Streetwise Professor

May 11, 2012

The Whale Turns Wily Coyote, or The Trader’s Epitaph

Filed under: Derivatives,Financial Crisis II,Politics,Regulation — The Professor @ 8:06 pm

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.

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    ‘nuf said.

    Comment by markets.aurelius — May 12, 2012 @ 10:52 am

  2. As I tried to tell people at the mortgage bank I worked for, hedging is not getting rid of risk, but substituting one risk for another (or sometimes several risks): it is to be hoped that the new risk(s) is smaller and can be managed. Liquidity of the market is one bug bear, basis is another, and when the two work in tandem life is a bitch. The latest look is that JPM took a 1-1/2 % hit on their aggregate position(s) – in itself not too bad, especially compared to so called hedge funds whose ability to generate alpha is usually non existent – imagine the results if they had a 50% cut like so many of our investment geniuses.

    As you note, there is thin line between a hedge and a basis trade – particularly because there are usually multiple ways to hedge, each with its own basis risk and risks unique to the item being risk (e.g. mortgage apps don’t close when expected, stuff can rot, etc.) What seems to be forgotten in a trading driven world is that the best hedged risk is the one avoided, or minimized before any secondary actions are taken in the markets. Fewer trades means fewer traders – a natural conflict of interest for traders.

    This is the problem that needs to be addressed: the Volcker rule does nothing about this.

    Comment by sotos — May 12, 2012 @ 11:49 am

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