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John Carney has hilariously convinced a bunch of people that JPMorgan whale-wizard Bruno Iksil might be running a synthetic bank on top of JPMorgan’s regular bank. The theory, propounded to him by a mysterious trader and sort of supported by an old PIMCO client note, is that Iksil was tasked with hedging JPMorgan’s inflation risk and did so by putting on a trade that was (1) long TIPS (for the inflation) + (2) long [write protection on] CDX (for the yield). Now I will tell you a thing, which is that I hedge my inflation risk by being (1) long TIPS (for the inflation) + (2) long MegaMillions tickets (for the yield),* but nobody calls me Voldemort.
Here is Doug Braunstein’s theory about Iksil:
On a conference call with analysts, Braunstein said the positions are meant to hedge investments the bank makes in “very high grade” securities with excess deposits. (J.P. Morgan has some $1.1 trillion in worldwide deposits.) Braunstein said the CIO positions are meant to offset the risk of a “stress-loss” in that credit portfolio. He added the CIO position is made in line with the bank’s overall risk strategy.
What can that mean? Presumably the sensible view to take from this is that this is actually part of a “stress-loss” hedge; the CIO is short (bought protection on) a lot of shorter-dated corporate credit and funds it by being long (selling protection on) a lot of longer-dated (5-year) corporate credit, so as to be relatively DV01-neutral but long jump risk. This has the advantage of (1) actually hedging a stress loss in high-grade short-term corporate securities, (2) fitting in with the relative lack of noise in the CIO portfolio,** (3) being what people have told Bloomberg Iksil was doing, and (4) being what JPMorgan has actually said it actually did in the CIO during the crisis. So it’s probably true no?
But it’s fun to pretend! If you pretend Carney is right you can have one of two views.*** One is Izabella Kaminska’s, which is “sure, I guess this is a hedge, but boy is it a mysterious one.” You can buy this if you have – as she does – a pretty postmodernist view of what a hedge is. I do too, mostly.
Whaledemort has received a lot of Volcker-related attention for reasons that are … well, that have to do with the fact that the Volcker Rule is among other things a free-floating reason to get angry at anything a bank does that you don’t like and/or understand. But it is true that JPMorgan and others really do want a very broad portfolio hedging approach to be recognized by the Volcker Rule. (Remember, they cited the likely-actual-Iksil-trade as something that is maybe not allowed by Volcker and should be.) I tend to be down for that – basically I’d argue that the core function of the financial system is to hedge a bunch of risks with a bunch of historically correlated but not precisely offsetting other risks – but it makes lots of people kind of nervous because when I say “portfolio hedging” you hear “just taking a bunch of crazy risks and pretending it’s a hedge.”
But the problem here is simpler: it’s that long TIPS + long unfunded credit is not an inflation hedge. Or, I mean, it probably effectively hedges the money that you put into that trade from inflation: if there’s really $100bn of funded exposure to TIPS + unfunded protection writing on CDX then, sure, let’s stipulate that that money is safe from inflation. But the rest of JPM’s $2.2 trillion balance sheet is no safer from inflation than it was before. (Which, btw: was pretty safe.****) It’s not a hedge for the rest of the bank, it’s just a safe-ish (except for the credit risk!) place to park some spare money.
In fact, the TIPS + CDX trade is not any sort of hedge for the rest of the bank; rather, it is a synthetic commercial bank. A commercial bank, outside of consumer/mortgage businesses, is basically a bunch of floating-rate loans to companies. A floating-rate loan to a company is reeeeeasonably insulated from inflation insofar as rates move to account for expected inflation. And a diversified portfolio of 3-7 year floating-rate loans to investment-grade companies has a credit exposure reeeeeasonably similar to a 5-year investment grade CDX index. You can get those exposures in the real world – by lending at floating rates to companies – or in the synthetic world – by buying TIPS and writing CDS on a credit index.
TIPS + CDX doesn’t hedge JPMorgan’s portfolio, it replicates it. This is why PIMCO, whose job is to find ways to put money to work in corporate credit, is recommending the trade to clients. Its whole business is to manufacture this exposure. JPMorgan’s CIO’s business is to hedge it. Or so I thought anyway.
The other view you could have is that of Felix Salmon, who kind of doesn’t believe that this is what’s going on, and sees the problems with the hedging theory, but still plays along:
This isn’t in any way a hedge of JP Morgan’s existing portfolio; it’s more of a doubling-down on it. Still, looked at one way, Iksil’s job is to take the assets that JP Morgan hasn’t been able to loan out, and get the kind of return on those assets that JP Morgan would be seeing if it had been able to loan them out.
It … is? I love this theory! I sort of idly speculated last week that if I were trying to get people angry at JPMorgan this – running a synthetic bank instead of a real one – is exactly what I’d accuse them of. Because real banks, like, Contribute To The Economy and Transform Maturity and Intermediate Credit and stuff. Synthetic banks just pretend to do that in the form of zero-sum bets with hedge funds.
Imagine that this theory is true. Of course JPMorgan can lend out all the money it wants – I WILL TAKE SOME***** – but maybe their decision tree runs like:
(1) If you can get a risk-adjusted return that is better than Treasuries****** plus an index investment-grade spread, lend away!
(2) If not, just chuck the money into Treasuries (or TIPS, whatever) and write protection on CDX.
That would, I suppose, not be crazy. After all it does seem to be difficult for banks to get rid of money they don’t want. One thing that I’ve pondered in my heart of hearts is that there may be some potential negative effects from the fact that investors are moving increasingly toward indexing – that as investors (both individual and institutional) lose interest in outperforming a benchmark, capital allocation will become less efficient because nobody’s really keeping track any more. Banks are the absolute paradigm of a group of people whose job is to allocate capital to the businesses that can best use it. It would be sort of amazing if the biggest US bank had a $375bn-and-growing portfolio devoted to “meh, we’ve got nowhere to allocate this cash, let’s just chuck it in an index and hope for the best.”
What the ‘London Whale’ Is (Probably) Doing [NetNet / John Carney]
Pimco and the JPMorgan Whale: CHIP-ing Away at a Scandal [NetNet / John Carney]
The 21st century hedge [FTAV / Izabella Kaminska]
Bruno Iksil and the CHIPS trade [Reuters / Felix Salmon]
Over explaining the London Whale [Reuters / Ben Walsh]
* Or, if it really makes a difference to you that selling protection on CDX is unfunded and MegaMillions tickets are not obvs, make that “… (2) long a blogging job (for the yield).” Or “… (2) long some other thing that is in no way connected with hedging inflation (for the yield).” Whatevs.
** Like, if you believe Carney’s trade is the trade, it should generate more VaR than the total VaR in JPMorgan’s CIO. See footnote *** here; mumbo-jumbo around the math and you get about $68mm of credit VaR from a $100bn trade [$1.5bn VaR calculated there for $2.2trn portfolio, divide by 22]. The reported total VaR in CIO is $67mm.
*** Others are unconvinced. I think that’s how to read Brad DeLong’s comment “He better hope his TIPS counterparties who owe him TIPS that do not exist have low counterparty risk, is what I’m saying’…”
**** Just for stupid fun, here is CPI inflation (FRED) vs. JPMorgan revenues (Bloomberg) since FY1997:
I submit to you that if you are a bank you do not need to hedge inflation risk.
***** And I have! I hope there’s a line somewhere in JPMorgan’s books that is like “hedge risk that mortgage borrower quits finance job to become blogger.”
****** Plus, like, do whatever you want about inflation.
******* This footnote is not attached to anything but – so many stars!