More Voldemort v. Volcker

I for one am pleased that the London Whale cannot stay out of the news despite all of JPMorgan’s best efforts to say that he’s NBD. His travels through the world’s oceans are delightful and instructive, and Mr. Whale, if you’re reading this and ever come to these shores, I’d love to buy you a drink or some plankton. On that note: lo these many hours ago I said:

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. … 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.”

And when I accused you of having that particular filter on your ears, by “you” of course I meant “Congress.” Per Jesse Eisinger:

Such “hedges” could encompass a lot of trades that looked awfully proprietary. A trade could seem to hedge a large business risk, like suffering loan losses if companies they lent to went broke in an economic downturn. But that might just be a bet on companies going belly up.

So Congress tightened the language. It wrote that the hedges had to be specific. When the Dodd-Frank financial reform law came out, the Volcker Rule provision defined “risk mitigating activities” as trades that were “designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings.” No macro-hedging, only micro-hedging. That is the will of Congress.

His basis for this is basically everyone in Congress, including in particular Jeff Merkley and Carl Levin, saying RAAARRRR SMASH PORTFOLIO HEDGING. And he notes that Whaledemort’s efforts – basically sitting in JPMorgan’s Chief Investment Office and possibly portfolio-hedging JPMorgan’s macro risks by buying kooky CDX bits – have revived a lot of this fretting about hedging things with other things that are not the things that you are hedging.

So I cannot understand this even a wee little bit.

Start with the obvious: if banks could only hedge things with the things that they were hedging they would … have some trouble hedging! If the only way that a bank would be allowed to hedge long $X of a particular CUSIP is by being short $X of the same CUSIP then you sort of can’t have a financial system, or at least not one that serves any economic function. (Like: go ahead and perfectly hedge my mortgage with no basis risk, JPMorgan! Here is one way to do it: not give me a mortgage. Other methods are left as an exercise for the reader but it’s hard.)

The way that you actually live in the world is: you have a book of exposures, which is built by things like customer flow and being in the lending business and generally intermediating credit and stuff. And you look at that book and make some calculations about its sensitivities to various events: if rates go up by 1% then you [make/lose] $X; if Company A defaults then you [make/lose] $Y; if the yen strengthens against the peso then you [make/lose] $Z. And you sort of tot that all up and then say which of these things are the biggest scariest things based both on likelihood of happening and loss in the case that they happen – like, if an asteroid crashes into the earth, then you probably have a bad day in your credit portfolio but who cares? – and ask yourself if there are trades you can make that make those exposures less scary in the plausible states of the world where the exposures were scary.

Sometimes, sure, that fright-reducing trade is “get rid of this terrifying exposure entirely” or some goofball short-against-the-box variant thereon. But that is a degenerate case because you are a bank, and your business is to take on exposures: if you never wanted any exposure to say the US housing market why are you in the mortgage lending business? So the normal case the fright-reducing trade is “do something with a large enough negative expected correlation to the other things in my book that I can feel good that if the bad thing happens I will make money on the hedge and vice versa.” And identifying that negative expected correlation is a skill, and its based on historical correlation and fundamental analysis and having an eye for what the likely situation is in which your existing exposure will be scary, and sometimes it looks a bit postmodern, and sometimes you get it wrong, but I submit that there’s no particular reason to think that Carl Levin is more likely to get it right than a bank. And I further submit that there’s no particular reason to think that totting up all the exposures in a trading book, seeing which ones cancel each other out, and then hedging the ones that don’t is likely to be a less successful strategy than trying to cancel out all the scary risks of each trade one trade at a time. The latter approach, in a book of a million trades, just gives you 999,999 more opportunities to be wrong.

But maybe that doesn’t matter. The Volcker Rule can I think have one of two purposes. It could be an honest attempt to get America’s hey-let’s-face-it-they’re-too-big-to-fail, deposit-funded, FDIC-insured banks to be more robust and not blow themselves up in the next crisis; in this view, prop trading is assumed (without evidence?) to correlate well with blowing oneself up and so is meant to be reined in. Alternately, it could be an attempt to impose a morality on bankers that they currently lack; in this view prop trading is just Not Done In Polite Company.

So let’s take this line again:

A trade could seem to hedge a large business risk, like suffering loan losses if companies they lent to went broke in an economic downturn. But that might just be a bet on companies going belly up.

Which view is this? I’ve been running around loosely defining commercial banks in various ways recently, but one way to loosely define a commercial bank is: it consists of a bunch of bets on companies not going belly up.* What that means is that if your primary goal is to keep commercial banks from sometimes exploding and bringing down the financial system, and a commercial bank comes to you and says “hey, I was thinking of betting on companies going belly up because …,” you don’t care about the “because.” It could be “… because my astrologist told me to.” That bet is good! It diversifies! It adds negatively correlated risk! At the time that companies are going belly up and banks are exploding left and right, this particular bank is not exploding as much because it has made money on the belly-up bet.

If, on the other hand, you care about the “because” – if you care whether this trade “seem[s] to hedge a large business risk” like companies going broke, or whether instead (instead!?) it is just (just!?) a bet on that happening – then you are in a world of morality. You want to regulate intent, not propensity to blow self up. And, like, fine. You can want that.**

But don’t pretend that you’re interested in preventing financial crises. If you’re interested in preventing crises, your questions about Iksil should be: what are his exposures? What are the exposures of the rest of the bank? If the bank is long credit and he is long credit then you should maybe worry (but, meh, he’s not). If the bank is at risk for a short-term jump down in credit, and he makes a ton of money on a short-term jump down in credit, then you should maybe be all pleased. Or not! Because a thing to live with in your life is that you can never predict every exposure – maybe he’s properly hedged JPMorgan’s credit exposure but will get thwacked by rates, or inflation, or FX, or skew between the credits he’s hedging with and the credits they’re lending to, or asteroids, or some other thing. Those are the things, I would think, that might be fruitful to worry about. Not how he feels about his exposures.

