Streetwise Professor

Yesterday’s news was dominated by the Facebook IPO.  I don’t have much to say about Facebook qua Facebook or IPOs: not my area.  I will just say that it is hard to justify the valuation.  The only rationalization I could provide is that the $100 billion plus market cap is the premium on the option to monetize its huge base of users.  I say option, because its clear that the existing sources of revenues can’t support the stratospheric evaluation.  There is a tremendous amount of uncertainty about the ability to devise such a monetization strategy, and that can support some high option-driven valuation-but $100+ billion?  I’m skeptical.  (And if there are doubts about the ability to monetize Facebook’s user base, what does one even say about Twitter?)

I will comment on companies associated with the IPO that are closer to my comfort zone: NASDAQ and the underwriters, specifically Morgan Stanley.

The IPO was beset by technical hitches, with a delayed opening, difficulties in handing the avalanche of orders in the opening process, and a consequent delay in sending out trade confirmations-something that is guaranteed to generate extreme angst among those trading the stock.

The post-open trading was also chaotic, with crossed and locked markets.

This suggests that despite its extraordinary efforts to prepare, NASDAQ had insufficient capacity to handle the huge interest in Facebook.  This, in turn, harkens back to an issue that was the subject of the first SWP post, almost 6.5 years ago: exchange capacity and capacity outages.  I seriously doubt it would be efficient for NASDAQ to invest in sufficient capacity to handle such an extreme case without any hitches.  That is, in an efficiently scaled system, there should be occasions when capacity is maxed out. It doesn’t make sense to build capacity to handle all contingencies.

The benefit from investing in the additional capacity to handle the FB IPO would redound almost exclusively to FB and those who wanted to participate in the IPO opening.  It doesn’t make any commercial sense for NASDAQ to pay for that.  The investment is pretty much specific to FB, so if it wanted the additional capacity, it should have paid for it.

This raises another issue that I’ve discussed from time to time, although in a slightly different context: the pricing of exchange services.  What should NASDAQ have charged to handle the IPO, and what price would FB have been willing to pay to reduce the likelihood of SNAFUs?  This raises some interesting industrial organization issues as well, as in this context it involves the arms-length negotiation of a specific investment.  Integration is often the efficient response to such a situation, but that appears problematic to me in this context.

Insofar as the secondary market trading is concerned, this is an example (the Flash Crash being another) of the implications of the SEC’s “information and linkages” market structure choice inherent in RegNMS.  This approach results in fragmentation and locked and crossed markets during periods of extreme market activity.

The alternative is a central limit order book, but a CLOB would likely have experienced different problems, likely similar to those experienced in the NASDAQ open, since the huge amounts of trading activity likely would have taxed and perhaps overwhelmed the CLOB’s capacity.

Again, the exceptional nature of the FB IPO would have likely stressed any market mechanism.  What happened yesterday is how the information-and-linkage approach behaves under stress-fragmentation and crossed markets.

On to Morgan Stanley.  It is evident that the underwriters-of whom MS was the leader-bought large quantities of stock to support the $38 issue price.  The exact total amount, and the amount bought by any of the underwriters, is not known, but it could represent billions of dollars.  The underwriters can’t afford to grant free puts for very long, so it is quite possible that Facebook will trade below the issue price, thereby imposing losses on the underwriters.

This experience triggered my historical reflexes, and I thought about the experience of another legendary underwriter-Jay Cooke. There are some superficial similarities between Cooke and MS.  I don’t take them too seriously, but one can hear echoes.

Cooke was the lead underwriter of another innovative entity with a dicey revenue model: the Northern Pacific Railway, of which Cornelius Vanderbilt said “you can’t build a railroad from nowhere to nowhere.” Jay Cooke & Company underwrote sales of the railroad’s bonds, and ended up taking ownership of large quantities of them, in anticipation of selling them-and selling them particularly to Europe.  But it proved unable to market the bonds, due in large part to economic shocks emanating from Europe: there were several bank failures in Europe in Vienna that spread to other European countries.  Moreover, there was a monetary shock emanating in Germany-namely, that country’s decision to cease minting silver coins-that had averse consequences for the US. Furthermore, Germany demanded a large reparation from France in the aftermath of the Franco-Prussian War, which was also financially destabilizing.

