The JP Morgan Debacle: Synthetic 'Hedges', Real Banking, and the Dodd-Frank Act

JP Morgan CEO Jamie Dimon has been a leading voice in the call to roll back the Volcker Rule and other provisions of the Dodd-Frank Act. His story is one that is familiar to investment traders and could be seen as a warning to many as they learn to build their own investments (click here). A lot of people are looking to build their investment portfolios in order to try and make more money later in life. Luckily, there are a number of different ways that people can make investments these days. For example, some people might like to download a Trading App to help them start investing and trading. This should allow people to make some real money in the future. However, it’s important to be careful when building investments. Jamie’s anti-regulatory message just lost a lot of credibility.

So far, the unforseen losses on JP Morgan’s London trades are around $2 billion (although more may be coming). That’s a level that the bank can probably absorb. But this story is so compelling because it highlights two deep problems in our banking and regulatory system. The first is the capture of the banking system by a culture of speculation that fails to serve the real economy. The second is the willingness of regulators – and bank risk managers themselves — to believe claims that this speculation is low risk or ‘hedged’ when in fact it poses great risks. The Dodd Frank Act includes tools to take on these problems, but regulators have to get tough and truly use those tools in order for them to work. And Congress has to resist Wall Street pressure to roll them back.

We don’t know exactly what JP Morgan’s trade was. But from their statements and what the press has found, JP Morgan appears to have hedged securities holdings with an arbitrage trade on a credit default swap index. The transaction would work like this:

1) Cash holdings from bank deposits were invested in what the bank calls ‘very high grade securities’. The highest grade securities would be some form of US Treasuries.

2) These securities were then hedged by buying credit protection on an index of investment-grade securities. Such protection could theoretically reduce risk, but it costs money.

3) The costs of buying credit protection were then offset by selling protection on another closely correlated credit default swap index – most likely a different maturity point of the same index.

This last step was probably sold as making the initial ‘hedge’ more efficient – but in fact it converts that ‘hedge’ into a speculative arbitrage or spread trade. If the spread between the instruments JP Morgan bought and sold is positive, then the bank makes a profit and increases the return on its securities. Even if the spread is low or zero, the trade can still be portrayed to regulators or risk managers as a hedge. The problem comes when the speculative trade goes sharply negative. Mathematical models say this risk is low for correlated trades, but these models have been proven wrong over and over again, going back to Long Term Capital Management in the 1990s.

Even before questions of risk and regulation, the first issue is just how far removed from traditional banking and the real economy this is. Rather lending deposits to businesses, JP Morgan placed the assets in low-return Treasury bills or perhaps blue chip corporates (the same large corporations who are currently sitting on over $2 trillion in cash). At current interest rates, the return on such instruments is very low. So the bank sought out higher returns. But instead of trying to raise returns by seeking out real economy lending opportunities, JP Morgan instead tried to increase its return by trading derivatives on synthetic credit default swap indexes – pure paper speculation.

To make things worse, because it was hoodwinked by its own mathematical models (JP Morgan now admits its VAR model was ‘inadequate’) the bank apparently did not even understand that this speculation involved risks at least as great as it would have incurred had it made real economy investments.

The replacement of real banking by purely speculative, synthetic banking is at the heart of the problems with our bloated and inefficient financial system. The Dodd-Frank Act contains multiple tools designed to address this problem. The foremost among these is the Volcker Rule, which is designed to get banks out of the business of financial market speculation and back into supporting the real economy. But many other sections of the Act address the problem too. These include the ‘swaps push out’ provision that would separate derivatives trading from core banking functions, new rules on derivatives that increase the collateral and margin that must be set aside against speculative trades, and even new prudential capital requirements that should force better recognition of speculative trading risks.

But the effectiveness of these rules depends on how regulators implement them – and unless regulators change their lenient attitude toward the culture of Wall Street trading or provide more benefits for other people who invest their money in stock trading uk, that implementation will not be effective. The clearest example is the definition of ‘hedging’. Most Dodd-Frank rules have exceptions of some sort for hedging operations that are truly risk reducing. This is true for the Volcker Rule and for many of the derivatives rules, including the swaps push out provision. The problem is that in the culture of speculative trading, hedging does not simply mean risk reduction. It means something closer to ‘a trade that will reduce my risks if markets behave as I expect while giving me the chance to increase my profits’. Basic economic theory says that you cannot reduce risks without sacrificing opportunities for higher returns. Those who know how to buy shares usually start off with safer investments and progress to riskier investments in the hopes of reaping bigger rewards. Hedge trades should lower risks, not increase profits, and ‘hedging’ operations – such as JP Morgan’s Chief Investment Office – should never be profit centers. In fact, it clearly was a profit center (until it became a loss center) and not in the hedging business.

The implementation of the hedge exemption in the Volcker Rule does not take this principle into account. It also allows vague and ill-defined ‘portfolio hedging’ that would be a perfect refuge for these types of arbitrage trades, along with dynamic rebalancing of hedges that is necessary for sophisticated arbitrage. To make things worse, the rule would not scrutinize trading positions held longer than two months. Many spread trades are held for relatively long periods. Indeed, as the AFR Volcker Rule comment letter argues, the combination of a broad hedge exemption and little scrutiny of long-term positions makes the current Volcker Rule proposal extremely vulnerable to arbitrage trading.

The Volcker Rule is not the only area where this episode reveals vulnerabilities. For example, in its implementation of new capital rules the Federal Reserve appears to have accepted the inadequate base levels of capital required in the new Basel III accord. It will apparently rely on model-based ‘stress testing’ to determine when additional capital is needed. Yet these stress tests rely on the same type of VAR model that failed in this case. Other areas of derivatives regulation, such as the ‘swaps push out’ requirement and dealer oversight have hedge exemptions that raise similar issues to those in the Volcker Rule. And basic derivatives protections like clearing and margining that would help make these types of trades safer are under attack in Congress – as well as by industry lobbyists putting pressure on regulators.

Regulators and Congress need to learn from this episode. We need to put tough restrictions in place to reorient banks on serving the real economy, and we can’t rely on Wall Street assurances that their speculative trading is safe. Strong versions of already enacted Dodd-Frank laws are a necessity, but Congress also needs to seriously consider measures to break up the big banks, such as Senator Brown’s SAFE Act.

7 thoughts on “The JP Morgan Debacle: Synthetic 'Hedges', Real Banking, and the Dodd-Frank Act

  1. Pingback: What JPMorgan’s Bad Trade Says About the Financial System | Taegan Goddard's Wonk Wire

  2. Pingback: The National Memo » What Five Hours From Last Thursday Can Tell Us About Dodd-Frank And JP Morgan

  3. Pingback: Standing up to Jamie Dimon: Is it SAFE? » TripleCrisis

  4. Pingback: Konczal on Too Big To Fail

  5. Pingback: Why We Never See It Coming – Trading 8s

  6. With havin so much content and articles do you ever run
    into any issues of plagorism or copyright infringement?
    My blog has a lot of exclusive content I’ve either created myself or outsourced but it appears a lot of it is popping it up all over the internet without my authorization. Do you know any solutions to help protect against content from being ripped off? I’d really appreciate

  7. We do not have a commonly accepted standard for distinguishing risk reduction from speculation in CDO hedging. The problems so astutely identified by the author cannot be addressed absent its development. Moreover such a standard could be applied retrospectively to the large banks and FNMA and Freddie Mac to ascertain the level of speculative trading undertaken and the means by which these institutions funded such arrangements.

Comments are closed.