPMC, like any commercial bank holding vast client deposits, must balance returns (by investing in long-term, high-quality bonds) against liquidity (through the overnight money market, yielding near zero in a QE regime). Excessive liquidity lowers the net interest margin; holding too little invites cash shortfalls. Moreover, bond portfolios need protection, since prices vary inversely with interest rates. When rates rise, the bank faces a double whammy: its bond portfolio suffers capital losses while funding costs escalate due to higher deposit payouts. Banks routinely hedge this exposure, including through Credit Default Swaps.
By all accounts, JPMC's Treasury in London was running huge positions. This forced them to trade aggressively in a relatively small, illiquid CDS market as a hedge strategy. This created price distortions that drew hedge funds and institutional traders seeking arbitrage opportunities. Continued pressure from the 'London Whale', however, meant that the pricing skews grew larger — spread valuations swung an unprecedented 50% in three months. Stresses on CDS market players mounted: the game was becoming relentlessly capital-intensive. They were squeezed, but could do little in an unregulated market with the Whale running amok.
If this were bad, it soon turned worse. Perhaps realizing the limitations of the original CDS hedge strategy, Whale & Co devised new plans. Defying all logic, they pivoted into related but riskier instruments, escalating their exposure to volatility. Hedge funds started to sense the desperation and waited for the position to crack.
Meanwhile, this had rung alarm bells within JPMC too. Reinforcements from the core i-banking unit were sent to the London Treasury. It did not take them long to figure out how untenable and inherently risky JPMC's position was. They wanted out, presenting the perfect revenge opportunity to hedge funds and CDS market punters. To liquidate the trades, these players wanted their price. $2B, or more, was this pound of flesh.
Perhaps I am guilty of over-simplification (for more gory details, refer to an excellent article on the Whale at Seeking Alpha). Regardless, the episode yields several striking conclusions. The most critical is the imperative for oversight across bespoke, illiquid derivatives markets. Another lesson is the limitations of relying on rigid, narrowly defined quantitative models to mitigate risk.
In an 'Occupy Wall St' backdrop, it is worth noting that this was not a case of i-banking excesses that have fired up public imagination and invited lawmaker attention lately. 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 familiar echo of the GFC, but other than an 'ought-to-regulate', that is where the parallel ends.
Unless you own JPMC stock, therefore, the pall of gloom and hyper-suspicion is somewhat ill-founded. A sigh of relief may not be out of line either. Until, of course, the next quake strikes.
(bankruptcy-protection instruments)
I was, however, greatly intrigued by JP Morgan Chase's massive derivative trading losses last quarter. For one, the initially reported figure was an obscene $2B (frankly, my imagination runs short when faced with such astronomical sums, for reasons not entirely unrelated to my humble circumstances)! Rumours abound, too, that the actual hole to be at least twice that ungodly number (phew).
Of course, financial markets are replete with instances of mind-numbing losses. I was in college when Nick "I'm Sorry" Leeson brought down Barings. He was neither the first nor last in a long line of market operators whose avarice or ambition — though rarely outright ineptitude — delivered similar rude shocks. Indeed, the trail of destruction in their wake invariably claimed more than a fair share of humble retail investors alongside the institutions themselves.
Naturally, it raises the question of how organizations of considerable repute come to such massive grief. These failures are difficult to reconcile with the high calibre of internal talent on display (for instance, Jamie Dimon himself has long been a star in an industry under intense public scrutiny). Equally, we ought to understand the process or technical inadequacies that led to a failure to detect and correct the exposure in time.
In the current instance, we can rule out derivatives themselves as the primary culprit. Targeting the financial instrument is like blaming steel for knife-wounds in street crime. That out of the way, the picture is no less turbid, with mismanaged hedges at JPMC's London Treasury at its core. The sequence unfolded as follows:
JPMC, like any commercial bank holding vast client deposits, must balance returns (by investing in long-term, high-quality bonds) against liquidity (through the overnight money market, yielding near zero in a QE regime). Excessive liquidity lowers the net interest margin; holding too little invites cash shortfalls. Moreover, bond portfolios need protection, since prices vary inversely with interest rates. When rates rise, the bank faces a double whammy: its bond portfolio suffers capital losses while funding costs escalate due to higher deposit payouts. Banks routinely hedge this exposure, including through Credit Default Swaps.
By all accounts, JPMC's Treasury in London was running huge positions. This forced them to trade aggressively in a relatively small, illiquid CDS market as a hedge strategy. This created price distortions that drew hedge funds and institutional traders seeking arbitrage opportunities. Continued pressure from the 'London Whale', however, meant that the pricing skews grew larger — spread valuations swung an unprecedented 50% in three months. Stresses on CDS market players mounted: the game was becoming relentlessly capital-intensive. They were squeezed, but could do little in an unregulated market with the Whale running amok.
If this were bad, it soon turned worse. Perhaps realizing the limitations of the original CDS hedge strategy, Whale & Co devised new plans. Defying all logic, they pivoted into related but riskier instruments, escalating their exposure to volatility. Hedge funds started to sense the desperation and waited for the position to crack.
Meanwhile, this had rung alarm bells within JPMC too. Reinforcements from the core i-banking unit were sent to the London Treasury. It did not take them long to figure out how untenable and inherently risky JPMC's position was. They wanted out, presenting the perfect revenge opportunity to hedge funds and CDS market punters. To liquidate the trades, these players wanted their price. $2B, or more, was this pound of flesh.
Perhaps I am guilty of over-simplification (for more gory details, refer to an excellent article on the Whale at Seeking Alpha). Regardless, the episode yields several striking conclusions. The most critical is the imperative for oversight across bespoke, illiquid derivatives markets. Another lesson is the limitations of relying on rigid, narrowly defined quantitative models to mitigate risk.
In an 'Occupy Wall St' backdrop, it is worth noting that this was not a case of i-banking excesses that have fired up public imagination and invited lawmaker attention lately. 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 familiar echo of the GFC, but other than an 'ought-to-regulate', that is where the parallel ends.
Unless you own JPMC stock, therefore, the pall of gloom and hyper-suspicion is somewhat ill-founded. A sigh of relief may not be out of line either. Until, of course, the next quake strikes.
(bankruptcy-protection instruments)
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7 comments:
Great read!
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
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!!
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!!
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..
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.
Hey keep posting such good and meaningful articles.
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