Streetwise Professor

March 23, 2013

Did Carl “Ahab” Levin Harpoon a Whale, or a Minnow?

Filed under: Derivatives,Economics,Financial Crisis II,Politics,Regulation — The Professor @ 8:23 pm

I’ve been asked for my take on the Senate report/hearings on the London Whale.  I’m responding more out of a sense of duty, rather than any actual enthusiasm for the subject.

There are two issues that need to be distinguished, IMO: the operational aspects of JPM’s CIO, and the economic substance of the transactions that cost the bank billions.

The operational aspect is indeed appalling.  The reliance on a spreadsheet with manual inputs to quantify the risks of the CIO is truly appalling.  Division, multiplication-whatever!   The failure to take into account market liquidity, and the ability to get out of a huge position in the event that circumstances changed.

The battle over marks-hardly surprising.  It has always been so, and will continue to be so long after we have all shuffled off this mortal coil.

With respect to the economic substance, I don’t have much to add beyond what I said last summer, or beyond what the wickedly sardonic Rhymes With Cars and Girls has written over the past days.  I encourage you to read Crimson Reach’s posts.

In a nutshell, Crimson ridicules the presumption that banks can invest in ways that are immune to the risk of loss, and mocks the Shocked! Shocked! response when losses are actually realized.  Relatedly, he eviscerates the attempts to distinguish between “hedges” and “speculative” trades.

These distinctions are indeed Talmudic.  Any investor-including banks-makes risk-return trade-offs.  With respect to banks particularly, they are in the business of taking credit risk.   There are myriad ways of taking on credit risk.  Making loans.  Buying or shorting corporate debt.  Buying or selling CDS .  What really matters is the risk of the overall portfolio.  There are many ways to achieve the same risk profile.  And since banks inevitably take on risk, there are many ways to lose money.  And believe me, banks have found them all.  Sovereign debt (remember the LatAm debt crisis, anyone?), mortgages, corporate debt, consumer lending.

What JPM described as a “hedge” was really a trading strategy was not a mechanical offset of an existing position.  It was designed to perform (relatively) well in a particular state of the world, i.e., another financial crisis.  In that sense, it was taking a view on the potential damage associated with that state of the world, and the likelihood of that state.  That state didn’t occur, and the position performed badly.

Like I said, there are myriad ways to invest or trade based on that view, and there’s virtually no way to prevent banks from investing or trading based on their views on risk.  That’s what banks do.  Deal with it.

These views will often be wrong.  Which is why banks frequently lose a lot of money.  When they share the same views, and hence trade/invest the same way, they will lose money at the same time: that’s when we have a systemic risk problem.  Again: LatAm sovereign debt in the ’80s; mortgages in the ’00s.  The blessing of the JPM case was that it was pretty much alone in its strategy.

Insofar as the atmospherics are concerned, I am sure that any forensic examination of any of these loss-making episodes would reveal the same kinds of behavior documented in the Senate report.  The same duplicity.  The same attempts to avoid blame.  The same attempts to defer recognition of losses.  The same arguments and backbiting.

The biggest problem with JPM was that, well, it was big.  If you look at many major financial debacles, a common feature is that big institutions make bets that are so big that they become price makers rather than price takers.  When the bets go wrong, and they want to get out, or to reduce exposure, size becomes a liability, rather than an advantage.  Size creates positive feedbacks, and in financial markets, positive feedbacks have very negative effects.  The holder of a big position suffers losses, and tries to reduce exposure: they are so big that these attempts move prices against them, thereby exacerbating the losses.

That’s what happened to LTCM.  That’s what happened to JPM’s CIO.  The difference was that JPM had the capital to survive: LTCM didn’t.  Another good thing.

Carl Levin is using the Whale Trade to dragoon the regulators into implementing the Volcker Rule, which is intended to prevent banks from “trading”, and to limit their activities to “lending” instead.  Again color me unimpressed.  Banks have proved since time immemorial that they can lose vast sums lending, thank you very much.  One of the virtues of trading is that the discipline of mark-to-market forces realization of losses sooner: it’s harder to conceal losses on the trading book than the banking book.  (I understand the complexities here.  Especially when banks are subject to capital requirements, realizing losses can force banks to shrink balance sheets in ways that generate fire sales and positive feedbacks.)  Yeah, the traders at CIO tried to finesse/manipulate the marks to defer recognition of the losses.  But they wouldn’t have even had to resort to chicanery had these losses been on the banking book: in a (perhaps perverse) way, the frantic attempts to jigger the marks demonstrate the ruthless disciplinary effects of marking to market.