Once Cooke & Company’s depositors became concerned about the company’s inability to market the bonds, a run commenced, and the firm suspended and went into bankruptcy. This sparked a broader financial panic in the US-the Panic of 1873.

So, in both 1873 and 2012 a big investment bank takes a large position in a company with a highly speculative revenue model, against the background of financial crisis in Europe.

We saw what happened in 1873.  We will see what will happen in 2012.  Almost certainly the outcomes will be quite different, because even if MS took a multi-billion dollar stake in Facebook, this is not a bet-the-company investment in the way that Cooke’s foray into the NPRR was.  It may cause some discomfort for MS and its shareholders, but likely nothing more than that.

And of course, the biggest difference between 1873 and 2012 is that there was no Fed in 1873. Again, I do not consider it at all likely that Morgan Stanley would be mortally harmed even if Facebook stock falls well below $38, but if it were the post-Lehman-we’re-not-going-to-let-that-happen-again-Fed would no doubt ride to the rescue, raising the question: would it take Facebook shares as collateral?

This seems like a highly speculative question, and perhaps even an idle one, but in these times one cannot rule out anything, no matter how fantastical it appears.

Addendum: The most likely reason why the Fed would be taking FB shares as collateral is if Europe well and truly implodes, and threatens to take down US institutions along with it.  The risk of a FB position alone is not great.

I have often noted that Russia is a high beta economy.  This reflects, primarily, its extreme dependence on raw materials generally, and energy particularly.  Economic contraction reduces the demand for, and prices of, these commodities, and this hits Russia hard.

Witness the events of recent days.  Europe is re-entering crisis mode, with Greece teetering again, and Spain-a much bigger problem-also in extremis.  China is exhibiting serious signs of weakness.  As a result, commodity prices are down, about 7 percent this month (as measured by the DJ commodity index).

And Russia is down along with commodity prices:

While most countries’ stock markets have been hammered amid Greece’s sovereign-debt woes and its possible exit from the euro, the plunge in Russian stocks—which have dropped from their 2012 highs by nearly twice as much in percentage terms as the MSCI Emerging Markets Index—has been particularly fierce.

“Such is the level of risk-phobia in the world right now, and Russia, despite the generally positive domestic backdrop and very cheap asset base, is viewed as being the most at-risk economy in the world,” said Chris Weafer, chief strategist at Troika Dialog, an investment bank in Moscow.

Moreover, capital outflows are continuing:

Activists who clashed with police before Putin’s May 7 inauguration are protesting non-stop in Moscow, using the Occupy Wall Street movement’s tactics. As the benchmark RTS equity index entered a bear market, Russia-focused equity funds recorded $251 million of outflows in the seven days to May 9, the most this year, while China lost $127 million, India $148 million and Brazil $167 million, EPFR Global data show.

Further:

Russia’s top central banker warned on Wednesday that capital flight is a “serious problem,” as newly released figures showed $42 billion has left the country in the first four months of the year.

“Capital outflow continues to be a serious problem for the Russian economy,” the central bank’s chairman, Sergei Ignatyev, told Russia’s lower house of Parliament.

The ruble is weakening too, down about 5 percent this month.

This follows a first quarter in which Russian growth exceeded expectations.  But that was also a quarter in which oil and commodity prices spiked.

One thing that complicates interpretation of these figures is that multiple things are going on. The first is the economic problems in Europe and Asia.  The second is the ongoing political uncertainty in Russia.  Both are pushing money in the same direction-out of Russia.  The difficulty is trying to determine how much of the outflow is attributable to each of these factors.  It is quite remarkable, however, that the election and the ebbing of the protest movement has quite evidently not staunched the outflow.

