Streetwise Professor

A couple of LIBOR-related items.

1. Timmy! claims that he and the FRBNY were “very forceful from the beginning” in dealing with LIBOR manipulation.  This is an example of why Timmy! (AKA Rodney Dangerfield) gets no respect.  His letter to the BOE was a classic example of bureaucratic CYA and buck passing: the BOE then exchanged the buck and passed the pound to the BBA which did . . . nothing.  More nothing happened for over three years, and it wasn’t the FRBNY that drove the process.  The scary thought is that is what passes for forceful in Timmy!’s world: the scary alternative is that Geithner is just BSing about his past forcefulness.  The thought that Geithner’s 2008 actions were forceful is Pythonesque, really:

Cardinal Ximinez: Cardinal Fang! Fetch… the Comfy Chair!
Cardinal Fang: [horrified] The Comfy Chair?
[Fang scuttles off, then returns with the Comfy Chair and sits the old lady down in it]
Cardinal Ximinez: Now, you will sit in this chair until lunchtime, with nothing but a cup of coffee at 11!

2. Central bankers are looking for an alternative to LIBOR, EURIBOR, etc

Central banks are exploring whether financial markets might be steered to adopting benchmarks other than Libor. Mr. Bernanke suggested a few alternatives at his hearings this week. Among them: The rate that financial institutions charge each other for short-term loans in “repo” markets in which they use their large securities portfolios as collateral for short-term loans. He said derivatives markets also provide alternatives, such as “overnight index swap,” or OIS, rates, which track central bank lending benchmarks.

That’s great going forward, but what about the $800 trillion or so in notional and/or principal amount of outstanding derivatives, loans, and other financial instruments with payments tied to LIBOR and its European and Asian cousins?  That would be a helluva lot of contracts to orphan.

LIBOR needs to be fixed, because of this massive amount of legacy contracts.  But how?  It won’t be easy, since the transactions that LIBOR et al should be related to-unsecured interbank transactions-aren’t orphaned: they’re damned near extinct.  Any decree by regulators that henceforth LIBOR should be something different than the creature that existed at the time these contracts, loans, etc., were created would potentially result in the shift of many billions of dollars of wealth, and spawn intense legal challenges.  (Ironically, any fines or damages arising from LIBOR manipulation-related legal actions will weaken banks and make the return of unsecured lending all the more remote a prospect.)

Looking for a replacement going forward is the easy problem: market participants have an incentive to come up with something more robust, there will be experimentation and competition, and perhaps with a little regulatory shepherding, in not too long something better (no doubt some sort of secured rate) will emerge as the benchmark.  Going forward, market participants can find transactions and benchmarks that are mutually beneficial.  That provides an incentive to get it right.

Finding a way to deal with the legacy of the past is going to be a much, much more difficult problem.  The primary effects of changes will be redistributive, rather than creative.  This will give rise to massive rent seeking and legal conflict.  Much fun will be had by all.  Especially the lawyers.

I owe thanks to Tim Worstall (never to be confused with Timmy!) for his Forbes blog post on, and compliments of, my Blame it on Ben? piece from Saturday.

I also owe Tim props, for he recognized the dangers that low interest rates pose to the traditional broker model back when MF Global went bust.

One clarification.  I didn’t mean to suggest that low interest rates caused MF Global, or Peregrine, or the Whale, in the sense that low rates were a sufficient condition for these things to occur.  Low interest rates aren’t necessary either: some firms take risk or commit fraud when interest rates are high, obviously.

But risk taking (such as MF Global’s gambling for resurrection) and fraud (such as Peregrine’s) are more likely when firms are on, or over, the financial brink.  Low interest rates put these firms on the brink, and made the courses of action that Corzine and Wasserman chose more attractive and compelling than they would have been had they been making money the old fashioned way.  Put differently. low interest rates increase the odds of such conduct.

With that clarification made, just let me say thanks Tim, and keep up the good work.

The futures industry is reeling over the latest theft of segregated customer funds, this time by Peregrine Futures’ Russell Wasendorf.  Wasendorf admitted to stealing seg funds in a note left at his side when he attempted suicide after it looked like his scheme was unraveling.  He has been indicted for fraud committed over the 2010-2012 period.  Over $200 million is missing, and his company is undergoing Chapter 7 liquidation.

Following hard on the heels of the MF Global disaster, the Peregrine revelations are raising further fears about what had once been considered sacrosanct: that customer funds are inviolate.  Even the CME Group, which has historically been a stalwart defender of the traditional segregation model in which FCMs are the custodians of customer money, has suggested that changes may be necessary:

Without question, the current system in which customer funds are held at the firm level must be reevaluated.