[JPM Whale-Watching Tour] Thar she blows! [FTAV / Lisa Pollack]
Interpretation of Volcker Rule That Muddies the Intent of Congress [DealBook / Jesse Eisinger]

* Also, like, NIM/rate curves and shit. But it’s worth emphasizing: it does not consist of a bet on companies; JPMorgan doesn’t double its profit if Facebook doubles its profit or whatever. It’s a bet on companies not going belly up; the profile of writing a bunch of loans is kind of “you do fine if companies do great; you do fine if they do fine; you do bad if they do bad.” It’s a written-put profile. So an appropriate hedge has a bought-put profile.

And I’m abstracting from mortgages but if US depositary banks are more mortgage banks than commercial banks then obvs (1) they are a bet on mortgages not going belly up and (2) the proper hedge for them is a massive bet that mortgages will go belly up possibly expressed by constructing securities designed to fail and betting against their clients and OMGOMGOMG etc.

** You can even have an economic case for your morality: you could be all “banks should be boring again” because boring banks attract boring bankers who don’t blow themselves up. I dunno; George Bailey blew himself up.

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19 Responses to “More Voldemort v. Volcker”

  1. VonSloneker says:

    As long as this fucker stays away from the "Chum Bucket" he can prop-trade-"hedge" his fins off, for all I care.

    – Plankton, Bikini Bottom

  2. OBX Brah! says:

    Craig: Hey, that whale talked to me too. After everyone left the show, I walked up to the glass and he started talking.
    Kyle: Well, why didn't you tell anybody?
    Craig: Well, I thought I was crazy. He said my dad was gonna sneak into my room naked one night and beat me up.

  3. Gargamel says:

    The FDIC's securitization "safe harbor" guidelines are similar, requiring a sponsor to retain 5% of a C[letter]O and that that 5% be "unhedged." OK, so JPM hangs onto 5% of the CDO, and some regulator gets to determine if some position or combination of positions somewhere else in JPM is "hedging" that 5% of a CDO-slug. It's, as you say, really just an excuse to give them the right to come in and find something wrong if they want to. Obviously, if the goal Mr. Junior Regulator is to impress his bosses and rack up fines and penalties, if he's looking for a place to "see" a punishable violation, this will provide easy pickings.

  4. PermaGuestII says:

    Call me Ishmael.

    -Ray Dalio

  5. trojan_ says:

    We're taking Willzyx to the moon. Long live the Zipods.

  6. FKApmco says:

    Dear Jesse and Michael:
    I am sick and tired of journalists talking shit about shit about which they don't know shit. That is all.

  7. Gretchen Morgenson says:

    Yeah, leave it to the pros

  8. Jonah says:

    Looks like my condo.

  9. Shamu says:

    WTF Matt? I put on a whole show and you just sit there looking like you'd rather be in front of your Commodore 64 making charts. This guy just gets an article or two written about him and it's all "I'll buy you a drink." Where's my fucking drink, huh?

  10. M. Lewis says:

    What the fuck does any of this mean?

    -OWS bond salesman BSD who would love to tell you about this one time he was in an elevator with John Merriweather and it was crazy, and then Ranieri got in and it was blowing his fucking mind.

  11. mcnet says:

    You ask:

    "If you’re interested in preventing crises, your questions about Iksil should be: what are his exposures? What are the exposures of the rest of the bank? If the bank is long credit and he is long credit then you should maybe worry (but, meh, he’s not).'

    This is precisely the question the Volcker rules ask. If the combination of non prop exposures net of hedge is not reasonably close to zero (lets not split hairs about actual zero, 'zero' means de minimus ,to allow for legit market making) at a federally backstopped bank, then the proposed metrics will flag it as an anomaly. The rules presume it is prop trading (the" rebuttable presumption"). JPM would be required to to rebut (and provide evidence) that it is not a prop trade.

    In the whale tale so far, all we've seen is the var on the index positions, so it appears it is a prop trade (and directionaly it doesn't look much like a hedge). Based on current disclosure rules we don't know what it's hedging and JPM doesn't have to quantify or disclose the underlying to curious minds.

    Under the proposed Volcker rules JPM would need to come clean and disclose what it's hedging. That would mean it would need to calculate var( among other metrics) on the underlying portfolio to support its claim that the CIO position is indeed a hedge against the existing book.

    JPM has hinted that these positions won't be rebuttable as anything but prop trades under Volcker.

    So this is either a last attempt to do some massive prop trading before the rules go into effect, or a bet that the metrics rules will be vague enough to allow them to exclude the CIO activity from scrutiny, or a broadcast of how the bank intends to organize itself to optimize the ambiguities in the rules as they currently stand.

    I'm kind of hoping that this brinksmanship by the banks during the last round of comments before the rules are adopted, which is intended to intimidate the regulators into backing off, backfires big time and actually stiffens the regulators spines.

    Humiliating poor dumb regulators by flaunting how the regulated will continue to outsmart them, in an attempt to bully them is a pretty ballsy strategy in a 99 v 1 presidential election year (even with promises of sinecures at the majors for the regulators post implementation).

  12. itchy throat says:

    This blog is something that’s wanted on the net, thanks