With respect to the outflows, Russian officialdom is whistling past the graveyard-and blowing smoke up everybody’s collective rear. Yeah, they say, we’ve had problems-but Happy Days Are Around the Corner!  The flows will reverse manana.

I howled when I read this:

Russian financial officials have assured that Russia would start seeing capital inflows in the second half of the year after the new government is formed. Prime Minister Dmitry Medvedev has submitted candidates for the cabinet to President Vladimir Putin for him to sign on the list of new ministers by the end of the month.

Yeah.  It’s all that uncertainty about the cabinet that is driving money away.

To the extent that the outflows are politically driven, rather than a manifestation of the high beta effect, the exact opposite is true.  It is the realization that the Putin Purgatory, with all its legal nihilism, is here to stay that is the problem.  Investors-including, it should be noted, many rich Russians-have seen the future, and know it won’t work.

When a strong world economy or supply shocks keep commodity and energy prices high, the high beta effect covers a multitude of sins in Russia.  When these factors reverse, things get double ugly.  There is the ugliness of the natural state, Putin’s Purgatory. That is, sadly, arguably a constant.  Then there is the ugliness that comes with a commodity price-crushing world economic contraction.

The thing to watch going forward is how these things interact.  Economic weakness resulting from the high beta effect will impact politics in Russia-and Putin will react to that in ways that will likely exacerbate Russia’s politically-grounded economic difficulties. The populism and promises of government largesse that Putin used to campaign for re-election will not be sustainable.  What will the popular backlash? How will Putin hit back?

Meaning that if the world economic situation continues to deteriorate, the brittleness of the Russian natural state will be tested.

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.

Spain’s banks, especially the cajas, are in desperate trouble due to that country’s real estate boom and bust.  The banks hold large quantities of mortgages and loans to developers that are seriously underwater, a fact that the banks have been very slow in recognizing-as is almost always the case.  Don’t recognize the losses, you can perhaps benefit from a miracle turnaround in the market in the future.  Recognize them, you are out of business immediately.

Spain’s government has responded by forcing the banks to write down their mortgage assets, and to raise more capital.  The problem is that capital is a buffer against possible future losses; you can’t get anyone to contribute capital to pay for losses already realized.  So where is the money going to come from?  Because private capital is not going to fund past losses, the only real candidate is the Spanish government, but it has agreed to stump up only 15 billion Euros, far short of the 50 billion Euros that market participants deem necessary.  But Spain, with nearly 25 percent unemployment rate and an ongoing recession (with a forest decline in its economy of 1.8 percent this year) is unable to fund the amount necessary to bailout the banks.  Its bond yields already top 6 percent.

Which means that the money has to come from outside . . . the ECB or the European Stability Mechanism.  But the Germans have already made it clear they are not going to permit the use of ESM funds. Much more ECB support is also unlikely.

So how is this going to work, exactly?

Spain is also ordering the banks to dump their bad real estate loans into asset management companies (an expedient that the Chinese have used on multiple occasions).  But that can lead to fire sales (if the asset management companies dump the assets) which exacerbates the underlying problems.  And this just moves the losses around.  It doesn’t eliminate them.

So Spain is in deep trouble, and there is no obvious way out.

All this is happening, moreover, at a time when Greece is spinning out of control again, and quite predictably.  There was no way to commit the Greek electorate to adhering to any deal negotiated with Europe.  And they are quite clearly rebelling at the idea, confronting Europe with the choice between a Greek exit from the Euro and shoveling more money down the rat hole.  There are already reports that the Troika is willing to make concessions on the recently negotiated bailout deal, concessions that will almost certainly have to be followed by more concessions, and yet more.

This all resembles a disaster like Chernobyl,or a plane crash, where there are cascading failures.  Perhaps one of them would be containable, but multiple failures-especially those that feed back on one another-are far, far more difficult to manage. I keep looking for a way out.  Not seeing it.

