Sunday, May 13, 2012

Hedges Don't Lose Money?

I was working out watching Jamie Dimon squirm like a worm, reminding me of Lawrence Summers pathetic recant of his rather innocuous speculation about gender talent distributions.  If a bank with $140B in market cap and over $2000B in assets loses $2B trading credit insurance, it sounds like no big deal, yet everyone, including Dimon, saw this as a a 'terrible, egregious, inexcusible mistake.'

 Dimon noted he had $8B in profits in their 'banking book' related to these trades that have not been marked to market, a point he could have expanded upon. Methinks he's rather eager to paint this as a rogue trader, a public execution of some inconvenient executives. I'm sure that some involved did it out of speculation and the potential for a large bonus, but some favored it as a hedge: any large position involves the support of groups with their differing motives--good faith idealists and cynical opportunists--but Jamie Dimon speaks as if this were indefensible, which I am sure is not true for all the participants. The trades do appear to be dumb but I'm sure there's a case where they don't appear that dumb (having been involved in a nasty legal dispute for 18 months, I can assure you that if an argument can not be presented as a reasonable good faith argument, it must involve torturing innocent children).

The game for a large bank seems to no longer include using mark-to-market hedges (they are even talking about criminal charges).  This probably isn't a horrible thing, in that large corporate hedges are used perniciously more often than not.  Sure, theoretically it need not be so, but as a practical matter, given agency problems it is.  For example, consider Metallgesellschaft tried to get very clever with their oil hedges and ended up having to eat a billion dollar loss. I know of a brokerage where in 2001 they discovered that their business was positively correlated to the stock market, so the CEO put on a big hedge shorting the market.  When the hedge made $20MM, he pocketed several million as a 'trader bonus', though surely it was a corporate hedge if it went the other way.  Then there's the history of gold companies, who discovered in the 1990s that shareholders don't want their companies hedging their core business with futures, they buy them in part for this exposure and don't like the idea that buying gold companies means their beta with gold prices is ambiguous.  Most gold companies now are long gold, which suits everyone just fine.  One could go on and on about how hedging core business risks has screwed up companies.

The notion that by definition hedges have zero expected profit and so lose money quite often seems totally alien to most legislators, journalists, and commentators, which is fine, but for Dimon to not mount a defense at all suggests either a really lame attempt to appear humble or suggests he has no idea what hedging means either.  Sandy Weill's hand-picked apprentice doesn't know much about  underwriting or portfolio management, but he does know a lot about the kind of thing Weill confused with banking, which is mainly acquisitions, PR and regulatory glad-handling.

These hedges are being abandoned for the wrong reason, because hedges sometimes lose money, as opposed to the good reason that these kind of big hedges are too often merely a label applied to bad corporate decisions.  


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Mercury said...

Are you saying that it might be a good idea to not have to mark-to-market hedging positions if they are hedging things that aren’t mark-to-market (what JPM appears to have been doing with these CDS index trades)? Shouldn’t that be only if the hedge has an identified, max liability (like being long a plain vanilla put)?

Eric Falkenstein said...

yeah. It's simply too common for these to become clusterpucks of opportunism and incompetence. It's too easy to claim these as pure profit when they work, which inflates insider bonuses, and basically expropriates from shareholders.

Patrick Sullivan said...

According to this it was just a
hedging strategy that backfired
. They were long investment grade credit, short high yield, and others figured out what they were doing;

'But now that the market participants got a rough idea of what JPMorgan's exposures are, they started putting on the opposite trades in anticipation of JPMorgan unwinding this book (which may already be taking place).'

jck said...

the accounting is asymmetrical, mtm for derivatives and accrual for the assets, explained there:

Bob Dobalina said...

Yeah, Eric, I have to say I don't "get it". I can't understand why Dimon didn't say "we got a hedge very wrong-- and the buck here stops with me because we should have nipped it in the bud even earlier-- but thanks to our excellent risk management process, it won't even come close to putting us in the red for even one quarter, and we're taking some management action to prevent mistakes even this small from recurring."

The fact that he didn't say that--he went on Meet the Press to eat some crow, ferchrissakes-- especially given where regulations and the markets stand currently, suggests that there's something more troubling afoot. Or that a realisitc worst-case outcome from getting out from under this position is much bigger than he is letting on.

blogger said...

Jamie Dimon is Simply Too Big to Fail.