CME Group recognizes that the demand for its services is reduced to the extent that suppliers of complementary services-such as brokerage-are deemed untrustworthy.

I consider it virtually inevitable that this will be the last nail in the traditional segregation model.  This will lead to a dramatic change in the organization of the FCM industry.  Though (as I discuss a below) that industry was already under tremendous strain.  Peregrine and MF Global are symptoms of that strain.

Other big news this week was JP Morgan’s reporting of a $4.4 billion dollar Q2 2012 loss, and a $459 million restatement of its Q1 results-along with an admission that the “integrity” of the marks in the CIO books.

Do Peregrine, MF Global, and JP Morgan’s travails have anything in common, except for bringing further discredit onto the finance and banking industry?  I think they do.  I think they are all consequences of near-zero interest rates.

The traditional FCM revenue model relied on interest income from customer funds invested by the FCM.  Very low interest rates make that model unviable.  That is a major reason why Corzine felt it imperative to transform MF Global-and to take on more risk.  I conjecture that similar pressures led Wasendorf to commit fraud.  (Though his admission that he had been doing so for 20 years cuts against that interpretation.  A hypothesis: Wasendorf had been engaging in this activity on a smaller scale for years, but escalated it sharply as the financial pressures on Peregrine grew in the low interest rate environment.)

The Morgan story is different, but the extraordinary monetary policies that have driven interest rates to extremely low levels are at the center of the story.  Morgan had about $360-$500 billion in deposits that it needed to invest, but traditional investments such as Treasuries offered such low yields that the bank went hunting for yield, and invested in more risky securities and derivatives to get it.  Yield chasing in Fed-created low interest rate environments has contributed to previous big losses, such as Orange County’s in 1994.

Bernanke and the Fed initially pursued a low interest rate policy in an attempt to prevent another depression, and have continued it in attempt to spur growth.  These are the justifications for these policies, and they are defensible ones.  But these policies cause collateral damage.  Financial blowups-from MF Global to Peregrine to the Whale-are plausibly just that.

During all the whinging about WTI, and the claims that it was inferior to Brent as a benchmark, I pointed out that although the former was subject to short term issues that could be fixed by investment in infrastructure, the latter was plagued by far more intractable problems that would compromise its viability over the medium-to-long term.  Indeed, WTI’s problems reflected an unexpected supply surge that actually bodes well for its long term viability, whereas Brent’s inexorable production decline would be virtually impossible to fix.

That reality is now becoming more widely recognized, pace Javier Blas’s piece in the FT:

The drop in production is putting the Brent benchmark in danger. Platts, the pricing agency that acts as the de facto regulator of the Brent physical market, is looking for solutions. It will need to work closely with ICE Europe, the exchange home of Brent futures and options, and the UK’s Financial Services Authority, which has an interest in the Brent derivatives market running smoothly.

The usefulness of West Texas Intermediate, the US crude oil, as a global benchmark has suffered over the past two years due to the so-called ‘Cushing syndrome’ – a glut at the Oklahoma town that serves as the delivery point of the contract. This glut is due to surging production and limited pipeline offtake capacity, and pushed WTI prices below what global fundamentals suggested.

Brent is now suffering from the opposite problem. The ‘North Sea syndrome’ – falling regional output combined with unlimited seaborne offtake capacity. The problem could push Brent prices above what global fundamentals suggest.

It is a lot easier to build pipelines than develop vast offshore oilfields. (Well, it is if administrations I won’t bother to mention let pipeline development proceed.)  This means that WTI’s “problems” can be fixed-and indeed, that its problem (a surge in supply in regions tributary to the delivery point) is a feature not a bug.  Brent’s.  Not so much.  Meaning that before very long CME/NYMEX is likely to be laughing, and Platts and ICE will be sobbing.

Like Freddie Krueger, I’m baaaaaack again, folks.  This time, more regularly, I trust.

Catching up on a few things that have caught my eye since last time-and like Freddie, I brought my knives.