There is little new to report on the multi-billion JPM loss.  The big question is what position JPM has remaining, what it plans to do with it.  The bank probably has the staying power to hold on for awhile, and can avoid dumping it on the market a la Amaranth/Brian Hunter or LTCM.  But as Jamie Dimon admitted yesterday, this will expose the bank to considerable volatility going forward.

The exact transaction/transactions at issue is/are unknown, so it is impossible to make a definitive evaluation.  What is known does permit some conclusions, however.

The first is that whatever the position is, it is big.  And size is often a liability.  The bigger the position, the bigger a liability it becomes.  Market judo uses your size against you.  For if things don’t go your way, it is hard to exit a big position, and even attempting to do so can exacerbate your losses.

Reading this, I didn’t know whether to laugh or cry (h/t R):

Senior traders and dealers described Iksil as a “bright guy”, who was faithfully executing strategies demanded by the bank’s risk management model but who may have simply misjudged the amount of liquidity in the markets.

How many traders could have this as their epitaph: “He Simply Misjudged the Amount of Liquidity in the Markets”?

You can just imagine the Wily Coyote moment. You try to get out of a position and find out you have just run over the cliff and there is nothing to catch your fall, as liquidity disappears from beneath your feet just when you need it.

A couple of other points.

First, there is a lot of pixels being strewn about as to whether the Morgan trade was a prop trade or a hedge, and how this relates to the Volcker Rule.  Well, that’s a big part of the problem.  There is no hard and fast line.  As Holbrook Working pointed out long ago, what is conventionally called hedging is really speculation on the basis.  And if your basis position is big enough, and the basis is volatile enough, you can lose a lot of money.

The first member of the billion dollar club-Metallgesellschaft-was allegedly hedging.  It wasn’t doing basis trades, per se, but had a huge calendar spread position. Ditto Amaranth. LTCM’s “convergence trades” (that became divergence trades) were essentially basis trades that could be characterized as hedges.

It’s all about size and capital and correlation and volatility.  The right (or should I say wrong) combination of those factors-and particular a good dose of sh*t happens-can create a lot of risk, and result in big losses.

This is why much of the discussion of the Volcker Rule is quite beside the point.

Second, there is the question of when things went pear shaped, and when Jamie Dimon knew they were going pear shaped. He was very contrite about, and critical of, the trade yesterday.  He vigorously defended it in April.  If he got the bad news sometime between the defense and the criticism it’s one thing.  If he defended the trade in April knowing that it was already losing, or was substantially riskier than he let on, and that the firm was looking for the exits, it’s quite another.

If it was the latter, you can imagine his dilemma. If he failed to defend the trade vigorously, it would have no doubt resulted in a self-fulfilling disaster, as everyone would have anticipated the impending unloading of the position and traded against it.  But if in defending the trade he made misleading or knowingly inaccurate statements, he would face serious legal problems.

Again, right now there are only questions.  But no doubt there will be intense scrutiny that will lead to many uncomfortable political and legal moments for Dimon, and for JP Morgan as a whole.

JP Morgan just announced a huge-$800 million $2 billion!-mark-to-market loss in the synthetic credit portfolio run out of its Chief Investment Office.  Bruno Iksil-“The Whale”-is almost certainly wearing the collar for this bloodbath (uhm, I think that’s a mixture of 3 metaphors-whatev).

Some immediate reactions.

