Volcker Rule Would Have Required JPMorgan Whale To Look Himself In The Mirror And Ask “Is This Really What I Want To Do With My Life?”By Matt Levine
It looks like London Whale Bruno Iksil is currently vacationing in a quantum state between fired and not-fired, which I suspect is relatively pleasant compared to, like, trading credit indices, and his immediate supervisors have all moved on to bluer oceans. But layers and layers of people above them continue to have to tug at their collars and worry about the whole why-didn’t-we-stop-his-whaling-and-what-does-it-mean-for-our-jobs thing. Jamie Dimon has done a certain amount of that, but today the regulators in charge of JPMorgan got ther chance to do some collar-tugging in front of the Senate. Let’s just assume that was enlightening.
In any case this, from the Fed’s Daniel Tarullo, must be right, right?
Regulators said they don’t yet have enough information to say whether the trade would violate the Volcker rule’s ban on banks engaging in so-called proprietary trading. Still, under the draft rule, J.P. Morgan would have had to provide regulators with documentation showing it was a permitted hedge, not a banned proprietary bet designed to make money for the bank.
“If a firm said, ‘We’re doing this because it’s a hedge,’ they would be required to explain to themselves, importantly, as well as to the primary supervisor, what the hedging strategy was, how it was reasonably correlated with the positions that they were hedging, and how they would make sure that they didn’t give rise to new kinds of exposures,” Mr. Tarullo said.
You can tell how very, very, very right it was by reading the proposed Volcker Rule,* which to be fair is in a bit of a quantum state itself but whatever; pages 65-68 have the criteria for being a hedge. Under the proposed rules, not only do you have to convince yourself that “the transaction hedge or otherwise mitigate one or more specific risks, including market risk, counterparty or other credit risk, currency or foreign exchange risk, interest rate risk, basis risk, or similar risks,” that “the transaction be reasonably correlated, based upon the facts and circumstances of the underlying and hedging positions and the risks and liquidity of those positions, to the risk or risks the transaction is intended to hedge or otherwise mitigate,” and that “the hedging transaction not give rise, at the inception of the hedge, to significant exposures that are not themselves hedged in a contemporaneous transaction,” but you also have to document your conclusions and let regulators know all about them.
Or, as somebody once ever-so-slightly-tendentiously put it, “if you want to be trading, you have to have a lawyer and a psychiatrist sitting next to you determining what was your intent every time you did something.”
I guess this new focus on soul-searching about hedging intent is socially productive but it’s also making me realize that I have no soul, because my reaction is along the lines of “hmm how hard could it be to demonstrate that X does those things, for any X?” and, honestly, it can’t be that hard, can it? We’ve talked just a little bit before about what JPMorgan’s Chief Investment Office was doing but really it seems pretty well established that, at least at the beginning, it was hedging credit risk in some sort of jump-to-terribleness way. So that has (1) an identified risk, (2) a reasonable correlation to that risk,** and (3) well, it seems likely-but-not-certain that day one there was no significant new market risk caused by putting on a delta-neutral-ish CDX trade.*** Over time that all became … not so much true … but the not-so-much-trueness seems to have been caused by JPMorgan trying to reduce its hedge rather than add to it, so it’s not clear whether it would have failed the Volcker soul-search.****
Some of the stylized facts in the previous paragraph come from the testimony of JPM’s bank’s regulator, Comptroller of the Currency Thomas Curry, which is useful not only to see what regulators think (and thought) of the Whale trade but also as a reminder that, even without the Volcker Rule, the OCC, Fed and others had pretty complete access***** to data on JPMorgan’s whale-sized positions, and basically signed off on them as a hedge until Bloomberg suggested there might be a problem:
In 2007 and 2008, the bank constructed a portfolio designed to partially offset credit risk using credit default swaps to help protect the company from potential credit losses in a stressed global economy. This strategy was reflected in regular reports received by OCC examiners. The OCC focused on the risk management systems and controls that the bank employed to mitigate credit risk in its portfolio. For several years thereafter, risk levels operated within bank-approved stress and other limits.
In late 2011 and early 2012, bank management revised its strategy and decided to offset it original position and reduce the amount of stress loss protection. The instruments chosen by the bank to execute the strategy were not identical to the instruments used in the original position, which introduced basis, liquidity, and other risks. As the new strategy was executed in the first quarter, actual performance deviated from expectations, and resulted in substantial losses in the second quarter. Whether risk management controls, procedures, and reports were properly structured, reviewed, approved, and acted upon in the execution of this strategy is another focus of our ongoing examination.
In April 2012, as part of our supervisory activities, OCC examiners met with bank management to discuss the bank’s transaction activity and the current state of the position. OCC examiners directed the bank to provide additional details regarding the transactions, their scope, and risk.
Did that additional OCC-driven soul-searching lead JPMorgan to discover the problems with its position? Maybe. But imagine the world where in 2011 JPMorgan came to the OCC and said that it had decided to reduce its portfolio credit jump-risk hedge by taking offsetting positions in non-identical instruments that its models told it were (1) highly correlated to its initial hedge, (2) liquid and not risk-additive, and (3) more cost-efficient than unwinding its hedge directly. Would OCC have had the expertise to question JPMorgan’s models and predictions, which turned out to miss the liquidity and correlation problems in its offsetting trades? Or would JPMorgan’s answers to its own soul-searching – which, after all, it thought were right – have been enough for them?
* But don’t!
** No? Imagine a stylized jump-risk hedge to JPM’s credit portfolio that is DV01-neutral-ish but long downside gamma; that is I suppose “correlated” to some sort of jump down but not that inversely “correlated” to the value of the credit portfolio? Would that rule it out as a Volcker-qualified hedge? Outside of the liquidity and market-cornering and general-implementation-fuck-up issues that actually existed chez Whaledemort, would that be a good thing? Discuss.
*** Was there counterparty/liquidity/whatever-ish risk? Maybe? Is there not always? Is that a thing? Presumably the goal of the hedge is to replace big risk X with smaller risk Y, but Y never hits zero.
**** Also, the rule specifically says “In addition, proposed § __.5(b)(2)(iv) only requires that no new and significant exposures be introduced at the inception of the hedge, and not during the entire period that the hedge is maintained, reflecting the fact that new, unanticipated risks can and sometimes do arise out of hedging positions after the hedge is established.”
***** Worth quoting:
99 per cent of all CDS trades live in an information warehouse called DTCC, to which the regulators of the banks have access in however much detail they want!!! What kind of regulator doesn’t go and look at the that, when the mere public, aggregated info shows this?
It baffles us. Absolutely baffles us.