1. The LIEBOR mess continues to metastasize.  It is now sucking in regulators.  Including Timmy! It appears that the dissembling about LIBOR, TIBOR, EURIBOR, etc., was the worst kept secret in the world’s financial centers.  And let’s pray that’s true.  If the Fed, the Bank of England, etc. DIDN’T know that there was a complete disconnect between the rates that banks reported to the BBA and the rates at which they were actually borrowing (or not)-now THAT would be a reason for panic.  In fact, they were all-bankers and regulators alike-operating pursuant to the Juncker Maxim: “When it becomes serious, you have to lie.”
2. I detest manipulation of markets, and have made a life’s work of studying it, calling out manipulators, and now and again testifying against them.  But I find it disgusting to hear high government officials in high dudgeon on the subject, when they are in fact often the most outrageous and shameless manipulators.  The most flagrant example: the Lilliputians who are the collective “leadership” of the EU and the Eurozone.  For what else can you call their repeated fudges, misstatements, lies, etc. related to the latest “solution” to Greece’s problems, or Spain’s, or Italy’s, than “manipulation”?  How many billions have changed hands on the EUphoric rallies that occur after the announcement of such solutions, and on the, umm, “retracements” that occur when the truth comes out.  The agreement on a Spanish bailout, and banking regulation changes, that came out of the most recent Summit of the Lilliputians is only the latest example.  Look.  Europe is screwed.  Metaphysically.  The math does not work.  Cannot work. Even mores, the politics cannot work.  The core is empty.  No real deal is possible.  Accept it.  And once you accept it, mock any pronouncement of the next “solution”.  And for God’s sake don’t buy except on the theory that other suckers buy and you will sell out before they do.
3. FCM Peregrine Financial Group apparently absconded with $220 million of “segregated” customer money.  This is both shocking and depressing 10 months after MF Global.  The scheme has apparently been going on for at least two years.  But the CFTC allegedly gave all FCMs the full anal probe post-MF, and saw-like Sergeant Schultz-NOTHINK! So since they can’t find a rather banal fraud at a middling futures brokerage, it’s truly obvious that they have game to regulate the entire world, and every complex financial institution and complex derivative trade in it.  What could go wrong? No doubt that the Peregrine debacle will lead to calls for more regulation.  Regulation, the only human activity where failure is the primary justification for more of it.
4. The CEO of inter dealer broker GFI, Mike Gooch, has said that hedge funds need to become liquidity suppliers/market makers in order to fill the gap left by banks, post-Volcker Rule.  I predicted this would be the outcome in a couple of posts written soon after the rule was mooted.  There is a serious question here: will this really lead to greater stability during times of financial turbulence?  Given that credit to hedge funds-which comes largely from banks, by the way (funny thing, that!)-typically contracts severely during periods of such turbulence, their market making activities are likely to contract as well during such times.  Meaning that market liquidity supplied by hedge funds will be highly pro-cyclical.  Bank supplied market liquidity is too, but the ones subject to the Volcker Rule-you know, the ones who have sticky insured deposits-are likely to be able to resist these cyclical pressures better than hedge funds because their funding is not as fragile.  So yes, Mike, hedge funds will be needed to fill the gap left by the exit of prop trading banks, but they won’t be there precisely when needed.  Things will work just swell.
5. Gazprom was named the most opaque corporation in the world.  I am shocked and stunned.  It is allegedly the most profitable.  Again, no surprise: government enforced monopoly is a nice gig.  But the company has been forced to make price concessions on contracts to big customers.  It is fighting a rearguard action against the flood of gas being discovered around the world.  It won’t happen overnight, but government mandated monopoly or no, the company’s future is not bright.
6. The to-ing and fro-ing over privatization in Russia continues.  Putin allegedly threw a spanner into Sechin’s ambitions to acquire “privatized” assets, including electricity generators.  But his words are pretty weak: “That does not mean we should limit ourselves to participation by Rosneftegaz.”  So you could envision some competitors in the bidding process, and them prevailing enough times to give the impression that a real privatization is going on.  But this is likely to be a Potemkin privatization, and Sechin et al are likely to prevail.  Sechin certainly thinks so: “Russia’s most influential energy official, Igor Sechin, said on Tuesday the state-owned energy holding Rosneftegaz was given permission to invest cash on its balance sheet in comments which seem to contradict assertions by a top government official [Akardy Dvorkovich].” I would bet on Sechin.  Hands down.
7. There is a spate of bad news about the weakness in China’s economy.  I have been a China bear for going on three years, or more actually.  The first reason for my pessimism has always been China’s ramshackle and rigged financial and banking systems: this predates the crisis.  This post provides an excellent overview of the reasons to find that system “scary.” Yes, the Chinese government has papered over past problems, but there are limits to this, as there are to all things.  Indeed, as the economy has gotten larger, and in the aftermath of the crisis and the massive monetary and fiscal response thereto, the state’s capacity to continue to do this is very questionable.  The second reason is that, contra Tom Friedman or Ray LaHood, I adamantly do not believe that the allocation of capital by the state, directly, and indirectly through financial repression and a hugely distorted banking system, will end well.  In fact, I believe the exact opposite is true.  Suppressing price signals and allocating capital to cronies and state owned enterprises is a recipe for grotesque misallocations of capital.  In the short to medium term, it can lead to impressive GDP numbers.  But spending insane amounts on investment eventually leads to catastrophe if that investment doesn’t produce returns.  That, in a nutshell, is what China looks like to me.  And these two sources of pessimism feed off one another: when the investments don’t generate returns, and in fact generate losses, the banks and trust companies and insurance companies and whatever that provided the finance are toast.  When you force feed a goose, you can at least get good liver pate (but not in California!).  When you force feed investment, eventually you get a bust.

