Streetwise Professor

May 14, 2012

Shine On You Crazy Dimon

Filed under: Derivatives,Economics,Financial Crisis II,Politics,Regulation — The Professor @ 8:33 pm

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.

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  1. Model risk is indeed the elephant in the room. The nice thing about [email protected] was that it tells you not only that you have a problem but what do about it. So if your [email protected] worsens overnight, either the market moved or your position changed. The solution in either case is to put on a countervailing trade. The trouble with [email protected] models is the assumption that such a trade is available to be done at all. The model risk was not, I think, widely understood until 2008ish.

    This was, AIUI, the reason it took the energy industry a relatively long time to adopt [email protected] JPM invented it in 1988 but it wasn’t widely used in the energy biz for another 10 or 15 years. What was the point of a [email protected] model that told you to lay off your risk by doing trades that couldn’t be done, such as in European gas, power, and coal?

    I think in the end people just shrugged and accepted their model was, well, potentially crap when you were most likely to need it.

    Dimon strikes me as one of those guys like ex-PM Gordon Brown. The latter simply hoped that everyone below him had everything under control, trousered the money, then claimed it was nothing to do with his decisions when it all went tits up. As the pointy-haired boss once put it to Dilbert, “I assume that anything I can’t do must be easy”.

    With what results we now see.

    Comment by Green as Grass — May 15, 2012 @ 7:34 am

  2. Credit Default Swaps Remain a Secret Weapon of Economic Warfare

    by Kevin D. Freeman on May 14, 2012
    JPMorgan Chase lost at least $2 billion in its failed hedging strategy not only because it was sloppy, but because it grew too big in a rarefied market of complex financial instruments that it had created.

    The strategy involved credit default swaps , a kind of derivative that was at the center of the 2008 financial crisis.

    Credit Default Swaps can be secret weapons targeted against our economy. It details who might have the motive, means, and opportunity to use those weapons. We must address this serious problem. And, we must do so soon. The weakness of JP Morgan demonstrates just how important this really is.

    Comment by Anders — May 15, 2012 @ 9:33 am

  3. I worte a comment somewhere else. Perhaps much of it is known in this blog, since SWP has spoken about some of it, at least, but I felt the impulse to respond to something relevant eslewhere, so thought of pasting it here, too:

    I’d like to add a comment or two on “hedging vs. speculation.” This is a silly distinction. While regulators should be expected not to understand it, industry professionals cannot be given a pass on this.

    First of all, on the opposite side of every hedger, in all likelihood, there is a speculator who transacts with him. So, there cannot be a hedger without a speculator. Second, hedging itself contains speculative elements – and inherently so.

    Financial markets are about managing uncertainty. If there was no uncertainty, thus, no risk, there would be no need to hedge anything. And where there is uncertainty, there is speculation.

    I can explain this on a concrete and simple example of simple vanilla options (then implications for something like CDS can be left to the imagination of the reader).

    To hedge a simple vanilla option on some underlying instrument one enters into a long or short position in that underlying (depending if it is a put or call options, correspondingly). The number of contracts in the underlying instruments one enters in, called delta, is calculated from the quantitative model. The input parameters of that model are inferred from the market observations. Market observations include a built-in information on the volatility of the underlying instrument and the risk-premium that the given market grants its participants for carrying the risk that cannot be hedged away (more about this a bit later). Those two quantities are defined by the market (for those who would expect to hear here an at-the-money vol, or historic one, or some other strange quantity, I would ask to bear with me). These two quantities are defined in the market through trading activities – as a result of the trading, speculators, yes, speculators, come to some consensus on the subject of what the corresponding forward looking volatility of the underlying instrument and the forward looking excess risk-premium granted as a compensation for carrying the unhedgable risks by the participants of the options market are. Again, this is defined totally speculatively – people agree on the price of risk through trading activities.

    Now, that means that the input parameters in the model are defined speculatively, therefore the hedge parameters are implied speculatively as well. In view of this, separation of hedging from speculation is a pure grotesque – if we were to call things by their names.