1. Whales get harpooned.  No matter how big you are, the markets are bigger.
2. Traders can move prices by putting on big enough trades.  It’s not moving prices that is the trick: it is profitably closing big positions after you moved the price.  There has to be some asymmetry.  If your buying drives up prices, your selling to exit a position is almost certain to drive them down-and indeed, drive them down more due to market frictions.
3. That is, to be profitable, Whale Trades require an exit strategy.  Corners have an exit strategy-but even these are not foolproof, as many cornerers have found to their dismay.  Some other manipulative strategies, such as moving a price that affects the payoff to a related derivative, also have an exit strategy.  But just flexing, just moving a price by trading in huge size, is vanity and usually results in losses because there is no exit strategy. Like the Duke of York, you can march up the price hill by buying a lot, but you end up marching down the hill again when you try to sell.
4. Banks can kiss any weakening of the Volcker Rule adios! Indeed, the rule is likely to be tightened considerably.  I’m sure Jamie Dimon is getting lots of love from his fellow CEOs.  Lots.
5. Speaking of Dimon, I wonder if he can kiss his job good bye.

Election-related news in Europe and Russia is dominating the headlines, and I’ll devote a post to each.

First, with respect to Europe, the Socialist Hollande won the presidency, and the ruling coalition in Greece did not win enough seats to continue the current arrangement.

There was much rejoicing in Paris.  That will not last long, when reality rears its ugly head.  The hangover from that celebration will be horrific indeed.

For Hollande faces a very ugly choice. If he governs as he campaigns with increases in taxes that Obama can only dream about and more generous benefits for civil servants, he will face a bond crisis before too long.   If he concedes to the fiscal realities facing his country, and Europe generally, he will face a political backlash for his betrayal.  France has a long tradition of politically disruptive civil unrest, mainly emanating from segments of the population that are the base of Hollande’s support.  If he crosses them by capitulating to “the markets” and “finance” and even (per NPR “Wall Street”-what, no financiers in Europe?), these erstwhile supporters will be in the streets.

Hollande and others in Europe talk about replacing austerity with growth, growth, growth.  How, exactly?  What is the magic growth formula?  If it is so obvious, why hasn’t anybody found it before? Has Hollande captured a unicorn whose horn will create a spurt of growth that will catapult France (and Europe) out of its current recession and fraught fiscal situation?  If debt and more government spending are the secrets to growth, why aren’t France and Europe booming already, given they’re neck deep in both?

“Growth” is a code word, a euphemism, a lie, for debt funded “stimulus”.  It describes a glittering goal in order to convince people to agree to dubious means.  But even if you believed that stimulus could produce growth, how is this at all possible if the markets are almost certain not to fund this additional spending?

Yes, everybody wants growth.  No disagreement there.  How to get it is the problem.

In countries like France, increasing growth has to come from the supply side-cutting onerous restrictions, particularly in the labor market, combined with a credible plan to ensure that future spending growth is fiscally feasible.  If these things can be done, it is possible-just-to get decent growth while avoiding short term austerity.  Germany implemented labor market reforms in the 2000s, and has reaped the benefits. This is what Italy is trying now, with uncertain prospects for success.

But these things are highly unlikely to happen in France, or in Europe more broadly.

Unions and even some corporate interests will defend the existing labor market institutions and other regulatory restrictions to the last ditch.  Indeed, Hollande’s base will not meekly accede to such changes. Maybe, just maybe, he could play Nixon in China, but that seems wildly implausible.

And credibility about future fiscal prudence is almost impossible to achieve.  The promises can be made today, but when time comes to deliver those in charge of implementation face acute risk of being thrown out of office.  Indeed, the Greek elections illustrate this dynamic graphically, and in record time.  The parties that agreed to the bailout terms suffered badly in the election, and now those already dubiously sufficient terms are at risk of being repudiated, mere weeks after they were agreed to.

All of these realities will be impossible to ignore in very short order.  I do not see how Hollande, or the Greeks, or the Euros collectively, can navigate between the Scylla of the bond markets and the Charybdis of mass protest in the streets.  Indeed, by raising expectations that have induced near euphoria in some quarters in France, Hollande has made the already narrow space between these mortal hazards narrower still.

So where does it go from here? Back to the old standbys.  Importuning the European Central Bank to loosen, and begging, pestering, cajoling, and guilting Germany into putting its taxpayers to work for everyone else in Europe.

