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May 17, 2012

LTCM. Amaranth. JP Morgan?

Will Jamie Dimon go down in history as the John Meriwether of this generation? Or perhaps the Nick Maounis of our time? Either metaphor can’t make the current CEO of JP Morgan feel very good about his legacy. And if I understand the trade properly, the end of the story is nowhere near being written

Banks hedge risks. This is what they are supposed to do. And when they don’t, the results have been disastrous (see: the failure of the S&Ls when their long-dated mortgage books were suddenly funded with short term, de-regulated deposits in the sharply rising rate environment of the 1970s). The best way to hedge is always through the cash markets, e.g., I loan out money for a period of time and assume credit risk, interest rate risk, liquidity risk and timing risk, but match fund the loan and mitigate three of the four risks (with only credit risk remaining, the precise thing that banks should get paid to do). The problem is, with the scale of banks and the increasing range and complexity of both business and retail products, match funding is a thing of the past. This risk gap is generally managed using derivatives. There is nothing inherently wrong with this.

However, problems arise when hedging strategies become excessively complex in their attempt to be as close to costless as possible and overly precise. As a long-time risk manager, the goal should be to mitigate risk to an acceptable level but to place a premium on hedge liquidity, transparency and simplicity. While a hedge might effectively hedge “delta” but not “gamma,” the best way to address this is to simply take on less gamma, not try to construct a sickeningly complex and illiquid hedge that models out beautifully but is essentially a custom suit on a person whose weight fluctuates wildly. Sometimes the suit fits, sometimes it looks like crap. And in JP Morgan’s case, they are sporting one of the ugliest suits we’ve seen in quite some time.

It actually reminds me a lot of LTCM. Super smart team. Could likely have put a man on the moon all by themselves. However, the bridge between theory and practice broke down in such a way that the global financial system was clearly at risk. Over a trillion dollars of notional risk supported by less than $5 billion of capital. And the strategies broke down in spectacular fashion because of what? Lack of liquidity and rising correlations. Hmm, lack of liquidity and rising correlations…that sounds a lot like what JP Morgan is facing at this very minute. And there is one other dimension that hastened LTCM’s decline and why the JP Morgan story isn’t close to being done - market knowledge. Once the market knew that LTCM was in trouble, the leaned hard against their positions until they cracked. Now LTCM’s capital base is a tiny fraction of JP Morgan’s, but what if $2 billion turned into $5 billion? Or $10 billion? Every sophisticated market participant is causing JP Morgan maximum pain, and it is simply a question of high-stakes poker. But let me assure you, JP Morgan is not holding many cards right now. 

The JP Morgan debacle also reminds me of Amaranth. While Nick Maounis didn’t run the firm-destroying natural gas trade (a trader named Brian Hunter did), he certainly must have known about it and if he didn’t, he should have known about it. There was a total breakdown of communication, risk management and accountability. Regardless of whether the Managing Partner made the trades, what does it say about their culture that a trader was allowed to put a bet-the-shop position on of that magnitude that blew through billions of dollars of LP capital? One could say the same thing about JP Morgan, Jamie Dimon and the CIO’s office. While the transactions in question may have been for hedging purposes, the risk rebalancing exercise rapidly grew to a scale that placed the firm’s capital position at risk. That this was allowed to continue in the face of rising market awareness (which serves to exacerbate the problem) is incomprehensible, at least to this former Wall Streeter.

I understand why Dimon continues to lobby against the strictest elements of the Volcker Rule, because banks should be allowed and, in fact, have to be allowed, to hedge their books. But when bank managements’ lose sight of the hedging mission and risk management and common sense discipline break down, they shouldn’t be allowed to lead. This is what the Volcker Rule should really be getting at.

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