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More Voldemort v. Volcker

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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.


You Say "Voldemort" Like That's A Bad Thing

Do you think that Bruno Iksil, when he woke up in Paris on Friday looking forward to trading from home in his black jeans, expected to become an international celebrity? The evidence suggests not. You may remember Iksil - possibly under other names like "Voldemort" or "the London Whale™" as the JPMorgan chief investment office trader who has sold protection on $100bn of notional of a CDX investment grade index to ... hedge ... JPMorgan's massive short position in credit ... or ... something?* Anyway a lot of people are mad at him because that's just too much protection to sell on that index and so they are complaining to Bloomberg and the Journal about how he is manipulating the market and also taking huge proprietary risks with JPMorgan capital that should obvs be regulated out of existence. This is weird in a lot of ways but one of them is that you can distill a lot of the Volcker-Rule complaints into "my God, you're telling me that JPMorgan is exposed to $100bn of credit risk on investment-grade debt issued by a diverse mix of 121 U.S. companies!?" No! JPMorgan is exposed to something like $750bn of credit risk on debt issued by a diverse mix of companies. Some of it's non-US. Some of it's not even investment grade. And that's just in its loan book.** Is writing $100bn of protection on the CDX.IG.NA.9 a terrible risk to take with investor and depositor and government-backstop money? Well, define "terrible risk." It's certainly less risky than operating the rest of JPMorgan.***

JPMorgan's Voldemort Probably Isn't That Magical

John Carney has hilariously convinced a bunch of people that JPMorgan whale-wizard Bruno Iksil could actually be running a synthetic bank on top of JPMorgan's actual 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 he was doing, and (4) being what JPMorgan has actually said it's actually done 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.