JP Morgan, Hedges and Proprietary Trades

I didn’t really want to write another post about the whole JP Morgan story since others (who we will get to in a minute) have already penned better explanations of what needs to be said..    The problem here is that everyone is focused on the idea of banning “prop trading”  and shooting down the idea that this Trade-Gone-Bad was a hedge.   My point in avoiding this discussion in my first post was that it doesn’t really matter:  you (you being a politician, journalist, farmer, or any other person who is not intimately familiar with JP Morgan’s specific risk exposures – which is ALL OF US) have no friggin’ idea what is a hedge and what is a prop trade, and it doesn’t matter!   The real problem is that this trade, even if we call it a hedge, wasn’t a good hedge.   If we want to figure out how to make banks safer, the answer is absolutely positively NOT “make sure everything is a hedge.”

I want to start with a tweet that BondGirl sent out last week, because it’s spot on with its sarcasm:

In my past life, I managed a sizable mostly-equities portfolio made up of different strategies.   One strategy was index arbitrage:  when the futures were trading out of line with the underlying index, we would sell the expensive one and buy the cheap one.   This trade, once we lock in our funding cost (via another trade), is a perfect hedge (minus dividend risk!).    Another strategy was pairs trades:  we might buy $HD and short $LOW, or buy $KO and short $PEP.   This, it should be obvious, is not a PERFECT hedge, but we would expect that our risk in being long $HD and short $LOW is less than our risk in just being long $HD, or our risk in being long $HD with a generic market hedge against it (ie, short S&P Futures).

In other words, when we hedged with an asset which we expected to be highly correlated, we figured to be reducing risk relative to our other options.   Guess what – we could be wrong!   $HD could implode while $LOW took all of their business away, and our hedge could make our trade performance worse than it otherwise would have been.   That happens sometimes, but it doesn’t mean that the other side of the trade wasn’t a “hedge.”

Similarly, we ran a merger arbitrage portfolio.  When company XX was acquiring company YY for stock, we’d buy the stock in target YY and short the acquirer XX in the proper ratio so that if/when the deal closed our positions would net out to zero and we’d capture the spread.   Guess what we used as part of a hedge for this trading book?  We carried a short S&P 500 futures position on a ratio basis.   Is this a great hedge?   Hell no – it’s about as far from perfect as one can get – but merger arbitrage performance tends to have a positive beta:  as the market does well, the deals get done.  When the market blows up, like it did in 2007/8, financing dries up, deals break, etc.    Might we have come up with an even better hedge – perhaps something like a bank financing index?   Absolutely, but we used the S&P hedge as a simple “better than not having it” hedge.   Having that offsetting futures position ate into some of our profits but also reduced our risk.

If I have net long equity exposure, would you say that buying treasury bonds is a hedge?  We sometimes used treasuries for exactly that reason.  How about gold?  Would you say that buying gold is a hedge for my equity portfolio?   How about just shorting $AAPL against every equity position?   This gets back to BondGirl’s tweet quote above – it’s hard (impossible?) to opine on risk management if you haven’t managed risk.   Even if you have experience in risk management, you can’t spout off about JP Morgan’s portfolio – which is probably about as complex as it gets – without knowing the details of their positions.   I’ll say it again: “Was this a hedge?”  is the wrong question.  It’s a diversion for politicians to rant about and get face-time in front of Congress, and it won’t result in our banking system becoming any safer.

This morning, Barry Ritholtz takes issue with the “Everything is a Hedge” argument, but I think that what he really does is show exactly why “is it a hedge or is it not a hedge?” is the wrong question.   Ritholtz claims that when your trade is so big that it distorts markets, it cannot be called a hedge.   Well that’s kinda silly – it’s quite easy to pick a hedge with a less liquid market than the other side of your trade.   In fact, even in the highly-hedged merger arbitrage world I used to live in, this happened all of the time – one leg of the pair would be much more thinly traded than the other.  I could have a big footprint in one leg of the trade, but that wouldn’t make it any less of a hedge.