Neither alternative is at all palatable to Germany.  Merkel will be caught between her own government-wrecking monsters: the frantic demands of the rest of Europe and the steadfast refusal of Germans to sacrifice their own high incomes and generous benefits for ungrateful (and often hateful and slanderous) citizens of Euroland.

Meaning that it is difficult to see how the standbys will work either.  They depend on German surrender, and it is hard to see that happening either.

To me, it seems almost certain that the core of the European game is empty.  The demands of the various constituencies and nations in Europe cannot be satisfied given the political and economic constraints.

Wen cores are empty, things fall apart. And when something as big as the EU falls apart, the consequences are historic and devastating.

John Parsons and Antonio Mello at Betting the Business argue that the dominance of OTC derivatives is not indicative of their efficiency, but instead resulted from the banks underpricing credit risk:

The logic that OTC markets are superior only works on the premise that banks are competing with exchanges on a level playing field. But prior to the financial crisis of 2007-2008 (and until the effort to reform finance is successfully completed), the playing field has been not level: banks have enjoyed some significant privileges. Key among them was the failure of some banks and regulators to properly price the credit risk embedded in derivatives.

This is a very strong statement, and one which John and Antonio do not provide persuasive evidence.  Their evidence is a post at FTAlphaville by David Murphy, which details the history of credit value adjustments (CVA), and a BIS report.  David notes that although in the early days of OTC markets, banks did not charge for the credit embedded in derivatives, they eventually did so.  Parsons-Mello argue, based on the BIS report, that regulators lagged these developments, and did not impose adequate capital charges on OTC derivatives exposures, particularly on CVA exposures which were larger than actual default losses.

There is some empirical evidence that speaks to this issue.  Papers dating back to the 1990s demonstrated that interest rate swap prices vary with counterparty credit risk, although the effect was small primarily because netting and the fact that principal is not at risk in an IRS made the credit exposures relatively small.  Counterparty credit risk in CDS is much larger.  Recent work by Gandhi, Longstaff, and Arora found small pricing effects in intedealer CDS trades, that became larger in the aftermath of the 2008 Crisis.  They conclude that the small effect reflects the fact that most interdealer traders were collateralized, though by variation margin rather than independent amounts (the OTC equivalent to initial margin).  The use of collateralization to reduce credit exposure is inconsistent with the hypothesis that credit risk embedded in derivatives is underpriced.

No doubt Parsons-Mello would interpret the evidence differently than Gandhi et al.

Collateralization is one way to control credit exposure.  Credit limits are another.  Reducing credit limits of firms that suffer adverse shocks to creditworthiness would tend to reduce the impact of such shocks on pricing.  Since credit exposure can be managed on a variety of margins-pricing, collateralization, credit limits-just looking price effects is not sufficient to determine whether credit risks embedded in derivatives are overpriced or underpriced.

The Mello-Parsons argument depends crucially on inconsistent capital treatment across equivalent categories of risk.  It is also somewhat in tension with an argument that they have made before that collateralization mandates do not raise the costs of trading OTC derivatives.  As they have pointed out before (as have I), credit that is embedded in a derivatives trade can be unbundled into a default free (collateralized) derivative and an unsecured credit line.  If capital charges are set consistently across equivalent risks, regulations that reduce credit exposure in a derivatives trade (e.g., a collateral or clearing mandate) can and will be offset by a substitution of an equivalent form of credit, leading to little or no change in overall exposure, just a change in its composition.

There is no reason to believe that regulators set capital charges consistently.  I think that John and Antonio are arguing that they should.  I would suggest that this is an impossibility.  This has been a theme of mine in several posts relating to Basel rules (you can find more related posts by typing “Basel” into the search bar).  The capital charges are inevitably make crude distinctions between different sources of risk.  Banks who understand the true risks far better optimize their activities to take advantage of disparities between their more informed estimates of actual risk and the regulatory risk charges.  Moreover, they tend to do so in a way that is highly correlated across banks because they all face the distorted capital cost structure.  Maybe making derivatives-related capital charges more sensitive to counterparty credit risk will reduce the subsidy of risk arising in derivatives books and the risk exposure there will fall commensurately; but the resulting structure of capital charges are likely to subsidize another risk, leading banks to pile into that activity.