    Now, the standard risk-neutral pricing paradigm (a la Black-Scholes-Merton) is built on an assumption, that you can instantaneously and costlessly hedge your option with appropriately many contracts in the underlying instrument, and therefore replicate your option with cash and the underlying instrument. This is the silliest arguments of all – as basic and as fundamental it is for pricing derivative instruments – and this is where the whole mess and misinterpretation starts from. Even if you would assume there is no ambiguity associated with the interpretation of volatility and its dynamic, there is no such thing as delta-hedging, if one as talking about eliminating the risk associated with the variability of the underlying instrument. If you could have it meaningfully done, why would you have a gamma exposure in the first place? Second, if an option can be replicated with a cash and underlying instrument position, then it is a redundant class of assets – why to introduce something so complex, relatively speaking, and trade it, when all it is is a combination of a cash and another basic instrument?

    So, again, talking about hedging, as if eliminating risk is just outright silly. It is a different story that you can perhaps hedge the exposure to a large degree (in liquid markets). Yet, you will leave some hedging gap behind and the risk-premium associated with baring that gap will, in fact, explain the volatility skew among other things.

    Now, back to JP… Even if we assume that whatever they did, they did with the understanding of the above, and I strongly doubt it, when you put such a large position in, you move the underlying market – and it is very likely at some point you move it against your derivative position. And I am not aware of any derivative pricing model, and I am convinced that neither JP Morgan, nor Goldman, for the sake of conversation, have such sophisticated models in place, whatever you might price with a naive model should be called at best naiveté…

    So now we can go back to VaR with this understanding perhaps. What is it that one expects from VaR? At one point in the second half of 90s, JP showed down the throat of the industry, first by shoving it down through the throat of the regulators, VaR. It was one of the biggest forgeries of the time. I recall a conversation with a top risk manager at Enron in early 2000s. We were discussing their VaR system, which they were taking pride in. I asked how they estimate the correlations, for example… She hesitated, and stated something like this, “we start from a guess, then we start negotiating with the risk measurement and compliance guys, and eventually converge to mutually acceptable correlation estimates.” I asked, “then why not to begin with the negotiation of the VaR itself, and save ourselves the whole heartburn?” That was the last time Enron spoke to me… 😉

    This turned to be a long comment. Perhaps it sufficiently conveys my reservations.

    The bottom line is, perhaps the regulators are going to take advantage of the situation in the spirit of “no crisis should go without taking advantage of it…” But the thing is, speculation in financial markets is an inherent, unalienable and incurable modus operandi. Speculation doesn’t not introduce new risks. Speculation exists because there is uncertainty, thus there is risk. Speculation simply attempts to price risk and transfer it from someone who doesn’t want to take it to someone who does – albeit at a premium.

    Comment by MJ — May 15, 2012 @ 10:36 am

  4. @MJ-spot on. As the expression goes, prices depend on the measure, and the market chooses the measure. We don’t live in a BSM world, so why pretend like we do?

    The ProfessorComment by The Professor — May 15, 2012 @ 3:11 pm

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

    He might be saying he cannot make head or tail of the law. I don’t know about SEC rules, but there are a lot of US laws which are impossible to fathom, especially ones concerning imports and exports.

    Comment by Tim Newman — May 15, 2012 @ 11:28 pm

  6. @SWP I wonder how long will it take for the steward of taxpayer money, the Congress, to step in, and further increase the cost of doing business…

    Comment by MJ — May 15, 2012 @ 11:34 pm

  7. @MJ – absolutely, thought there are trade hedges that do not involve speculators, and risk reduction can occur. Maybe a better way to say this is that hedging is the process by which you chose what risks to take, and adopt strategies that change the risk profile inherent in or generated by one’s operations.

    The ludicrous accounting rules for Hedge accounting don’t make anything easier back-fitting to an r2 correlation can be ludicrous, particularly in a world where basis is – gold hedging oil anyone?

    Finally the whole measurement issue is something that comes up again and again: where a lot of data exists, it will be used even if there are huge elements that cannot be quantified but that can blow apart any analysis. Mortgage finance has been the worst offender I know of: OAS analysis prices an option that does not and cannot exist, while the CMO structure got so complicated that I called them the unknowable owned by the unknowing. The Enron story is priceless: a great example of how gross assumptions are carried to the fourth decimal place. At least it SOUNDS AND LOOKS impressive.