I agree with Barry’s observation:

“Hence, for a huge bank with trillions on its book, there is the rationale that any trade, any position, any financial transaction, is potentially a hedge against some other position the bank is holding.”

Pretty much, yes!  Which is exactly why talk of what’s a hedge and what’s not a hedge is a diversion.    I somehow missed the existentialism of Barry’s conclusion: “And once you define everything as a hedge, well then, nothing is a hedge,”  but let’s move on. (Or, you can read Sonic Charmer’s reaction to Barry’s post).

Bloggers Matt Levine @ Dealbreaker and Sonic Charmer have written some excellent posts delving into more about proprietary trading, hedging, etc.

Levine’s Magnum Opus delves into concrete examples, and is a must read for those wanting to better understand why “to hedge or not to hedge” is a distraction.

Sonic Charmer’s post adds to the discussion with a clear-spoken explanation of the problem, and a detailed explanation of why The Volcker Rule is not the solution:

“The first thing to understand about these trades is that – all along – JPM has classified them as hedges. Hedges are not ‘prop trades’ and there’s no sane way to classify them as such (or more precisely: there’s no way to clearly define, for a given trade, which part/how much of it is a Kosher, Volcker-Approved Hedge and which of the rest/residual is Unkosher, Volcker-Disapproved Prop). The second thing to understand about these trades is that they were risky and dumb and didn’t work as hedges that well. We know that now because golly they have lost $2 billion dollars and hoo boy is that a lotta clams. But JPM apparently did not know that before learning it via the tried-and-true risk/control method of Noticing Large Negative P&L Emails Coming To Your Blackberry Right Before Dinner And Ruining The Rest Of Your Evening.

What this establishes, I think, is that trades can be risky and dumb and lose money without being ‘prop trades’. A trade can serve a ‘legitimate’ purpose – like it’s intended as a hedge, to ‘legitimate’ activity – and yet still lose a lot of money. Now you and I and Paul Volcker all agree that all else equal we don’t want banks to lose a lot of money. So a ‘rule’ like, say, Don’t Put On Trades That End Up Losing Money might make sense (if you also had a time machine and could check the future), but a rule saying Don’t Do Prop Trades makes no sense as a way to prevent risk, because it simply does not ‘prevent banks from taking on risk’. Exhibit A: JP Morgan. Right now.”

Now, accounting specialists will notice a problem with Sonic Charmer’s first sentence:  these trades did NOT meet accounting standards as a “hedge.”   I want to be quite clear that when I am talking about “hedges” I’m talking from a risk management perspective – not from a FASB/GAAP/SEC/CIA/FBI/ETC accounting standard.   Another thing should be quite apparent -  none of us is suggesting that JP Morgan should have free reign to lose as much money as they want to and then get a taxpayer funded bailout.  On the contrary – we’re merely pointing out that the proposed solutions to avoid that problem in the future are, well, no sort of solution.

The final irony comes from SoberLook, by way of SonicCharmer again:  JP Morgan’s DVA gain from the declining value of their own debt could be greater than the loss that all the hullabaloo is about… Oy vey.  And we didn’t even discuss that they have a $15 Billion buyback active – with the stock down 10% since the story broke, they will be able to buy back more stock, cheaper!  Make sure you read SonicCharmer’s example via sarcasm.

Related:

Kid Dynamite:  So You Want To Talk About JPM’s Trading And The London Whale

Levine, Dealbreaker:  Tale of a Whale Fail

Ritholtz: Everything Is a Hedge

SoberLook: JPM Made Some $5 B on Friday Via DVA Magic

Sonic Charmer:  I’m Pretty Sure JP Morgan Lost $2 B Just to Spite Me

Sonic Charmer: Has Everyone Got the JPM Story Backwards?

-KD

disclosures: no positions in any of the stocks mentioned

 

 

 

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