Learn a Lesson from JP Morgan
Posted by John Forman in News, tags: banks, CDS, curve, Dodd-Frank, hedge, illiquid market, JP Morgan, JPM, regulation, risk managment, risks, trade, Volcker Rule
There’s a massive amount of commentary in the news and among market participants about JP Morgan and the big loss it reported earlier this week. The politicians, and anyone else calling for stricter regulation of the banks, are having a grand old time with this development, suggesting that Dodd-Frank and the Volcker Rule were exactly intended to avoid this sort of thing happening. Actually, I’d argue that they are (or should be) designed to ensure the security of the financial system (FDIC insurance being there to protect depositors). To that end, here we are with no risk to the financial system from the JPM loss because the bank has a “fortress balance sheet”.
Isn’t that what every bit of discussion and legislation has been about the last few years? Shouldn’t we be looking at this case as being a perfect example of why all banks should have such strong balance sheets?
We cannot possibly expect banks to never have losses. In this case it was a bad trade/hedge decision and execution. In another case it could be a higher level strategic business decision (acquisition, entry into a new market, etc.). Just as we cannot prevent individuals seeing negative consequences from either rational or stupid activities, we cannot expect companies (banks, automakers, or otherwise) to have every decision produce a positive result. It’s a question of risk management and having the cushion to ensure the inevitable issues don’t get transmitted through the system.
That’s my political/social rant for now.
Getting into the trade
As for what JPM actually did to suffer the loss, it’s a pretty convoluted thing that most individuals won’t understand well and really don’t need to in any case. I won’t try to explain the details of it here because frankly I’m trying to work through what the Thomson Reuters reporters have pulled together thus far and we may never get the whole story regardless. What it seems to come down to is JPM having a short position in the credit default swap (CDS) market, which essentials is akin to going long a bunch of corporate bonds (taking credit risk). It’s hard to see this as any kind of hedge since JPM would have credit risk in its portfolio from the lending it does.
The hedge aspect seems to be from using different CDS instruments to go long later, but there was a maturity mismatch. It’s kind of like trying to hedge 10yr Notes with 2yr Notes in that it is different than a simple interest rate hedge because you have created a yield curve exposure (yield curve could flatten or steepen). JPM seems to have been caught out by events influencing the two maturities of CDS in different ways.
And of course all of this tends to get exacerbated by relatively illiquid market conditions and the fact that JPM essentially became the market at a certain point. This is part of what created the problems in 2007 and afterwards when the financial crisis began to unfold. There was suddenly no one to take the other side when institutions wanted to get out of their positions, and actually folks (read hedge funds) actively working against them.
Focus on the hedge structure
The hedge mismatch is something worth thinking about if you look to do hedging in your trading or investment activities (most individuals don’t, but some do). One thing I hear often among forex traders is their action (or intention) to use one currency pair to hedge a position in another. For example, a trader might go long USD/CHF to hedge a long position in EUR/USD. The rationale here is that you remove the USD-related risk because you have a long USD position matched up with a short USD position.
Here’s the problem, though. While you do remove the USD risk, you have now added a short CHF exposure. You’re now long EUR/CHF. This is an entirely different trade than the one you started with.
Hedging should be about reducing or eliminating a certain risk, not about creating a new one. JPM seems to have made two mistakes. They introduced a “curve” risk by hedging with shorter-dated CDS, and they introduced a liquidity risk by being so big in a relatively illiquid market. Make sure you don’t create new risks with your own hedging.
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