    We don’t live in a BSM world but everyone acts like we do, so everyone has to pay attention. If you don’t your job is at risk. That and the infinite capacity to delude ourselves that uncertainty can be eliminated or managed explains why we all run around trying to get a handle on the unknowable and “solve” the perceived problems (that may or may not exist).

    The upside of all this is that the Salvation Army has fewer quant cranks to deal with.

    Comment by sotos — May 16, 2012 @ 7:17 pm

  8. Sotos, this subject belongs to the category of “politically incorrect.” You raise it – you make enemies… enemies amongst the quants who are in business of selling their BS (no pun intended 🙂 ), risk managers, heads of trading desks, compliance guys, eventually corporate management. It is a dangerous territory. As SWP mentioned, everyone pretends this elephant is not in the room, even though everyone hears its steps and how the floor shakes underneath. But if you pretend the elephant is not in the room, you must also pretend that nothing happens when it walks over you. Well, at least quants and traders are disposable, aren’t they? Besides, in a typical trading operation, a typical employee has a two-year professional life-span – in two years, before his/her BS is apparent, he has jumped to another, fellow trading operation.

    Comment by MJ — May 16, 2012 @ 11:45 pm

  9. MJ I think you have just hit on why my career stinks, or at least one of the reasons. How embarrassing!

    Comment by sotos — May 17, 2012 @ 6:36 am

  10. it is indeed sad. and the puzzling thing is, this is one of intellectually most challenging, yet, satisfying human endeavors. just pity that the industry is infested with cowboys…

    in the next few days (or the couple of weeks) i plan to write something better organized on this subject for a respectable outlet. they expressed interest in it. when done, will past it here, as well, if you wish.

    Comment by MJ — May 17, 2012 @ 10:21 am

  11. Hey MJ-1. Looking forward to it. 2. Are you suggesting this isn’t a respectable outlet? 🙂

    I’d be glad to host a guest post on the subject.

    The ProfessorComment by The Professor — May 17, 2012 @ 10:47 am

  12. I am not, Professor. 🙂 As always, I learn a lot from you, and thus I am here. 🙂

    Let me write it, first. I am so swamped these days that the result is just lack of productivity as I have not figured out yet how to organize my workload.

    Comment by MJ — May 17, 2012 @ 9:55 pm

  13. Borrowing a bit of narcissism from our beloved president, I thought of posting here another comment I wrote in another respectable forum (see, I am a fast learner, Professor ;)) on the subject of the failure of VIX to do what it was meant to do. While it is not directly related to JP’s VAR of the loss being described here, the issue comes from the same source:

    “ It is not accidental that there is not a strong direct link between the SPX volatility and VIX, even though the motivation behind the introduction of VIX must have been that desired link and offering of a vehicle to hedge the volatility exposure in SPX.
    In my opinion it comes from one fundamental source with two observations:
    a)Standard option pricing models rely on so-called implied volatility, which is viewed both as a measure of the “riskiness” of S&P index and the “juiciness” of the corresponding option. This “buy one get one free” offer, in fact, produces “none” as two different nomenclatures are mixed together resulting in loss of information, metric, perspective, insight, etc;
    b)The designers of VIX assert that its derivation is model-independent, since put-call parity is model independent (and this is the reason why VIX was derived the way it was), so the derived index indeed should be descriptive of or strongly related to the volatility of the underlying index. I am inclined to declare this assertion to be wrong.
    Put-call parity, as we know it from the literature, holds and is model-independent only in a risk-neutral paradigm. While a type of put-call parity in risk-averse paradigm holds as well, it is somewhat different from the one in risk-neutral paradigm and demonstrates loss of an important risk-aversion effect in the corresponding risk-neutral context which, in fact, explains the volatility skew.

    This is why VIX fails to be what it was intended to be.

    Comment by MJ — May 30, 2012 @ 9:49 am

  14. @MJ-borrow away! Obama has a lot of narcissism to spread around 😛

    The ProfessorComment by The Professor — May 30, 2012 @ 12:27 pm

  15. I’d rather borrow some wealth in that case 😉

    Comment by MJ — May 30, 2012 @ 12:59 pm

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