Did Carl ‘Ahab’ Levin Harpoon a Whale, or a Minnow?

I’ve been asked for my take on the Senate report/hearings on the London Whale.  I’m responding more out of a sense of duty, rather than any actual enthusiasm for the subject.

There are two issues that need to be distinguished, IMO: the operational aspects of JPM’s CIO, and the economic substance of the transactions that cost the bank billions.

The operational aspect is indeed appalling.  The reliance on a spreadsheet with manual inputs to quantify the risks of the CIO is truly appalling.  Division, multiplication-whatever!   The failure to take into account market liquidity, and the ability to get out of a huge position in the event that circumstances changed.

The battle over marks-hardly surprising.  It has always been so, and will continue to be so long after we have all shuffled off this mortal coil.

With respect to the economic substance, I don’t have much to add beyond what I said last summer, or beyond what the wickedly sardonic Rhymes With Cars and Girls has written over the past days.  I encourage you to read Crimson Reach’s posts.

In a nutshell, Crimson ridicules the presumption that banks can invest in ways that are immune to the risk of loss, and mocks the Shocked! Shocked! response when losses are actually realized.  Relatedly, he eviscerates the attempts to distinguish between “hedges” and “speculative” trades.

These distinctions are indeed Talmudic.  Any investor-including banks-makes risk-return trade-offs.  With respect to banks particularly, they are in the business of taking credit risk.   There are myriad ways of taking on credit risk.  Making loans.  Buying or shorting corporate debt.  Buying or selling CDS .  What really matters is the risk of the overall portfolio.  There are many ways to achieve the same risk profile.  And since banks inevitably take on risk, there are many ways to lose money.  And believe me, banks have found them all.  Sovereign debt (remember the LatAm debt crisis, anyone?), mortgages, corporate debt, consumer lending.

What JPMorgan (JPM) described as a “hedge” was really a trading strategy was not a mechanical offset of an existing position.  It was designed to perform (relatively) well in a particular state of the world, i.e., another financial crisis.  In that sense, it was taking a view on the potential damage associated with that state of the world, and the likelihood of that state.  That state didn’t occur, and the position performed badly.

Like I said, there are myriad ways to invest or trade based on that view, and there’s virtually no way to prevent banks from investing or trading based on their views on risk.  That’s what banks do.  Deal with it.

These views will often be wrong.  Which is why banks frequently lose a lot of money.  When they share the same views, and hence trade/invest the same way, they will lose money at the same time: that’s when we have a systemic risk problem.  Again: LatAm sovereign debt in the ’80s; mortgages in the ’00s.  The blessing of the JPM case was that it was pretty much alone in its strategy.

Insofar as the atmospherics are concerned, I am sure that any forensic examination of any of these loss-making episodes would reveal the same kinds of behavior documented in the Senate report.  The same duplicity.  The same attempts to avoid blame.  The same attempts to defer recognition of losses.  The same arguments and backbiting.

The biggest problem with JPM was that, well, it was big.  If you look at many major financial debacles, a common feature is that big institutions make bets that are so big that they become price makers rather than price takers.  When the bets go wrong, and they want to get out, or to reduce exposure, size becomes a liability, rather than an advantage.  Size creates positive feedbacks, and in financial markets, positive feedbacks have very negative effects.  The holder of a big position suffers losses, and tries to reduce exposure: they are so big that these attempts move prices against them, thereby exacerbating the losses.

That’s what happened to LTCM.  That’s what happened to JPM’s CIO.  The difference was that JPM had the capital to survive: LTCM didn’t.  Another good thing.

Carl Levin is using the Whale Trade to dragoon the regulators into implementing the Volcker Rule, which is intended to prevent banks from “trading”, and to limit their activities to “lending” instead.  Again color me unimpressed.  Banks have proved since time immemorial that they can lose vast sums lending, thank you very much.  One of the virtues of trading is that the discipline of mark-to-market forces realization of losses sooner: it’s harder to conceal losses on the trading book than the banking book.  (I understand the complexities here.  Especially when banks are subject to capital requirements, realizing losses can force banks to shrink balance sheets in ways that generate fire sales and positive feedbacks.)  Yeah, the traders at CIO tried to finesse/manipulate the marks to defer recognition of the losses.  But they wouldn’t have even had to resort to chicanery had these losses been on the banking book: in a (perhaps perverse) way, the frantic attempts to jigger the marks demonstrate the ruthless disciplinary effects of marking to market.

In brief, drawing distinctions between “hedging” and “speculating” or between “trading” and “lending” or “investing” or “market making” is typically futile.  Banks can f*ck up-or make lots of money-doing any of these things. And have.  Rather than attempting to micromanage the activities of banks, it’s better to focus on making sure they have the incentives to take risks prudently, and have the capital to absorb the inevitable losses.

Which is why, as far as I am concerned, the would-be Ahab Carl Levin set out to kill a great whale, and brought home a minnow.

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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