In other words, risk based capital charges are an extremely blunt tool. They are a form of regulated pricing, and like virtually all regulated price structures, lead to acute distortions.  I am skeptical that they are a reliable means of reducing systemic risk.  Indeed, by inducing correlated risk taking across financial institutions, they can actually exacerbate that risk. (Mello-Parsons do recognize the difficulties of setting the capital charges: I think the difficulties are so acute as to make it virtually impossible to get anywhere near right, and very easy to make big mistakes.)

Assessing a CVA-based capital charge also creates the very serious risk of inducing vicious cyles/feedback loops, especially during times of crisis.  CVA charges are based on CDS prices, and CDS prices vary not just with expected default rates and losses, but also embed risk premia and liquidity adjustments that depend on market frictions and market-wide conditions.  Put differently, CDS prices reflect default rates and losses in the equivalent measure, and the market chooses the measure.  During crisis periods in particular, as liquidity dries up and risk limits (e.g., VaR limits) bind, expected default losses in the equivalent measure rise relative to expected default losses in the physical measure, meaning that CDS spreads widen absolutely and relative to what the spreads implied by expected default losses.

With CVA-based capital charges, such widening in CDS spreads will lead to higher CVAs and more variability in CVAs, which depending on how the CVA charge is implemented, could lead to higher capital charges, or to actions intended to reduce capital charges.  Increases in capital charges raise the costs associated with outstanding positions and new deals, thereby leading to reductions in positions, increases in collateral postings, or both.  These will tend to exacerbate market stresses, as firms dump positions to reduce exposures (and CVA) and sell assets to raise cash to meet collateral calls, which will lead to additional price movements that can affect CVAs, and on and on.

Put another way, it binds regulatory capital very tightly to conditions in the CDS market.  The more concerned you are about the functioning of that market, especially during times of stress, the more concerned you should be about hardwiring regulatory capital requirements to the CDS market.

That is, like any market-price based mechanism for setting collateral or capital charges (think of VaR), a CVA-based mechanism is highly likely to be procyclical, and perhaps severely so.  This makes it a major potential source of systemic risk.

In sum, I do not discount the possibility that capital requirements led to an underpricing of credit risk in OTC derivatives, and hence caused these markets to be larger than they should have been, or would have been given requirements that discriminated accurately among different risks in banks’ books.  The evidence one way or the other is rather thin.  I am highly skeptical, however, of the ability of regulators to address this problem without creating others equally severe, given the information advantages that banks have and their ability to optimize their risk taking subject to the (distorted) structure of capital requirements.

Moreover, I am downright frightened of basing derivatives capital requirements on CVA, or any market-price based measure.  It is individually rational for banks to price using CVA, but tying capital charges to this measure will almost certainly lead to procyclical capital charges that are highly correlated across major financial institutions.  That is a very bad-and very scary-idea.

I therefore do not dismiss the Mello-Parsons diagnosis, though I am not completely sold.  I am particularly concerned that any “cure” could be worse than the disease.

Posner & Weyl are continuing to flog their idea of an FDA for financial products.

I wrote about this really, really bad idea in February.  Given the swooning over the Posner-Weyl proposal, that post needs to be re-released.  So here it is.

I don’t need to change a word.  The FDA idea is a very bad one and the metaphor is completely inapposite.  Posner and Weyl are repeating their argument, and so my rebuttal needs no change.

It is good to see that not everyone is swooning.  This blog at The Economist rips into the proposal.  Great!

But gee, the points in the Economist post seem familiar.  Very familiar.  Every damn one.  To the points I made two months ago.

Purely coincidental, I’m sure.