That’s all for now folks.  Catch you again soon. Promise.

Barclays’ has copped to an attempted manipulation of LIBOR.  It has agreed to pay about $450 million to the UK’s FSA, the CFTC, and the USDOJ.  The CFTC filing states that Barclays had two motives for its actions.  First, when Barclays’ reports to LIBOR were high relative to other banks’ (which Barclays people referred to as having their head above the parapet) and thereby raising questions about the bank’s financial condition, it allegedly reduced reported rates in order to allay such fears.  Second, the bank’s traders allegedly influenced rate submissions, and conspired with traders at other banks to change their submissions, in order to advantage derivatives positions.

As I noted in 2008, when the story first broke, the second possibility created substantial legal liability for banks like Barclays that submitted the false reports.  Under the anti-manipulation law in effect in the US at the time, it was necessary to have specific intent to create an artificial price of something like the LIBOR-based Eurodollar futures contract.  The emails divulged today suggest such a specific intent.

Perhaps crucially, the Order only finds that Barclay’s attempted to manipulate, not that it had in fact succeeded.  This will be an important issue going forward.  To prove manipulation, and crucially, to collect damages, it will be necessary to show that Barclay and other submitters of LIBOR quotes indeed distorted the index, that is, they caused an artificial price in a futures contract based on LIBOR or some other interest rate like Euribor.

Proving this will be a very data intensive exercise.  Moreover, there are two distinct issues-the impact of manipulation on the final settlement price of the futures contract (which is based on LIBOR), and the impact of manipulation on futures prices prior to expiration.  The second issue will prove more challenging than the first because the connection is more direct in the final settlement price.  Even that will pose some issues, however, because of the necessity of identifying the “but for”, i.e., what interest rate should banks like Barclays have reported.   This will necessarily require looking at actual interbank transactions, raising the question of how many such transactions there will be during periods of time of money market stress starting in 2007.

These issues are not impossible.  Similar, and arguably even more challenging issues, were confronted in a class action lawsuit against those who misreported  natural gas prices to publishers like Platts.  (Full disclosure: I consulted with plaintiffs in that matter, and wrote a declaration in support of certain aspects of the plan of allocation of settlement monies.)

The whole fiasco does point out, yet again, the overriding importance of basing cash-settled indices on actual transactions, wherever possible.

This is becoming an important issue in oil markets as well, as “Price Reporting Agencies” like Platts and Argus are under great scrutiny.  But oftentimes the problem is not amenable to easy solution.  You can’t have a reliable transaction-based index that is not susceptible to manipulation if (a) there are few transactions, and/or (b) market participants have the option to report transactions.  Pharonic pronouncements from regulators that PRAs make bricks without straw are futile.

None of these issues are new.  I (and my colleagues at UH) dealt with them in 2003 in our efforts to create an “energy data hub” in the aftermath of the price reporting scandal post-Enron.  Voluntary reporting is extremely problematic.  Compulsory reporting (along the lines of one of the few salutary features of Frankendodd) is necessary (but not sufficient for some markets) to produce reliable price indices.  Arranging this on an international market like oil seems virtually impossible to implement, let alone enforce.

This is the longer explanation behind my rather cryptic quote from this WSJ article from last week.

Going back to LIEBOR, the Barclays $450mm coughed up is the first fine, but it won’t be the last one.   In the energy markets, the CFTC collected about $250 million: fines will be many multiples of that in LIBOR and Euribor and TIBOR and whatever.  And believe it or not, the really big money will likely be in civil litigation, and the battles will be much more intense there as well, IMO.

Global regulators are lumbering towards announcing proposals on the margining of non-cleared swaps, though they will miss the original G-20 deadlines:

Global regulators said on Wednesday they will issue proposals in coming weeks on rules to encourage banks to put derivative trades through a central clearing house, but they won’t be ready for the G20 summit in June.

. . . .

The FSB said it will issue a consultation paper on setting globally agreed margin rules for trades that are cleared directly between two parties rather than through a central clearing house.

