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Ina Drew Spent Her Whole Life Preparing To Construct A Poorly Correlated Credit Macro Hedge

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You've all peered into Ina Drew's soul by now, right? My basic reaction was, "she kicks it old school." This is obvious from the way that she stayed in Short Hills after getting rich, instead of decamping to, like, the moon, I guess? More telling, perhaps, is the fact that she seems to have been present at the creation of the idea of buying and selling financial instruments to hedge a bank's credit risk:

By the mid-1980s, Drew was working directly under an economist named Petros K. Sabatacakis, the head of Chemical Bank’s global treasury department. Among the department’s tasks was managing interest-rate risk ... Still, the group was considered a sleepy backwater until Sabatacakis turned their attention a few years later to banking’s other major risk: credit default. The bank was most vulnerable to its lenders1 defaulting in a recession; in a recession, the Federal Reserve generally lowers interest rates to increase borrowing and spending. Sabatacakis determined they should continue to buy those securities whose value would rise in a recessionary environment. “It was a trader’s mentality,” says Glenn Havlicek, a trader who worked under Drew for 22 years. “It may seem elemental, but at the time, the idea of mixing a trading solution and a credit-crisis solution — it was in its awkward infancy.”

That was an awkward infancy! Basically you notice that there's a correlation between (1) spreads widening and (2) rates tightening, so you get long rate product to hedge your spread product? That's a pretty blunt instrument:

Drew’s deals essentially turned on one key question she seemed to answer correctly more often than most (or at least when it mattered most): Would interest rates go up or down? That insight seemed valuable but hardly cutting edge to her new colleagues. “She was like the idiot savant of ‘I’m long’ or ‘I’m short,’ ” says one former JPMorgan employee, summing up how some of his colleagues perceived her success.

I will blindly assert that the correlation between (1) Treasury rates and (2) a bank's credit risk in a recession is not, like, -1. So that blunt-instrument hedge creates quite a bit of basis risk, if you'd like to think of it that way - though I suspect Chemical didn't. And I say unto you, if your infancy involves taking a lot of basis risk in your treasury department's macro credit hedges, you will ... grow up to take tons of basis risk in your treasury department's macro credit hedges, no?

But now you can measure it, with misleading precision. And what you can measure with misleading precision, you can obtain in arbitrary amounts that turn out to be not the amounts you wanted. Chemical's late-80s macro credit hedge was "buy Treasuries," but JPMorgan's circa-2011 macro credit hedge was more like "buy protection on credit index tranches that have very high delta to credit while at the same time selling protection on larger amounts of lower-delta product." This is cheaper than "buy Treasuries," in the sense that you still get some spread in good times, but leaves you with a lot of exposure to your deltas and correlations not working out as you expect. Especially when your expectations of those correlations are formed by vague hand-waving from a continent away:

At some point in December of last year, a former executive from the group says, Drew checked in with Macris and Martin-Artajo about the position while the two men were in New York. They answered, but the executive, who understood the trade, remembers thinking that they did not give as full an answer as they could have. “I think they glossed over details to the point where Ina knew the product, the size they were trading, but she did not know what the true P.& L.” — profit and loss — “impact could possibly be in a stressful scenario,” he said. She was asking the right questions, he said, but did not seem to be picking up on what was not being said.

The Times article does a pretty neat job of armchair-psychologizing Drew, and you can read other good efforts from Felix Salmon and Kevin Roosé. I don't know what Drew was thinking. I resist ascribing weird motives to her because basically JPM got picked off and, like, the world requires that someone will get picked off, and yeah you can probably build a psychological profile of who gets picked off versus who doesn't, but the reason that that profile is 7,500 words and in the Times Magazine has to do with contingent factors well beyond the fact that Drew happened to get picked off on a trade.

But how would the late-'80s Ina Drew have hedged the risk of a credit crisis? The answer is surely not "get long CDX while getting short tranches." It's "buy Treasuries," right? That would have worked better.

The Woman Who Took the Fall for JPMorgan Chase [NYT]
Who is to blame for Ina Drew’s downfall? [Reuters / Felix Salmon]
The Primacy of Judgment on Wall Street [NYM / Kevin Roosé]

1. Sic, and arrrrgh.