JPMorgan Agonistes

The Morgan trade that has roiled the bank, and arguably more important, the politics of banking, is coming into clearer focus.

What transpired appears to be a classic collection of trading and hedging SNAFUs.  There are two different issues that should be distinguished.  The first is the motive for the trade, the second is its structure.  The underlying motive makes sense at an abstract level, but the structure was FUBARed.  But once the structural issues are considered, one must seriously consider whether the motive, however attractive in the abstract, is at all feasible, especially for a behemoth like Morgan.

Morgan was apparently looking for a systemic risk hedge, something that would protect its huge exposure to corporate default risk against a Eurocrisis, a dramatic weakening of the US economy, etc. In the abstract, this is a laudable goal.  In the abstract.

Given this objective, it put on a trade in tranches of the IG.9 credit index.  These tranches are very sensitive to credit conditions.  What’s more, their valuation and risk are highly dependent on correlations.

Crucially, given the sensitivity of the tranches to credit conditions, to maintain the desired hedge JPMorgan (JPM) had to dynamically manage the position.  It managed the risk by selling protection on the IG.9 index.  Crucially, the structure of the position required Morgan to sell protection as credit rallied.

And credit indeed rallied, due to the ECB’s aggressive actions at the end of 2011.  So Morgan had to go into the market big time, and sell more and more protection.

By doing so, it ran into all the curses that beset dynamic hedges, especially somewhat dirty ones in which what is being hedged (the tranches) and the instrument being used to hedge them (the index) have different sensitivities to parameters-correlations, in this instance-that are themselves moving randomly, and moving a lot.

The hedging instrument was relatively illiquid, meaning that it was prohibitively costly to adjust the hedge in response to every move in the relevant prices and parameters.  But given the structure of the position, failure to adjust continuously gives rise to hedging errors that work against the position. Its value was also buffeted by changes in the crucial parameters.

Moreover, Morgan’s very size worked against it.  Dynamic hedges chase the market: you are buying when prices rise and selling when prices fall.  This is how you pay for the hedge.  But when for a bank as big as Morgan, its hedging trades exacerbated the adverse price movements.  This made the hedge far more costly than a standard model, which presumes that prices move exogenously and are not affected by the trades of the hedgers, would predict.  Morgan’s price impact was revealed by the divergence (“the skew”) between the price of the index and the prices of the underlying credits.

Morgan found itself trying to navigate between the Sybil of holding an unbalanced position that subjected the bank to market risk (in movements in the index as well as to movements in the crucial parameters) and the Charybdis of massive transactions costs inherent in trading in relatively illiquid markets in immense size.  And in its attempt to navigate that divide, it apparently was bashed by both monsters.

Moreover, once it was in the position, there was-is-no obvious way out, especially given the fact that now everyone and his extended family is aware of Morgan’s predicament.

Looking at all this reminds me of the portfolio insurance debacle on Black Monday, 1987, when dynamic hedging strategies blew up spectacularly.  Morgan has been a one bank portfolio insurance wrecking ball.  A poster child for what can go wrong with dynamic hedges that make sense in a frictionless, complete markets, BSM world, but which can go horribly, horribly wrong in messy reality, where markets are incomplete and illiquid.

Indeed, all of the potential problems with dynamic hedges were/are present in spades for this particular transaction.  Most notably, dynamic hedges are major liquidity users.  Morgan was trading in relatively illiquid products.  Moreover, the risk that Morgan was hedging against was also correlated with liquidity, which is a wrong way risk from hell (which portfolio insurers also found out to their dismay in ‘87).  The position was also highly sensitive to parameters-correlations that are (a) hard to estimate accurately, and (b) quite volatile, especially in the very conditions that Morgan was purportedly hedging against.  Furthermore, all of these problems were exacerbated to an extreme extent by the size of the positions and the trades.

A couple of broader points deserve comment.

First, this episode indicates that there is a source of scale diseconomies in banking.  You can be too big for your own good-and your own safety.  So what is to be done about that?  Of course the immediate response-as predicted here-is to pile on more regulations, something that the administration is pursuing furiously, in its tried-and-true let-no-crisis -go-to waste fashion.  But the market imposes its own discipline.  Morgan’s stock price has fallen substantially, its credit rating has been cut, and its financing costs have risen.  These all limit the bank’s ability to grow further, and indeed will likely lead to some contraction in its size. Moreover, the demonstration effect will lead the markets to evaluate the costs of size across financial institutions generally, leading to adjustments in the cost of capital based on updated information about the real costs large entities incur to manage risk.

Second, although hedging against systemic risk sounds superficially attractive, Morgan’s experience, and a little reflection, suggests that the ability to do so is chimerical.  Systemic risks, by definition, affect everybody in the system.  They can’t be diversified away.  Everybody wants to shed them, so they are priced in equilibrium.  You have to pay to get rid of them.  Morgan apparently underestimated the cost of paying other market participants to take on this risk from them.  In part, this was because the need to trade dynamically in order to put on the hedge meant that there wasn’t a sticker price, paid up front, to get someone to take on the risk.  Instead, the cost was paid day after day, via the market chasing, slippage, and transactions costs associated with the trading strategy.  Like portfolio insurance, it looked cheap on the white board or the computer screen, but turned out far more expensive in reality.

This is particularly true for a big, systemically important institution that has to trade in large size to implement such a strategy.  This size magnified all of the pitfalls of dynamic hedging.

In essence, Morgan put on the trade because it wanted to shrink its exposure to certain risks.  It did so by implementing a dynamic trading strategy, which turned out to be a very costly way of doing that.

So how can big banks shrink their risk exposures, if not via dynamic derivatives trading strategies? By getting smaller.  By shrinking their balance sheets.  The market price responses to Morgan’s revelations are likely to lead to that very result, not just for Morgan, but for other big banks as well.  Just as portfolio insurance implemented by dynamic trading shrunk significantly once its true costs were realized, the same thing is likely to happen here.

Attempting to regulate bank activities via Talmudic-and often nonsensical-distinctions between “hedging” and “prop” trades is a fool’s errand.  Hedges can go horribly wrong.  Moreover, quite perversely, regulatory burdens actually tend to create compliance overhead costs that tend to encourage size; the advantage that big institutions have influencing regulators accentuates this effect.  Some combination of capital requirements (with devilish details) and market discipline is a better way to control bank size.

Which means that there is a positive externality to Morgan’s struggles.  Its travails demonstrate vividly the costs of size.  Morgan apparently underestimated the cost of managing risk exposure, and its big loss not only is making it aware of the true cost, but is educating the market as well.  This will affect the cost of capital not just for Morgan, but for all banks, and in a way that will impose a cost on size and complexity.  It is unlikely that this higher private cost will reflect completely the social costs of size, but it is certainly to be welcomed.

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About Craig Pirrong 238 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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