“Momentum on OTC derivatives has accelerated in recent months,” FSB Chairman Mark Carney said at a news conference in Hong Kong.

The FSB is expected to push for a minimum margin that banks must post on derivatives trades that aren’t processed through a central clearing house. The aim is to provide an incentive for trades to be centrally cleared, or at least ensure there is a lower risk of an uncleared trade running into difficulties.

Here we go again.  Regulators believe they know how to determine the risks of transactions, and price those risks.

This of course worked out so well with Basel II, which deemed that mortgage loans and mortgage backed securities and sovereign debt were low risk and provided incentives for financial institutions to invest in them.

How’s that working out?

The clearing proposals in particular are frightening for at least two reasons.  First, they are predicated on the view that clearing necessarily mitigates systemic risk, a highly misguided view as I’ve pointed out here for years. Second, and relatedly, the very policy of attempting to encourage the movement of transactions to CCPs will tend to increase the riskiness of CCPs by leading them to clear products that are not well-suited to clearing, thereby increasing the riskiness of CCPs.  And because these CCPs are systemically important, this creates systemic risks.

It is also interesting to note that this one regulatory effort my be undermined by another one.  The New! Improved! Basel Rules will set capital requirements for exposures to CCPs.  The prevailing belief is that this will result in low risk weights (2 percent) on exposures to CCPs.  But an analysis by JP Morgan suggests that actual risk weights are likely to be far higher:

New capital rules outlined under Basel III are designed to incentivise the use of a CCP by levying a relatively small 2% risk weight against a bank’s exposure to a clearing house. This charge is much lower than the punitive charges proposed against traditional bilateral non-cleared trades and is designed to make clearing more financially attractive.

However, in-depth research by JP Morgan analyst Kian Abouhossein and his European banks team has cast doubt on this presumption. Taking a hypothetical clearing house that is only 45% funded against its theoretical capital requirements, they argue that the move towards central clearing could in fact prove far more costly under the new rules than initially thought.

This is because the new Basel III rules are expected to require a higher risk weight for exposure to central counterparties that may be regarded as underfunded; the rules will also levy a higher charge depending on whether the ultimate counterparties to the trade are clearing members, or clients of clearing members. Banks that clear trades on behalf of clients will also be required to take credit valuation adjustment charges against those clients which represent a measure of potential loss in the event that client counterparty goes bust.

In summary, JP Morgan finds therefore that the proposed floor 2% risk weight can only be attained under specific circumstances. In reality, the bank argues, the real risk weighting could shoot up dramatically.

So on the one hand, global regulators are trying to encourage the movement of trades to CCPs, but other global regulators are devising rules that will (unintentionally) make CCP exposures extremely expensive.

I am sure this process of setting prices for counterparty risk will turn out just swell, and lead to an efficient allocation of  these risks.

All these various efforts to regulate margins and capital weighting for counterparty exposures are a species of centralized price control.  All such schemes are doomed to failure.  Doomed.  The regulators lack the information to determine the right prices, and are in fact at an information disadvantage relative to private actors, so these schemes inevitably result in substantial losses arising from adverse selection problems.  Moreover, it is grimly ironic that these schemes are touted as a means of reducing systemic risk, when in fact they are far more likely to create systemic risks.  As I’ve noted repeatedly (and as others, such as Roberta Romano have also pointed out), these regulated pricing schemes tend to encourage everyone to load up on the same risks, and it is these correlated risk exposures that create systemic risk.

These global Sorcerer’s Apprentices believe that they are preventing the next crisis.  It is more likely that they are casting the spell that will bring it about.

As I’ve written before, there is good HFT and there is bad HFT.  The crucial policy choice is how to encourage the former and discourage the latter.

As I’ve also written extensively, going back to the very first days of the blog, many of the problems with electronic trading are best addressed by exchange pricing policies.  In particular, to the extent that abusive trading strategies involve distinctive patterns in orders and cancellations, exchanges can devise pricing structures that make it costly, and perhaps prohibitively so, to utilize these strategies.  Exchanges can also implement pricing strategies that encourage beneficial HFT strategies that increase market liquidity.  Although it would be stretching it to say that exchanges internalize all of the costs and benefits associated with deterring abusive and promoting constructive HFT strategies, they certainly have a far more powerful incentive to get it right, and far better information and knowledge, than does a regulator.

Exchanges around the world, and in different asset/instrument classes, are indeed responding to development.  The latest is the Oslo Bors:

Oslo Bors will issue punitive charges to traders if they send too many orders into the exchange that do not result in deals being done, as the industry seeks to crack down on the practice of “quote stuffing”.

. . . .

