May 17th, 2012
by William K. Black, New Economic Perspectives.
The usual apologists have rushed to the defense of Jamie Dimon, JP Morgan Chase’s CEO, after he announced that JPMorgan (NYSE: JPM) lost over $2 billion on purported hedges. The academic apologist-in-chief, Yale Law’s Jonathan Macey, is outraged that anyone is concerned about these matters. Macey, channeling Dimon’s flacks, asserts that the facts are as follows:
“The sole purpose of hedging is to reduce risk. The particular trades that J.P. Morgan was making were designed and intended to protect the bank’s balance sheet against losses from its exposure to the apparently increasing risk of some of its European assets, including approximately $15 billion in European distressed debt.”
My prior column explained why the purported hedge was not a hedge but a speculative investment in derivatives in contravention of the purpose of the Volcker rule. This column makes two more basic points. First, if JPMorgan’s “sole purpose” was “to reduce risk”, particularly of “$15 billion in European distressed debt” – why didn’t it sell the distressed debt? That would have eliminated the risk, which is far better than “reducing” risk. A true hedge would lock in any loss in the “European distressed debt” so the vastly better strategy if JPMorgan’s “sole purpose” was to “reduce risk” was to sell the inherently extremely risky assets. Even a true hedge is rarely perfect and has some risk of performing poorly, so selling “distressed” assets was unquestionably the superior alternative if one believes (and I don’t) Macey’s assertion that JPMorgan’s sole purpose in dealing with the distressed debt was minimizing its risk.
JPMorgan’s investment managers may, of course, have excellent personal reasons not to sell the European distressed debt. It may be that they had not reserved properly for the market losses on that debt. The debt is likely not be in default (yet) and still paying interest. That makes the managers’ reported “profits” look far better than if they had properly recognized the market value loss on their “distressed” assets. Those inflated “profits” lead to bigger bonuses. These types of conflicts of interest among proprietary traders are common and they pose a serious risk to the bank because they create perverse incentives that often lead to severe losses to the bank.
Second, even if we ignored the clearly superior alternative of selling the European distressed debt, the obvious question (and therefore a question not asked by the media) is why JPMorgan didn’t enter into a real hedge. The most obvious real hedge was to purchase CDS protection from a highly creditworthy counterparty. Macey asserts that JPMorgan purchased "extremely complex" financial derivatives, “designed and intended to protect … against losses from its exposure to … $15 billion in European distressed debt.” That assertion is nonsensical. The rule in hedging is that simpler is better. Unnecessary, “extreme” “complexity” is one of the clear warning signs of fraud. There was a simple derivative instrument, purchasing CDS protection, available to create a real hedge against the “European distressed debt.”
Purchasing an “extremely complex” derivative of a derivative was not simply unnecessary and unduly expensive and risky – it was also clearly not “designed and intended to protect” against losses on the “European distressed debt.” We know that it was “designed” to do the opposite – the “extremely complex” derivative of a derivative was likely to lose value if the “European distressed debt” lost further value. Macey and I cannot know what the “extremely complex” derivative of a derivative was subjectively “intended” to do. We know the following things about evaluating likely subjective intent:
One cannot rely on the self-serving statements of the traders because they have powerful incentives to claim that they intended to hedge.
One normally infers that financial participants intended the predictable consequences of their actions – and this faux hedge was designed in a manner in which it would amplify rather than reduce the risk of loss in the European distressed debt.
Unnecessary complexity is a badge of fraud.
The Volcker rule can be evaded by falsely claiming that a speculative position in a financial derivative was intended to be a hedge.
JPMorgan continued to invest in the derivative of a derivative even as it lost billions of dollars and performed as an anti-hedge – it magnified its losses on the European distressed debt – an (in)action that is a common “double down” tactic of speculative traders but impermissible for one who “intended” the purchase of the derivative as a hedge and later learned that it was failing to perform as a hedge.
