To the question at hand, was JPM “gambling” or was this merely “hedging” gone awry? It helps to understand what a hedge is and why it might be used. Any business faces a variety of risks. Banks, in particular, face risks associated with the credit quality of the general economy. For an institution of JPM’s size, if the economy weakens, defaults are likely to rise or the bank is likely to need to increase reserves against potential losses. It’s obvious why a bank might attempt to hedge such risks.

Reportedly, JPM started out doing this last fall. They bought credit default derivatives (yes, the instrument that sunk AIG) as protection against weakening credit. This instrument carried protection on over 100 companies. Fine. Sometime early this year, JPM began to unwind this trade and reverse it. This was done not by selling the protection they had, but by selling…hold on…forget about the complexities of the trade itself. The only important thing here is that the so called hedge was “traded” and not held as a hedge. All of us carry insurace on our homes and cars. Do we change the amount of hedging against potential disasters. Imagine if every spring you decided just how much fire insurance to have. Maybe this season is particularly dry, would you buy $1 million coverage on your $500,000 home? Would you go naked next year if spring were wetter than normal? In other words, JPM was not behaving as if it were hedging risks- it was tryinig to outsmart the insurance it already had.

Yes, that last sentence of the previous paragraph is key. JPM was hedging risks it gets paid to take. Banking is a business of getting paid to take risk. A bank borrows deposits cheaply and lends them at much higher rates. The bank, in exchange for turning demand deposits (overnight money) into long-term, economic growth generating, loans and investments gets to keep the difference. From time to time, profits will fall- that’s why they get paid to do this in the first place! So, why would JPM try to hedge its risk through derivatives instead of simply being a better banker? Why not just increase reserves or sell some loans? Furthermore, banks have a built-in “natural” hedge in the form of interest rates. Most banks profitability increases when interest rates fall, which they are likely to do when an economy weakens (admittedly, we’re already at zero, but the so-called hedging activity is not new to this cycle).

So why does JPM (and its brethren) decide to use derivatives to “hedge”? Because those natural measures would impact reported results. Traders always think they are smarter and quicker than the rest of the world, why not use sophisticated derivates to hold the books steady despite what happens to the underlying assets? This trade was not a hedge- it was a bet or “gamble”. They traded known and widely understood risks and tools for esoteric and hidden risks. This is exactly what we don’t need at systemically important institutions.

Another reason this “hedge” was nothing of the sort: a hedge is supposed to be offset by an underlying asset. If you are worried about the house burning down and the insurance pays, it’s because you lost your house. Net financial loss to your balance sheet is close to zero. If JPM was hedging, then which asset went up while the hedge lost? Hedges do not generate $2 billion net losses. We can’t blame simple execution errors either for if banks of the size and sophistication of JPM can simply get the trade wrong, then no organization with systematic importance can be allowed to take such risks.

Oh, and another reason it wasn’t a hedge: trades so large that they distort the market itself are not hedges. JPM’s trades were so large, they distorted the credit indexes they were based on! There is no hedge if you “are the market”. I’m reminded of a Wall Street tale told to me by a retired trader I know. Back in the 70s or thereabouts, there were five Wall St hotshots that used to gather at a bar on the east side after work. In those days (not unlike now), wine and dining clients was a regular occurance and these guys often gathered at this particular bar to swap stories afterwards, talk shop, commiserate and exagerate. One day they got the bright idea to buy the bar since they spent so much time and money there. A few months later, they discovered the bar was losing money. The culprit was them: they were their own biggest customers. It’s not a hedge if you are the bar.

This morning’s WSJ has a great article on how the “London Whale”‘s trade unfolded. It details reports of how Mr. Iksil (aka the “London Whale”) was “trying to wipe everyone [on the other side of the trade ] out”. In fact, his other nickname is the “Caveman” for “pursuing trades that rivals sometimes thought were overly aggressive but often led to huge profits.” Then the kicker: after making huge profits on the risk trade last fall, Mr. Iksil reversed the trade which eventually led to the recent large loss. Details on the reversal are sketchy, but if you are hedging, why reverse the trade? It could be “reversed” to a position of net zero, but it wasn’t. It was turned into a bullish bet on the same companies. The risk to bank’s fundamental business hadn’t changed, but trade did a 180! How on earth is that a “hedge”?

Back to Maria and those that claim “do we really want to discourage risk taking?” I suppose the answer lies in a Clintonian definition of “risk”. If we mean risk as in taking deposits and making loans or investing in venture capital, the answer is of course no. If by “risk” we mean gambling with derivatives that serve no genuine banking function, then the answer is emphatically yes! And if investment banks are to gamble “with their own money”, then why should they have access to the Fed window and implicit backstops from the Treasury? Why shouldn’t their leverage be limited? Remember that derivates are enormously levered devices that keep the actual leverage off the books. Bring back Glass-Steagall!

Soros notes some interesting observations such as noting that

“the Bundesbank has seen the danger…once the Bundesbank starts guarding against a break-up, everyone will have to do the same. Markets are beginning to reflect this.”

To me, this raises the danger level for investors, but George disagrees.

I’m not doing the essay justice here, so read it for yourself:

http://www.ft.com/intl/cms/s/0/f7ac05c8-82fa-11e1-ab78-00144feab49a.html#axzz1rpp9y4cs

It was a bit controvercial when his 2010 article proclaimed this. After all, Goldman was still doing bring business and there were no signs of client defections. You’d think customers would be the first to dislike the offending GS behavior.

Today came an interesting opinion piece in the NYT. A long-time employee writes why he is leaving GS and it isn’t pretty for the firm. Greg Smith is leavings because of “the trajectory of its culture…the environment is now as toxic and destructive as I have ever seen it.” Almost corroborating Taibbi’s claim is that “Goldman Sachs is one of the world’s largest and most important investment banks and it is too integral to global finance to continue to act this way.”

