December 22, 2024

High & Low Finance: Masked by Gibberish, the Risks Run Amok

Or should we simply conclude that playing in the modern world of derivatives is best left to those whose survival is not critical to the nation’s economy, and who do not benefit from government-backed deposit insurance?

That question is brought to mind by a reading of the fascinating — well, to me, anyway — story of how JPMorgan Chase got into the mess of the London whale trades that dominated the financial news last year, as told in a report by the Senate Permanent Subcommittee on Investigations that was released last week.

Much of the attention has focused on what Jamie Dimon, the chief executive, knew and when he knew it, and the extent to which the bank intentionally deceived regulators and investors as the investment strategy was blowing up.

I, on the other hand, was struck by the sheer incompetence and stupidity documented in the report.

Consider the following presentation written by Bruno Iksil, the whale himself, on Jan. 26, 2012, as the losses were growing. He called for executing “the trades that make sense.”

He proposed to “sell the forward spread and buy protection on the tightening move,” “use indices and add to existing position,” “go long risk on some belly tranches especially where defaults may realize” and “buy protection on HY and Xover in rallies and turn the position over to monetize volatility.”

That presentation was made to a JPMorgan group called the International Senior Management Group of the Chief Investment Office, which seems to have approved it.

If the proposal does not make sense to you, don’t despair. It is largely gibberish.

“This proposal,” the Senate report states, “encompassed multiple, complex credit trading strategies, using jargon that even the relevant actors and regulators could not understand.” The subcommittee asked officials of both JPMorgan’s Chief Investment Office, or C.I.O., and its regulator, the Office of the Comptroller of the Currency, just what that meant. Nobody seemed to know. (Mr. Iksil, safely overseas, chose not to talk to the subcommittee staff.)

Ina Drew, the bank’s chief investment officer at the time, who supervised the group, said she did not know. One risk officer at the bank said he thought Mr. Iksil was simply proposing a strategy of buying low and selling high. Of course, that is a fine strategy if markets cooperate. But anyone who simply proposed that would have been seen to be blowing smoke. Use all that jargon, and some people will assume you are actually saying something.

The comptroller’s office was able to explain some of what was said, but no one seemed to be sure just what a “belly tranch” might be. The subcommittee speculated it might refer to a security with more credit risk than the safest ones, but less risk than the riskiest ones.

In any case, after the meeting Mr. Iksil embarked on a disastrous strategy that led to larger and larger losses. The portfolio he was running — which the bank initially said was a hedge to reduce its exposure to a general deterioration of credit conditions — became one that would benefit from credit conditions improving.

Over the next two months, as the losses grew, neither senior bank officials nor regulators seem to have had a good understanding of what was happening.

The bank officials were preoccupied with making the mess seem less messy. That involved what they called defensive trading — buying what they already owned to keep market values from falling further — and, when that did not work, fudging the valuations. It involved changing risk models to make what was going on seem to be less risky than it was, and coming up with creative ways to calculate how much capital was really needed.

The regulators seem to have been in their own “see no evil, hear no evil” world. When they eventually had to pay attention, the comptroller’s officials were not bothered by the bank’s withholding of information from them. Instead, one top official dismissed the entire problem as little more than “an embarrassing incident.” Comptroller’s officials immediately said the trades were perfectly proper hedges, something that turned out to be untrue.

Floyd Norris comments on finance and the economy at nytimes.com/economix.

This article has been revised to reflect the following correction:

Correction: March 21, 2013

An earlier version of this column mischaracterized the subcommittee’s speculation on what a “belly tranch” might be. The thought was that it might refer to a security with more risk than the safest securities and less risk than the riskiest ones, not with less risk than the safest securities and more risk than the riskiest ones.

Article source: http://www.nytimes.com/2013/03/22/business/behind-the-derivatives-gibberish-risks-run-amok.html?partner=rss&emc=rss

Speak Your Mind