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. Methinks he’s rather eager to paint this as a rogue trader. I’m sure that some involved did it out of speculation and the potential bonus, and some favored it as a hedge; any large position involves the support of different 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 bet 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 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 seemed to either be 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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About Eric Falkenstein 136 Articles

Eric Falkenstein is an economist who specializes in quantitative issues in finance: risk management, long/short equity investing, default modeling, etc.

Eric received his Ph.D. in Economics from Northwestern University , 1994 and his B.A. in Economics from Washington University in St. Louis, 1987

He is the author of the 2009 book Finding Alpha.

Visit: Eric Falkenstein's Website

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