On the basis of these factors we can conclude that it was extremely unlikely that the JPMorgan traders subjectively intended the investment in the CDS index as a hedge against losses in the European distressed debt. Their actions are far more consistent with the intent to take a speculative gamble on an “extremely complex” financial derivative while developing a hedging cover story to cover their flanks against potential claims that they were violating the Volcker rule. The actions of the senior managers, including Dimon, as the “extremely complex” financial derivative suffered severe losses is also more consistent with the proposition that they intended a speculative gamble on CDS indices rather than a hedge. The senior managers knew early on that the CDS index was not functioning as a hedge, but (at least in the versions made public) they did not unwind the faux hedge, sell the European distressed assets, or institute a real hedge of the distressed asset. That strongly suggests that they did not have a subjective intent to hedge.
I want to caution readers that we do not know the real facts about the JPMorgan transactions because these derivative deals are so opaque and because JPMorgan’s explanations have not been candid. Macey’s assertion that JPMorgan was hedging “some” of its European assets – a category broader than the “15 billion in European distressed debt” is so vague that it casts additional doubt on the “failed hedge” story. JPMorgan should be able to produce a document, prepared prior to the purchase of the CDS index, explaining (1) exactly what assets the CDS index was purportedly “designed” to hedge and (2) the basis for the conclusion that research demonstrated that the CDS index would perform as a reliable hedge for those specific assets. If such a document exists, I predict that the paragraphs setting out the purported “basis” for believing the CDS index would function as a reliable hedge will be facially absurd.
But I doubt that such a contemporaneous hedging document with a “basis” statement even exists. So I ask the SEC, the Fed, the OCC, and the relevant House and Senate Committees to subpoena that document today and make it public next week. If such a document exists the release will be embarrassing for JPMorgan, but it will not reveal any information that needs to be kept confidential for any valid business purpose.
Ultimately, the subjective intent of JPMorgan’s traders and senior managers is not the critical question. The “extremely complex” CDS index was not remotely close to being an appropriate hedge (a fact that was easily determinable in advance) – and it would have been financially insane to attempt to hedge with a CDS index rather than selling the European distressed debt if JPMorgan’s “sole purpose” really were “reducing risk.” It was equally clear – in advance – that purchasing CDS indices would seriously increase JPMorgan’s overall risk of loss if Europe’s economy deteriorated. Regulators cannot enforce a rule that only allows them to act if they can divine (and prove) a subjective intent to violate the rule.
The really scary aspect of this story is that JPMorgan continues to claim that its purchase of a huge position in an “extremely complex” financial derivative that exposed it to severe loss and could never be a true hedge is permissible under the Volcker rule because JPMorgan called it a hedge. “Hedginess” does not hedge. It is speculation in financial derivatives and it will, eventually, cause catastrophic losses (again) if we do not stop it. The current draft of the Volcker rule is a disgrace. It was designed by JPMorgan’s lobbyists to embrace hedginess. It is imperative for the global economy that the final interpretive rule to outlaw hedginess and permit only true hedges. There are many euphemisms for hedginess such as “economic hedging” and “dynamic hedging.” None of them are real hedges. Each of the faux hedges increases global systemic risk.
Our real problem is that Treasury Secretary Geithner, Ben Bernanke, the Federal Reserve Bank presidents, and the Fed’s economists are overwhelmingly anti-regulators who largely do the bidding of the systemically dangerous institutions (SDIs). Dimon and Macey are enraged about the timing of JPMorgan’s loss because they were so close to rendering the Volcker rule toothless. The true test for the Obama administration and Congress comes now. Will they act to save the Volcker rule from Dimon’s lobbyists”? Do the Republicans really want federally insured banks to be able to invest again in “extremely complex” financial derivatives that can bring the return of the “green slime” that destroyed the global economy? Under what principle of “limited government” should the government subsidize that kind of speculation? What are Mitt Romney’s and President Obama’s positions on whether we should gut the Volcker rule by permitting hedginess?
Other Articles by William K. Black
About The Author
William K. Black is the author of The Best Way to Rob a Bank Is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.
William writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.
Follow him at: @WilliamKBlack