On March 31, 2011 Senator Jim DeMint (R-SC) introduced S. 712, the Financial Takeover Repeal Act — which would repeal all the provisions of the Dodd-Frank Act. On May 18, 2011 Senator Dean Heller (R-NV) signed on as a co-sponsor. [GovTrack] Gone would be the orderly liquidation process requirement for banks, gone as well the provisions requiring more transparency and accountability for derivatives trading, and gone would be any protection for bank depositors under the Volcker Rule. Perhaps in light of what’s happened to JP Morgan Chase of late the Senators would like to alter their positions?
Remember 2008? Remember when trading by investment firms created a Mortgage/Housing Bubble? Remember when traders scrambled to grab up mortgages hand over fist to warehouse offshore, slice and transform into CDOs, and then hedge their bets with credit default swaps? Remember how they managed to cost the U.S. economy some $10 Trillion in wealth? Or, how they deftly wiped some $50 Trillion in wealth from global totals?
Evidently, someone at JP Morgan Chase didn’t get the memo.
JP Morgan Has a Whale of a Time?
The story started coming out on April 5th and by the next day Business Insider had an interview posted on The London Whale: “Well it’s reported that he’s taken a huge bet worth possibly tens of billions of dollars on so-called corporate credit default swaps — these are essentially insurance policies against particular companies going bust. Now, this guy’s gone one step further and bet on an index of policies for 125 U.S. companies.” Hmmm, now “corporate credit default swaps” — where have we heard that one before?
We won’t know because the information is “proprietary” as to exactly what got the London Whale harpooned, but there is information in the public domain about some of JP Morgan Chase’s “creative trading.” For example, there was this report from Bloomberg on April 3, 2012:
(JP Morgan Chase) “sold $59.1 million in structured notes tied to a proprietary volatility index in March, the most for any month since the gauge was created more than a year and a half ago.
The J.P. Morgan Strategic Volatility Index, which uses a strategy based on a set of rules, has increased 17 percent this year. The gauge seeks gains when the market for longer-term futures on the VIX trade higher than those with closer expirations, which is referred to as “contango,” and also when the reverse is true, called “backwardation.”
If “backwardation,” “contango,” and “proprietary volatility indices,” sound like so much blubbering jingo, it’s probably because they are. By May 10, 2012 Jamie Dimon, JP Morgan Chase CEO, was finished trying to brush off the reportage about $2 billion losses as being a “tempest in a teapot,” and changed the company line:
“Yesterday, Dimon changed tacks. Losses on the investment office’s “synthetic credit portfolio” had reached $2 billion so far this quarter, though he refused to give any meaningful details on how that had happened. Presumably, these are derivatives of some sort, but even that basic fact was too much for the bank to specify.” [Bloomberg]
“Synthetic credit portfolio.” Doesn’t that have a familiar ring? Dimon continued:
“Here’s what little Dimon said of the trades in question: “The synthetic credit portfolio was a strategy to hedge the firm’s overall credit exposure, which is our largest risk overall in this stressed credit environment. We’re reducing that hedge. But in hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored. The portfolio has proven to be riskier, more volatile and less effective as an economic hedge than we thought.” [Bloomberg] (emphasis added)
Interesting phrases: “synthetic credit portfolio,” “hedge credit exposure,” new strategy,” and “riskier than we thought.” Sound familiar?
We can conjecture that JP Morgan Chase’s problems began with bets from their bond portfolio, including those “synthetic credit” instruments:
“The bank’s problems may have started with its bond portfolio, worth $379 billion at the end of March. JPMorgan had just 30 percent of its portfolio investment in securities guaranteed by the federal government or its agencies, generally considered some of the safest bonds. It was a shift from the end of 2010, when those types of bonds amounted to 42 percent.” [NYT]
What if we substituted “speculative bet” for “economic hedge,” because as it’s been pointed out very clearly an “economic hedge” is one that doesn’t qualify for hedge accounting. And, if it doesn’t qualify for hedge accounting then how it can work to offset a risk is a matter more akin to speculation than determination. [Bloomberg] Translation: The Little Wizards were back at it — assigning values to things based on happy assumptions and elegant algorithms, a process perilously close to Mark to Mythology valuation. We’ve seen that movie before. Now, what inspired model failed this time?
“Dimon at least had the good sense to sound a note of contrition yesterday. He said the firm’s new “value-at-risk” model had proved inadequate and the company was going back to using an older model. He said the money-losing trade was “flawed, complex, poorly reviewed, poorly executed and poorly monitored.” He said it was “sloppy” and that “all appropriate” measures would be taken. He said there were “egregious mistakes” made and that the wound “was self-inflicted.” Before he answered questions, he said, “We will admit it, we will learn from it, we will fix it and move on.” [Bloomberg]
“New Value At Risk Model“* — if we thought the Wall Street Wizards, having been burned by Black Swans, Outliers, and Fat Tails when the Mortgage Market Collapsed, had learned something about the dangers of Quantifying Manic Mr. Market in 2008 — we should think again.
