Thursday, 26 April 2018

JP Morgan and Dimon's Texas Hedge

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I would love to have got through today without reference to JP Morgan and its travails but doing so would be a bit like trying to write a football column and disregarding the last gasp goal which gave Manchester City its first English football Championship in forty four years. Congratulations to ManCity and to ManCini. Not so many congratulations to Jamie Dimon and to Ina Drew.

Anthony Peters, SwissInvest Strategist

The weekend press had a field day as the revelations came too late for any serious analysis in the Friday papers and it is rare for the weekend guys to have a subject all to themselves before the main City Desk gets its teeth into the story.

There were pages of hows, whys and whos and again and again the question was being asked “Didn’t they learn anything from 2008?” I shall try to avoid attempting to answer those questions here. The speed with which Dimon reacted and the candidness of his response is at once refreshing and scary.

In my mind, there is no doubt that his own personal position as the King of Wall Street has been severely undermined and I wonder whether the defenestration of Ina Drew, JP’s CIO, will be enough to pacify the marauding hordes. Can the boss survive the ignominy while retaining his moral authority?

Unless I am mistaken, the great JP Morgan self-deception was that hedges could be put on the book and that they could make money at the same time – in other words that the desk could buy and option and still be paid premium. If that isn’t the recipe for a Texas hedge, what the hell is?

Dimon was quite clear when he declared that this was not a matter of the Volker Rule having been broken; he announced that the Dimon Rule had been broken too. I am not so sure about this. It appears as though the CIO’s Desk in London had positioned the Texas hedge to beat all Texas hedges. Is this Dimon’s fault? Is this Drew’s fault? Or is it the fault of Javier Martin-Artajo and Bruno Michel Iksil? In a way it all their faults but in a way it is the blame of none of them either.

The simple truth is that the total risk on a bank’s balance sheet is an aggregated amalgam of individual risks and that although there are certain statistical probabilities which will affect the exposure, there is no algorithm which will cover all eventualities.

I was preparing a piece for the IFR (If in doubt, take the bond…) on Thursday when I sent a preview to Uncle Lol, a trading friend of mine – he is the man who taught me everything I know (but not everything he knows) – for a read through. In his reply, along with other comments, he wrote the following: “They have spent untold billions on risk management programmes, only to find out they don’t work too well in dysfunctional  markets”. I responded “As far as your comment is concerned, it all started going wrong when they began to believe that taking risk could be fitted into a quant model and managed by assessing correlation risk – B****X!”. What a coincidence.

I don’t know the details of what went wrong at JP but I was struck by the statement issued by Ina Drew’s office which assured us that she had instructed the desk in question to position hedges which would reduce the bank’s risk exposure to the European debt crisis.

Now, to you and me that would mean selling down some of the risk – there is so much truth in the old adage that the only perfect hedge is a flat book. However, there has been a growing conviction in the business that there are generic derivative solutions to hedging. Every hedge is imperfect – that’s fair enough as long as one accepts that hedges are risk mitigators and not risk removers. No matter how perfect or imperfect any hedge is, it costs money – the equivalent to the insurance premium, if you care.

Unless I am mistaken, the great JP Morgan self-deception was that hedges could be put on the book and that they could make money at the same time – in other words that the desk could buy and option and still be paid premium. If that isn’t the recipe for a Texan hedge, what the hell is?

Synthetic and not so magnificent

There is one more point. I spent a good part of my career working in the structured credit space. Those who know me will always be perplexed that such a pure credit animal as myself should have found himself poking around in the world of CLOs and CDOs and, to be honest, it was never my choice.

However, my many years in the business had given me access to a number of major institutions which were busily testing the water in structured credit and as it was the hottest game in town. My employers, in their wisdom, seconded me to the structured sales desk in order to leverage my Rolodex.

In the event it took me several years to get my head around the correlation products which I was supposed to be selling and having come to the business from basic training in good old corporate lending, I felt uncomfortable with the concept of CDS – the first derivative of credit – driving an equally synthetic lending process.

As said, I don’t know of the details of the JP fiasco but I am tempted to believe that blocks of supposedly correlated credits were hedged with completely unrelated blocks of correlated credits which created a theoretical low or even zero Delta position but which in reality bore no relationship to each other.

Why does the unsinkable Titanic keep springing back to mind?

That aside, the investor base in pure and uncorrupted cash credit – be that loans or bonds – is very different to the one which plays in credit derivatives and the various repackaged products which gives the two forms and sub-forms of credit exposure massively unrelated reactions, unrelated liquidity and hence unrelated price movements in response to certain events in the real world.

However, the derivative chaps have been Masters of the Universe for some time now and I am led to believe that nobody, Jamie Dimon included, has had either the wisdom to recognise or the courage to admit that there is still a very large section of the credit laboratory which is dedicated to the art of alchemy.

I could go on but I believe that the overriding conclusion is that if the wizards are removed from the banking process, the returns on equity will implode and banking will return to the sleepy corner where it lines up with the utilities as the pension funds’ last resort for low, boring but predictable returns.

With that, we are warned, the top talent will depart the industry. Given what the top talent has achieved in the past decade, as far as I am concerned, it can’t depart fast enough.

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