Bente Landsnes, chief executive of Oslo Bors, said: “A market participant does not incur any costs by inputting a disproportionately high number of orders to the order book, but this type of activity does cause indirect costs that the whole market has to bear.

“The measure we are announcing will help to reduce unnecessary order activity that does not contribute to improving market quality. This will make the market more efficient, to the benefit of all its participants.”

Oslo Bors’s action is just another example of organizational and strategic innovation in response to a technological shock.  With many exchanges introducing such strategies, they will learn from each other’s experiences, and use this knowledge to refine their strategies.

The demands for regulatory actions against HFT will no doubt continue despite the actions of exchanges to price utilization of their systems in ways that promotes liquidity and deters abuse.  This is because, as is almost inevitably the case with regulation, many of the demands for intervention are self-interested efforts to hamper more efficient competitors.  HFT has undercut many traditional liquidity suppliers, and made their skills obsolete.  As surely as day follows night, and as reliably as the sun will rise in the east tomorrow, this process of creative destruction is leading those on the destroyed end of the process to importune governments to hamstring those on the creative end.

And spare me the nostalgia for the old floor days.  There was a lot of corner cutting-and worse-on the floor, and many abusive HFT strategies have clear parallels in abusive strategies that were used by floor traders.

In a very ironic twist, this debate brings to mind two conversations, held more than ten years apart, with a legendary trader.  In the circa 2000 conversation, he welcomed the advent of electronic trading because he believed that electronic trading leveled the playing field.  He said he was tired of “getting raped by the floor.”  In the circa 2011 conversation, he lamented the rise of HFT, because he couldn’t make money in the new electronic age.

That’s creative destruction at work.  Yes, the innovations are not always-in fact, never-entirely beneficial.  But remember that these innovations destroy incumbents, and are especially effective at doing so when they result in substantial efficiency gains. Thus, the innovations that reduce costs most often generate the greatest hostility-and hence the most insistent demands for regulation by those the innovation displaces.

Since the innovations often do have some negative consequences or uses, those crying for regulatory intervention often have examples to bolster their case. But as the actions of Oslo Bors and other exchanges illustrate, market participants have an incentive to devise means that mitigate and perhaps eliminate the negative effects of the innovation.  Market participants also have legal recourse to attack others.  The proper scope for prescriptive regulation is limited to those effects that market and legal responses to the innovation cannot address.  And even then, it is imperative to be circumspect about regulatory responses, given the susceptibility of regulators and legislators to self-interested efforts to hamper competition and more efficient competitors.

The Morgan trade that has roiled the bank, and arguably more important, the politics of banking, is coming into clearer focus.

What transpired appears to be a classic collection of trading and hedging SNAFUs.  There are two different issues that should be distinguished.  The first is the motive for the trade, the second is its structure.  The underlying motive makes sense at an abstract level, but the structure was FUBARed.  But once the structural issues are considered, one must seriously consider whether the motive, however attractive in the abstract, is at all feasible, especially for a behemoth like Morgan.

Morgan was apparently looking for a systemic risk hedge, something that would protect its huge exposure to corporate default risk against a Eurocrisis, a dramatic weakening of the US economy, etc. In the abstract, this is a laudable goal.  In the abstract.

Given this objective, it put on a trade in tranches of the IG.9 credit index.  These tranches are very sensitive to credit conditions.  What’s more, their valuation and risk are highly dependent on correlations.

Crucially, given the sensitivity of the tranches to credit conditions, to maintain the desired hedge Morgan had to dynamically manage the position.  It managed the risk by selling protection on the IG.9 index.  Crucially, the structure of the position required Morgan to sell protection as credit rallied.

And credit indeed rallied, due to the ECB’s aggressive actions at the end of 2011.  So Morgan had to go into the market big time, and sell more and more protection.

By doing so, it ran into all the curses that beset dynamic hedges, especially somewhat dirty ones in which what is being hedged (the tranches) and the instrument being used to hedge them (the index) have different sensitivities to parameters-correlations, in this instance-that are themselves moving randomly, and moving a lot.

The hedging instrument was relatively illiquid, meaning that it was prohibitively costly to adjust the hedge in response to every move in the relevant prices and parameters.  But given the structure of the position, failure to adjust continuously gives rise to hedging errors that work against the position. Its value was also buffeted by changes in the crucial parameters.

Moreover, Morgan’s very size worked against it.  Dynamic hedges chase the market: you are buying when prices rise and selling when prices fall.  This is how you pay for the hedge.  But when for a bank as big as Morgan, its hedging trades exacerbated the adverse price movements.  This made the hedge far more costly than a standard model, which presumes that prices move exogenously and are not affected by the trades of the hedgers, would predict.  Morgan’s price impact was revealed by the divergence (“the skew”) between the price of the index and the prices of the underlying credits.

