andrew jackson

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Does Jamie Dimon Even Know What Hedging Risk Is?

From Bloomberg:

J.P Morgan Chief Executive Officer Jamie Dimon said the firm suffered a $2 billion trading loss after an “egregious” failure in a unit managing risks, jeopardizing Wall Street banks’ efforts to loosen a federal ban on bets with their own money.

The firm’s chief investment office, run by Ina Drew, 55, took flawed positions on synthetic credit securities that remain volatile and may cost an additional $1 billion this quarter or next, Dimon told analysts yesterday. Losses mounted as JPMorgan tried to mitigate transactions designed to hedge credit exposure.

Having listened to the conference call (I was roaring with laughter), Jamie Dimon sounded very defensive especially about one detail: that the CIO’s activities were solely in risk management, and that its bets were designed to hedge risk. Now, we all know very well that banks have been capable of turning “risk management” into a hugely risky business — that was the whole problem with the mid-00s securitisation bubble, which made a sport out of packaging up bad debt and spreading it around balance sheets via shadow banking intermediation, thus turning a small localised risk (of mortgage default) into a huge systemic risk (of a default cascade).

But wait a minute? If you’re hedging risk then the bets you make will be cancelled against your existing balance sheet. In other words, if your hedges turn out to be worthless then your initial portfolio should have gained, and if your initial portfolio falls, then your hedges will activate, limiting your losses. A hedge is only a hedge if it covers your position. That is how hedging risk works. If the loss on your hedge is not being cancelled-out by gains in your initial portfolio then by definition you are not hedging risk. You are speculating.

Dimon then stuck his foot in his mouth even more by claiming that the CIO was “managing fat tails.” But you don’t manage fat tails by making bets with tails so fat that a change in momentum produces a $2 billion loss. You manage tail risk by making lots and lots of small cheap high-payoff bets, which appears to be precisely the opposite of what the CIO and Bruno Iksil was doing:

The larger point, though, is I think we all know damn well what Jamie Dimon and Bruno Iksil were doing — as Zero Hedge explained last month, they were using the CIO’s risk management business as a cover to reopen the firm’s proprietary trading activities in contravention of the current ban.

Personally, I have no idea why the authorities insist on this rule — if J.P. Morgan want to persist with a hyper-fragile prop trading strategy that rather than hedging against tail risk actually magnifies risk, then there should be nothing to stop them from losing their money. After all, these goons would quickly learn to stop acting so incompetent without a government safety net there to coddle them.

The fact that Dimon is trying to cover the tracks and mislead regulators is egregious, but that’s what we have come to expect from this den of vipers and thieves.

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Populism & the Fed

A bizarre piece from Gregory Morris writing for Bloomberg:

Today, as its 100th anniversary approaches, many followers of both the Tea Party and Occupy Wall Street movements are calling to “End the Fed.” The rich irony here isn’t that reactionaries and radicals are in agreement on something; after all, they are both passionately populist. The irony is that it was populist outrage and calls for reform that created the Fed in the first place.

The three decades from the demise of the second central bank to the point where the Lincoln administration began printing greenbacks to finance the Civil War were known as the years in the wilderness for American finance. Banks printed their own notes — and let the buyer beware. Bank runs and panics were a common fact of life.

Even with the terrible economic conditions we’ve seen in the past few years, it’s difficult today to comprehend the precarious state of business and personal finance in those days. Not only was there no central bank to restrain economic swings, there was no deposit insurance and no social safety nets. Banks were chronically undercapitalized and went bust with alarming frequency. There was no recourse for depositors. Farms and shops were foreclosed, families put on the street.

Really? Populist outrage led to the creation of the Fed?

I thought it was a cabal of bankers and financiers meeting in secret.

From Wikipedia:

At the end of November 1910, Senator Nelson W. Aldrich and Assistant Secretary of the U.S. Treasury DepartmentA. Piatt Andrew, and 5 more of the country’s leading financiers, who together represented about one-fourth of the world’s wealth, arrived at the Jekyll Island Club to discuss monetary policy and the banking system, an event led to the creation of the current Federal Reserve. According to the Federal Reserve Bank of Atlanta, the 1910 Jekyll Island meeting resulted in draft legislation for the creation of a U.S. central bank.

Now I know that depositors want their deposits insured. I know that a world of bank runs and panics is not a very reassuring atmosphere for businesses. But let’s be honest — things weren’t that bad. Here’s real GDP-per-capita from the end of the Civil War to the end of World War I:

Does that look like stagnation or weakness to you? No — it looks to me like a consistently rising standard of living powered by significant wealth creation. Sure — bank runs and panics, and bank failures and foreclosures were common. That’s the nature of creative destruction — good ideas can much more easily succeed if bad ideas are free to fail. That meant that society, and the economy, were much more experimental. And that’s the cost of innovation, and endeavour and experimentalism — an atmosphere of volatility.

The real issue is that the Fed’s defenders don’t really like creative destruction, because it is too risky. They cling to the comfort blankets of mild-to-moderate yearly inflation via money printing, significant government intervention to save failed businesses like GM, AIG and Bear Stearns, and an economy and political system swung (if not controlled) by too-big-to-fail megabanks, and their CEOs. Most fiercelythey cling to the risk-free 6% dividend they receive year-in-year out — a risk-free 6% of which most private citizens and investors can only dream.

The reality is that modern economic planning is the art of papering over the cracks. The social safety net, and depositors insurance are there not to create wealth (for they do no such thing) but to keep the febrile masses from rioting. The Fed’s defenders are puzzled that after all those monetary helicopter drops (stimulus, QE, QE2, etc, etc) the masses (Tea Party, Occupy) are still demanding more. The “great moderations”, and free lunches have (as I have explained in detail here and here and here) created a hyper-fragile monolith of delayed crises — America’s huge debt load, youth unemployment, biflation, etc — ready to crash down on society.

Loose monetary policy has created tsunamis of malinvestment, and bubbles (housing, NASDAQ, etc) that ultimately drag the economy back down to earth, resulting in crises that — as Paul Krugman so memorably put it back in 2001 — are reinflated, and reinflated, and reinflated by more and more and more interventionism, and new bubbles to replace the old.

That isn’t sustainable economics, or sustainable growth. Sustainable growth is driven by investment in the things that society wants and needs. It’s driven by people working, saving, and investing in products, services and businesses that they deem to be valuable. That is the nature of a free market, not the government or central bank firing off trillions of dollars to whoever they designate as “systemically important”. Sustainable growth is driven by experimentalism. If an experiment fails, it falls to pieces and a gap in the market is opened for the next experiment. Sustainable growth is not driven by bailouts and moral hazard — ever. That means that investors and financiers will think long and hard before committing capital, instead of throwing it into ponzi schemes and derivatives-black-holes.

There is a sensible middle ground between creative destruction and modernity. If anyone is to be bailed out, it should be the poorest, not billionaire bankers and Wall Street megabanks. Let the government insure the deposits of the masses. Let the government provide a safety net to prevent homelessness and starvation, and sickness — so long as it is funded sustainably from tax revenues, and not borrowing.

But let failed businesses fail. Let bad experiments end. Let bad debtors default on their debts. If the financial system is fundamentally weak then let it crumble — let a new system take its place.