In brief, drawing distinctions between “hedging” and “speculating” or between “trading” and “lending” or “investing” or “market making” is typically futile.  Banks can f*ck up-or make lots of money-doing any of these things. And have.  Rather than attempting to micromanage the activities of banks, it’s better to focus on making sure they have the incentives to take risks prudently, and have the capital to absorb the inevitable losses.

Which is why, as far as I am concerned, the would-be Ahab Carl Levin set out to kill a great whale, and brought home a minnow.

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  1. Spot on once again, Prof. Everything you say is true. But the fact remains these folks did mislead their investors and regulators. And the capo di tutti capi apparently was aware of the extent of the problem early on in this fiasco. Sen. Levin uncovered enough to warrant a deeper look into whether there was a conspiracy to mislead investors and regulators, or even to suborn perjury, from the top down, particularly after it became known the Senate launched its own investigation.

    The whole red-herring re changing v@r systems Jamie offered up now looks laughable — oh, we were dividing instead of multiplying … good God! I guess, technically, he was right — an important cell on the excel spreadsheet had an operator error (pun intended), which was quickly addressed on the spreadsheet (I can’t believe it … still).

    Of course, the whole bank’s v@r was blind to what was occurring on that spreadsheet. You also have to wonder what was being entered in the bank’s overall v@r calc — spreadsheet output? Some excel-based notion of what: position delta? gamma? vega? theta? How were portfolio greeks calc’d? How, if the position was on a spreadsheet, were cross-correlations done for the big variance-covariance matrix the bank presumably ran throughout the day to update its bank-wide real-time risk? Oh, wait, that probably was on another spreadsheet, right? Someone would have to manually enter the output from the excel spreadsheet for the Whale position(s) to the overall JPM risk spreadsheet. That’s a lot of F9’s being hit throughout the day!

    Be that as it may, what is most interesting in this whole process is the positive feedback loops these banks create. It would be a dissertation worthy of the economics world’s equivalent of Hugh Everett that explains what’s happening in the price-formation multiverse when a clusterf*ck of such dimension (carried on an excel spreadsheet … I still can’t beleive that!) creates a massively dense strange attractor. The gravitational pull of that position caused price-quantity (markets’ equivalent of space-time) spaces to deform into markets as remote as palm oil!

    Comment by markets.aurelius — March 24, 2013 @ 7:32 am

  2. FYI re Everett:

    Comment by markets.aurelius — March 24, 2013 @ 9:21 am

  3. @markets. You’re spot on too. All you say is true. As the old Watergate adage goes, it’s not the crime, it’s the coverup.

    Re the economics, yes . . . how could the spreadsheets talk to one another??? (Not that I really believe the correlations anyways.)

    Further re economics . . . yes, it is all about the feedback loops (as I tried to suggest in the post). Do you have a specific cite re the palm oil connection?

    The ProfessorComment by The Professor — March 24, 2013 @ 5:09 pm

  4. Professor: Please help me. As a layman, I see the real-economy value of lending, investing, market-making. But no one has properly explained to me the real-economy value of hedging, speculating and trading. As a taxpayer, I naturally wonder why I have to “deal with” the consequences of insuring activity that seems so pointless and destructive.

    Comment by novice — March 25, 2013 @ 6:47 am

  5. Prof, re palm oil — I was engaging in hyperbole and drawing a connection between two oil markets.

    @ novice: there is no such thing as “investing.” In a world that consists of an infinite number of probable events between the “present” and some arbitrarily defined future interval, everything is a speculation. We can develop explanatory models that allow us to identify the most likely evolution of that arbitrary interval of time, but there is no certainty in how the future evolves. For this reason, people who are willing to bear the risk of an infinity of unknowable future outcomes — who believe they’ve identified a way to recognize the most likely evolution of a process over some arbitrary interval of time — are highly valued by people who are unwilling to bear those risks.