Morgan found itself trying to navigate between the Sybil Scylla of holding an unbalanced position that subjected the bank to market risk (in movements in the index as well as to movements in the crucial parameters) and the Charybdis of massive transactions costs inherent in trading in relatively illiquid markets in immense size.  And in its attempt to navigate that divide, it apparently was bashed by both monsters.

Moreover, once it was in the position, there was-is-no obvious way out, especially given the fact that now everyone and his extended family is aware of Morgan’s predicament.

Looking at all this reminds me of the portfolio insurance debacle on Black Monday, 1987, when dynamic hedging strategies blew up spectacularly.  Morgan has been a one bank portfolio insurance wrecking ball.  A poster child for what can go wrong with dynamic hedges that make sense in a frictionless, complete markets, BSM world, but which can go horribly, horribly wrong in messy reality, where markets are incomplete and illiquid.

Indeed, all of the potential problems with dynamic hedges were/are present in spades for this particular transaction.  Most notably, dynamic hedges are major liquidity users.  Morgan was trading in relatively illiquid products.  Moreover, the risk that Morgan was hedging against was also correlated with liquidity, which is a wrong way risk from hell (which portfolio insurers also found out to their dismay in ’87).  The position was also highly sensitive to parameters-correlations that are (a) hard to estimate accurately, and (b) quite volatile, especially in the very conditions that Morgan was purportedly hedging against.  Furthermore, all of these problems were exacerbated to an extreme extent by the size of the positions and the trades.

A couple of broader points deserve comment.

First, this episode indicates that there is a source of scale diseconomies in banking.  You can be too big for your own good-and your own safety.  So what is to be done about that?  Of course the immediate response-as predicted here-is to pile on more regulations, something that the administration is pursuing furiously, in its tried-and-true let-no-crisis -go-to waste fashion.  But the market imposes its own discipline.  Morgan’s stock price has fallen substantially, its credit rating has been cut, and its financing costs have risen.  These all limit the bank’s ability to grow further, and indeed will likely lead to some contraction in its size. Moreover, the demonstration effect will lead the markets to evaluate the costs of size across financial institutions generally, leading to adjustments in the cost of capital based on updated information about the real costs large entities incur to manage risk.

Second, although hedging against systemic risk sounds superficially attractive, Morgan’s experience, and a little reflection, suggests that the ability to do so is chimerical.  Systemic risks, by definition, affect everybody in the system.  They can’t be diversified away.  Everybody wants to shed them, so they are priced in equilibrium.  You have to pay to get rid of them.  Morgan apparently underestimated the cost of paying other market participants to take on this risk from them.  In part, this was because the need to trade dynamically in order to put on the hedge meant that there wasn’t a sticker price, paid up front, to get someone to take on the risk.  Instead, the cost was paid day after day, via the market chasing, slippage, and transactions costs associated with the trading strategy.  Like portfolio insurance, it looked cheap on the white board or the computer screen, but turned out far more expensive in reality.

This is particularly true for a big, systemically important institution that has to trade in large size to implement such a strategy.  This size magnified all of the pitfalls of dynamic hedging.

In essence, Morgan put on the trade because it wanted to shrink its exposure to certain risks.  It did so by implementing a dynamic trading strategy, which turned out to be a very costly way of doing that.

So how can big banks shrink their risk exposures, if not via dynamic derivatives trading strategies? By getting smaller.  By shrinking their balance sheets.  The market price responses to Morgan’s revelations are likely to lead to that very result, not just for Morgan, but for other big banks as well.  Just as portfolio insurance implemented by dynamic trading shrunk significantly once its true costs were realized, the same thing is likely to happen here.

Attempting to regulate bank activities via Talmudic-and often nonsensical-distinctions between “hedging” and “prop” trades is a fool’s errand.  Hedges can go horribly wrong.  Moreover, quite perversely, regulatory burdens actually tend to create compliance overhead costs that tend to encourage size; the advantage that big institutions have influencing regulators accentuates this effect.  Some combination of capital requirements (with devilish details) and market discipline is a better way to control bank size.

Which means that there is a positive externality to Morgan’s struggles.  Its travails demonstrate vividly the costs of size.  Morgan apparently underestimated the cost of managing risk exposure, and its big loss not only is making it aware of the true cost, but is educating the market as well.  This will affect the cost of capital not just for Morgan, but for all banks, and in a way that will impose a cost on size and complexity.  It is unlikely that this higher private cost will reflect completely the social costs of size, but it is certainly to be welcomed.