Perhaps JP Morgan Chase CEO Mr. Dimon would like another look at its VAr models as well:
In the first quarter, he said, the bank deployed a new model that underestimated losses on the hedges that relied on credit derivatives. When it redeployed the old model, it nearly doubled the estimated potential losses in the chief investment office, where the hedges were done. [NYT]
Additionally, we ought to be thinking of the intent expressed in the Dodd-Frank Act to make such proprietary trading more transparent.
What we don’t know CAN hurt us.
We don’t know, for example, how “economic hedges” were supposed to work, that’s proprietary information. We don’t know who traded what with whom, that, too, is proprietary information. We don’t know who valued what when trading whatever with whomever. Yes, it’s proprietary information. We don’t really know if, or how much, depositor’s funds were used in some way in these speculative bets. We have Mr. Dimon’s word that the trades “didn’t break the Volcker Rule,” but that’s problematic because the final provisions of the Volcker Rule haven’t been determined. However, we do know that because JP Morgan Chase is a bank, and a very big bank, it is “covered” by the FDIC, and the U.S. taxpaying public.
We also know that Dimon, and to be fair many others on Wall Street, have been quick to complain about the “onerous burdens” of financial regulation reform.
He has criticized the new, post-financial-crisis regulations — Basel III, Dodd-Frank, the Volcker rule and the new rules governing derivatives — as being Draconian. He has whined that the time to criticize Wall Street has come and gone. [Bloomberg]
Not quite. Senator Carl Levin (D-MI) noted the obvious:
“The enormous loss JP Morgan announced today is just the latest evidence that what banks call ‘hedges’ are often risky bets that so-called ‘too big to fail’ banks have no business making. Today’s announcement is a stark reminder of the need for regulators to establish tough, effective standards to implement the Merkley-Levin language to protect taxpayers from having to cover such high-risk bets.” [Business Insider]
Senator Levin is referring to the loophole in Volcker Rule drafting sought by JP Morgan Chase and other big banks.
“The loophole is known as portfolio hedging, a strategy that essentially allows banks to view an investment portfolio as a whole and take actions to offset the risks of the entire portfolio. That contrasts with the traditional definition of hedging, which matches an individual security or trading position with an inversely related investment — so when one goes up, the other goes down. ” [NYT]
“Portfolio hedging?” As in “economic hedging,” as in a loophole to allow the bankers to perform some more magic with the numbers and the valuation of risk. This is hardly the time to blame the regulatory agencies either.
Both the SEC and the CFTC argued against loosening the restrictions in the Volcker Rule, which isn’t officially to go into effect until July 21, 2012, and Fed Chairmen Ben Bernanke has already stated that the deadline won’t be met. Treasury, the Fed, and the OCC all argued in favor of more “generous” terms for the bankers. [NYT]
Reflections in an Emboldened Eye
One of the more intriguing comments from Mr. Dimon was his statement that the bank would “learn from the mistake and move on.” Unfortunately, this is also what the Wall Street Bankers said in 2009. What was one of the reasons for all those Toxic Assets on the bank books in 2008? The failure of their Value At Risk computations! What happened in 2012? JP Morgan Chase’s Value Ar Risk computations failed — again.
What was one of the crucial factors in the Mortgage Meltdown? Credit swaps and other exotic derivative trades which were based on Mark to Mythology valuations. What’s the value of JP Morgan Chase’s hedge portfolio now? Who knows? There is Mark to Market (valuing positions based on current price), Mark to Model (valuing positions based on statistical predictions), but Mark to Myth (valuing positions based on statistical predictions themselves heavily weighted to the management’s most optimistic projections for monumental revenues) appears to have won the day on Wall Street.
There is probably a message in here somewhere: If you can’t determine the value of a position it likely isn’t a good idea to bet (excuse me, “economically hedge”) depositors money on it.
However, the real message of the JP Morgan Chase debacle of 2012 may well be that for all of Wall Street’s proclamations of innocence in the Mortgage Meltdown of 2008, and all their pious promises that they’ll be good boys from now on (i.e. 2008) — the regulators were right — they are in need of adult supervision.
* Value At Risk Models were at the heart of the last credit fiasco, Joe Nocera, economics writer at the New York Times explains:
“VaR isn’t one model but rather a group of related models that share a mathematical framework. In its most common form, it measures the boundaries of risk in a portfolio over short durations, assuming a “normal” market. For instance, if you have $50 million of weekly VaR, that means that over the course of the next week, there is a 99 percent chance that your portfolio won’t lose more than $50 million. That portfolio could consist of equities, bonds, derivatives or all of the above; one reason VaR became so popular is that it is the only commonly used risk measure that can be applied to just about any asset class. And it takes into account a head-spinning variety of variables, including diversification, leverage and volatility, that make up the kind of market risk that traders and firms face every day.”