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The House’s ping-ponging alternation of smacking and caressing Jamie Dimon today got pretty boring but I was struck by one number that Dimon mentioned, perhaps because it was about the only number that he mentioned. One Republican, with somewhat unclear intent,* suggested that the biggest risk to JPMorgan is that interest rates go up and asked Dimon how JPMorgan hedges that risk. And Dimon pointed out that actually JPMorgan is well set up for that, since it will make money if rates go up, and said “It probably cost us over $1 billion a year to benefit from rising rates.” You can’t as far as I can tell find that number in JPMorgan’s disclosures, but here is a potentially related thing:
So JPMorgan is supposedly spending over $1bn a year on a bet that pays off $2.3bn if rates rise by 100 basis points this year. The odds of that are low, let’s say, less than 45% anyway, which would make that a breakeven trade.
That can’t really be what he meant; nor does it even make sense as a thing. Dimon was discussing that cost in the context of the chief investment office’s available-for-sale portfolio having about a 3-year average duration; at a $375bn portfolio and around a 35bps spread between 3- and 5-year swaps, that suggests that he’d be making about $1bn a year more with about a 4.5-year maturity in that portfolio – at which point he’d I guess be indifferent to rates going up? Of course he’d be making even more with a 10-year average maturity – maybe another $2 or $3 billion – but then he’d lose, instead of breaking even, if rates went up.
I wouldn’t make any economic decisions on that math! I wanted to flag the thing, though, as a weird concession to politicians’ thinking. The “cost” of hedging that rate risk is not as easily reducible to numbers as the exchange suggested: the cost to JPMorgan of being well positioned if interest rates rise is that it is less well positioned if interest rates don’t rise; the better off it is in a high-rate future, the worse off it is in the low-rate now. That is within reason a sliding scale: put all your money in 30-year bonds and you’ll make more interest now but get hosed if rates rise; lend it all overnight and you’ll pay a lot of carry for the option to re-lend it when rates rise. The cost of one choice is giving up the other.** Sometimes there’s a sensible zero to anchor to – Dimon’s implication, here, seems to have been that JPMorgan would make about $1bn per year more if it had zero exposure to rising rates than it does now that it has positive (+$2.2bn/yr) exposure to rising rates – but that doesn’t make the “real” cost $1bn. Why is zero exposure to rising rates the right amount?
Still, the cost is real enough even if the measurement is suspect. JPMorgan is foregoing actual cash interest every quarter in order to retain the flexibility to profit from rising rates. The world being as it is, some of the cash interest that it is foregoing would counterfactually be paid by homeowners who’d love to refinance their houses, but leave that aside – the point I’d focus on is that spending actual cash money often makes you sad. Far better, in many cases, to pay for your hedge – your profit in one counterfactual state of the world – by selling another counterfactual state of the world that you think is less likely. Rather than foregoing interest now in order to profit from rising rates, sell some options on rates going lower in order to pay for options on rates going higher.
That’s hard to do in this specific case – what with rates being pretty much zero-bounded – but it’s a decent description of what JPMorgan probably did to get Dimon hauled in front of Congress. JPMorgan wanted to hedge certain credit-market catastrophes, and rather than whack its profits and incur earnings volatility to pay for that hedge, it instead sold hedges on certain other credit-market catastrophes. But it got those hedges all tangled and ended up in the wrong catastrophe. And it’s perhaps a mark of JPMorgan’s contrition that Jamie Dimon is so willing to talk specifically about the dollars he’s spending to hedge interest rate risks: paying for hedges with cash in the real world is less pleasant and less creative and often less profitable than paying for them with worse outcomes in potential worlds, but right now it probably sounds a lot better to Congress.
House Panel Hearing on JPMorgan [DealBook]
* I’m guessing the subtext was either “all your regulation isn’t free you know” or “buy gold!”
** The same congressman asked Dimon how much it costs him to manage risks in Europe, which he sensibly declined to answer except to say that they avoid some countries and impose maximum risk limits on others. If Spain had enough bonds, JPMorgan could put its whole CIO portolio in 7% yielding Spanish bonds and make $26bn a year in interest, so in some sense the cost of hedging Spanish risk is $26bn a year. In some pretty stupid sense though.