The J.P. Morgan situation continues to metastasize.  As I suggested in my first post, its biggest effect is regulatory/political.  Yes, $2 billion is a lot of money, but it in no way threatens JPM in the slightest.  But the political and regulatory aftershocks are massive. This has changed the entire financial industry regulatory/political dynamic.

The contention focuses on the Volcker Rule, and in particular the “portfolio hedging” exemption. Look.  Financial institutions are portfolios of assets and liabilities.  From a systemic risk perspective, you care about the probability that the value of a big bank’s portfolio of assets will fall below the value of its liabilities-or that funders fear that it might, and hence refuse to rollover the firm’s debt, leading to a liquidity crisis.  What you should care about is the risk of the portfolio.

Derivatives trades are typically the most efficient and rapid way to adjust that portfolio risk up or down.  To evaluate a particular derivatives trade, you have to evaluate its effect on the risk of the entire portfolio.  It makes no sense to evaluate a derivatives trade as a “hedge” solely by pairing it up against another individual transaction.  This is particularly the case when you are talking about macro risks, like broad conditions that affect creditworthiness of entire continents.  Why wouldn’t you hedge macro risks with macro hedges?

So the questions become: How do you evaluate the effect of a trade on the risk of a portfolio? Does the return justify any additional risk (for risk minimization is decidedly not the appropriate objective function)? Can regulators evaluate the risk better than financial institutions themselves?

And there’s the rub. Morgan’s story is thats new risk measurement model deemed the trade as risk reducing.  But the trade didn’t perform as the model said it should.  So Morgan went back to the old model, which showed it to be far riskier than the new model.  Under this interpretation, risk was assumed unintentionally, due to incorrect modeling.  That’s quite a different thing from a speculative punt.

There are many ways that could have occurred, some of which reflect discreditably on Morgan, others not.  My guess is that the new model was seriously wrong about correlations.  These are devilish hard to get right generally, and in credit particularly.  Moreover, any VaR-type model almost always fails to capture properly the effect of position size on risk.  These models take price processes as exogenous, but if you are big enough that’s not true.  The big trader’s actions can themselves cause the model to give wildly misleading results.  Any risk model has flaws, but these flaws are less severe for price takers than price makers.

And as for alternatives to VaR, such as conditional expected loss measures, please.  They are just different ways of representing the same underlying information, and rely on the same assumptions. I guarantee that if Morgan’s VaR-esque new model underestimated risk, any other metric, such as conditional expected loss, would have done so too if it was based on the same underlying distributional assumptions and parameter estimates. Indeed, some of these estimates are more sensitive to distributional assumptions than VaR, because they depend on modeling of behavior of the tails.  They tend to go further beyond the available data than VaR models.

And could a regulator do any better? Yeah.  Right.  Get serious.

Can simple rules, such as “any trading position must be shown to reduce a specific transactional risk” uniformly lead to better results?   Not, in my opinion, when you are talking about complex financial institutions with diverse portfolios.  Indeed, although trades characterized as “portfolio hedges” can be used for “speculative” purposes (though again speculative trades can be justified if the return is sufficiently large), constraining the ability to manage risk can lead to riskier and less profitable banks, rather than safer ones.

In brief, the “hedge vs. speculation” distinction is simplistic. As a result, things like the Volcker Rule, which are predicated on that (and related) concepts, are not going to reduce systemic risk, and are in fact likely to increase it.

Jamie Dimon of course attacked the Volcker Rule vociferously.  Which is why the big loss is such a political issue.

Dimon is personally in a very bad spot.  Very bad.  He has already executed the vertical chop: those involved in the trade 3 levels down the org chart have resigned or been fired.  The fate of the entire London office is up in the air.

Dimon is between the devil and the deep blue sea.  If he admits that he had hands on involvement, he is directly culpable-and if his subordinates must go, why shouldn’t he?  Conversely, a claim of ignorance is hardly creditable to him.  But it is probably the best of the two alternatives, and it seems to be the one he is taking.

Along these lines, Dimon said something quite stunning on Sunday (h/t R):

He said he didn’t know if his firm broke any laws or U.S. Securities and Exchange Commission rule.

He didn’t know whether laws had been broken. A clear confession that he doesn’t really know what went on in London-or is pretending not to know.  Knowing what went on exactly in London is hard: knowing whether a crime was committed should be easier than that.

This is not a good position for a CEO to be in, especially one like like Dimon.  Given the intense scrutiny that he and Morgan will face, and the frenzied political environment in an election year, and the Occupy insanity, he is in a very vulnerable position.