    Bear in mind, too, the past is never fully revealed: We are limited by our measurements — and the devices and methods we use to make those measurements. Anyway, when we think we’ve observed the evolution of a process, say, a time series of prices, what we really have is a snapshot of one (1) possible path among an infinite number of paths. That’s why we spend so much time on the statistical properties of time series — trying to understand what the other possible paths were, any one of which was equally likely to occur as the path we actually observe.

    When I was a kid, I mis-heard the Jim Morrison’s lyric in Roadhouse Blues, and thought he was saying, “The future’s uncertain, and the past is never clear.” (You can hear it here and perhaps understand why I misapprehended it: … at ~ 3:30 into the song … imagine hearing it on a tinny little transistor radio). Anyway, that misapprehension stayed with me all my life as a true statement of reality.

    Hope that helps.

    Comment by markets.aurelius — March 25, 2013 @ 9:19 am

  6. No, it does not help. But I stumbled into this blog from a mainstream site, and it’s clear I’m way out of my depth. The more links I follow (rhymes with girls), the more abstract the discussions become, the less I understand.
    As for there being no such thing as investing, I was borrowing the examples of the professor, who was saying it’s futile to draw distinctions between hedging/speculation, trading, lending, investing, etc.
    I guess. But you cite “the people who bear the risk of an infinity of unknowable future outcomes,” and that’s part of what I don’t get. Often, they do not bear the risk. An unknowable future outcome bites them in the bum, they fail, and the government assumes the risk, in the form of bail-outs and backstops. This is thought to be necessary to preserve the financial system, which to my mind, under the current arrangement, means another downpayment on another unknowable future outcome in the form of a black swan. I was hoping there might be a way to leave the risk-bearers with full ownership of the risk, such as limiting what insured banks can do, or withdrawing the insurance. And my original question was really just a way of trying gauge/grasp the real economic value of modern, complex hedging/speculation, to see if it warranted the same taxpayer protection as lending (assuming there is such a thing as lending).
    I don’t get it. But I didn’t get The Doors, either, or William Blake.

    Comment by novice — March 25, 2013 @ 1:27 pm

  7. @novice. Jammed up today. Will try to respond this evening. Thanks for your interest and patience.

    The ProfessorComment by The Professor — March 25, 2013 @ 1:59 pm

  8. @Novice, hardly a novice observation at all. What you are describing is the true goal of all finance – heads I win, tails, someone else loses. The loser is not just limitted to the government: traditional Wall Street has operated this way for years – take a big risk, make money and get a huge bonus (or better a contract guaranteeing payment even if your pulse stops or they discover you are legally brain dead), lose a bundle, find another job withthe large severance package.

    All the socialization of loses means is thath te firms play this game too, sticking the gov. with the bag.

    Comment by Sotos — March 29, 2013 @ 9:13 am

  9. I’m surprised this didn’t get any play, coming as it does from these two guys (William M. Isaac and Richard M. Kovacevich):

    “… The Dodd-Frank bill ignores the fact that regulatory failures turned what should have been a manageable problem into a worldwide financial and economic crisis resulting in the longest recession and most tepid recovery since the Great Depression.

    “Roughly 20 financial institutions perpetrated the recent crisis. About half were investment banks and the other half were S&Ls. Only one, Citigroup, was a commercial bank which had largely morphed into an investment bank prior to the crisis. These firms failed in every respect, from business strategies to ethics. There is no excuse for their behavior or for the regulatory failures that tolerated it. Over 100 full-time regulators are assigned to Citigroup. Why did they fail to deal with the risks?

    “Seven thousand commercial banks are now subjected to Dodd-Frank’s penalties and burdens in the same way as the twenty guilty parties. Sadly, many smaller banks may become extinct due to the costs of complying with these new regulations. And millions of individuals and small businesses – particularly those most in need – will be denied or will pay higher prices for loans and other banking services.”

    I’m looking at my copy of “The Road to Serfdom” right now. … oh, my …

    Comment by markets.aurelius — March 29, 2013 @ 10:51 am

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