Interestingly, his main claim is that “the interests of the client continue to be sidelined in the way the firm operates and thinks about making money” and “how callously people talk about ripping their clients off”. The problem for GS’s future, Smith writes, is “how little senior management gets a basic truth: If clients don’t trust you they will eventually stop doing business with you. It doesn’t matter how smart you are.”

Which raises some interesting questions. If GS’s behavior is so bad, why aren’t clients defecting? Are they that oblivious, clueless, blind or dumb? Or does GS offer things that can’t be matched elsewhere such that customers stay anyway? Perhaps clients simply don’t feel these claims are accurate and that GS really does care about them? As illustrated by Buffett saving Salomon in the early 1990′s or Arthur Andersen disappearing after Enron, reputation and trust are so important in finance that if GS’s business doesn’t hurt from these allegations, either they are not taking advantage of clients or clients are truly oblivious. It’s hard to see a middle ground.

Please have mercy on us color blind folks. Is it too much to ask that your charts use colors that are clearly distinct? I once failed a chemistry lab because I couldn’t see the goop on the microscope slide turn from pink to purple. Like there is a difference to us color challenged?

Red, green, yellow lines- all just look like a kid was drawing scribbling lines to us. Even when lines are labeled, we’re lost after two series cross. Red and blue are hard to decipher if the screen is off or the printing is off. They key is to use colors that dramatically contrast to a degree where color is nearly irrelevant. Bright red and green can just be bright lines, but a blue line and a light green line are different in intensity/brightness/contrast and can almost always be deciphered by all but the worst colorblind cases.

Sincerely,

A Few Percent of the Population

ps.

And “magenta”- whatever the hell that is- is really just a joke to us.

Even more hilarious, is the youtube vid I noticed off to the side of this debunking video:

Unfortunately, WordPress will not embed a video on Yahoo!, so I have to give you a link:

http://finance.yahoo.com/blogs/daily-ticker/author-grabell-stimulus-deserves-somewhere-between-b-c-191641177.html

———-

You guessed it, it is prediction time! Along with the new year, the pundits will come out and make confident, bold predictions about the year to come. They’ll hardly ever revisit last year’s forecast and how wrong it was, but no matter, they will confidently predict this year’s path anyway. Of course, this annual exercise tends to hit the press in January and January is the month that supposedly predicts the stock market for the rest of the year. (Recaps of this topic here and here.) I’m going to pre-empt the February 1st or 2nd headlines right now.

For 2011, the January Barometer was wrong, again. January 2011 was an up month and the rest of the year was down, albeit slightly. That makes the miss three-in a row, 50% on the last decade and only 64% since 1926. No doubt pundits that will choose a time period with more favorable statistics which to cite as evidence (you get 69% by choosing just 1940 onward).

Let’s play a game, shall we? Please post in the comments links to any January Barometer articles you find, so we can chuckle at their ignorance of statistics and logic. I expect them to start appearing in early February.

———-

And here are the TWO instances of nonsense I’ve already seen:

In this article from CNBC.com, we learn that “Since 1945, a positive January in an election year has never missed in predicting a full-year gain for the Standard & Poor’s 500, going 8-for-8″. Wow, a whole 8 data points, conveniently ignoring pre-1945 data (why?) 8 data points is not statistically significant for, well, anything. But go ahead and peruse the article anyway, it’s laughable. It includes gems like “Whatever the S&P 500 doesn’t provide in absolute return this year, it will likely make up for in predictability”. What the heck does that even mean? I’m floored.

And then we have this little interview on the otherwise good ‘Breakout’ on Yahoo!Finance. At about 2:10 into the interview, the guest disclaims “even with a few errors”, the January Barometer is still “pretty good”. Uh huh.

Please use the comments to share other incidences of magical thinking.

Hedge funds seem to make all the headlines. Rarely do we hear about plain old mutual funds much anymore. ETFs, derivatives and hedge funds are the investments du jour (or perhaps, “du la decennie” or “of the decade”?) There is a tremendous misunderstanding of what “hedge funds” are, how they invest and what to expect from them. The category is as broad and diverse as the “mutual fund” category is.

Regardless, the first step before putting your money anywhere is to understand how likely it is to be subject to fraud or manipulation. In this department, hedge funds do not shine. A recent paper concludes that many hedge funds “intentionally mismark their stock positions.” You see, any fund must report its value to investors periodically. Whether that be monthly or quarterly, all the funds holdings must be valued and summed on a certain date to arrive at the fund’s value. The change in value from period to period is, obviously, the funds performance. The paper’s authors used SEC filings to determine if those positions were being valued properly. They compared each fund reported their holdings value as with public databases of prices.

Say a fund owns stock of Apple and report to the SEC that as of a certain date (usually quarter end), the fund owns 100,000 shares worth $35,157,000. The author’s compared this value of $351.57 per share with the “official” databases used to price securities by investors everywhere. What they found were striking differences between what the funds reported and the values used by everyone else.

Now, there are several reasons why this could be: a stock could be thinly traded. Advisors are legally allowed to used various methods in determining a price when none is readily available or reasonably accurate. So the authors examined only highly liquid, publically traded investments where pricing is well established (you can’t really argue what the final price for a share of AAPL, IBM or XOM is on a certain date).

What the authors found, was that about 7% of the 2.3million positions examined over a decade showed valuation deviations. Consistent with the assumption of intentional manipulation are the following:

• Even highly liquid positions were regularly mispriced
• Price discrepancies were more likely to show a reporting of returns slightly above zero more often than slightly below zero
• Discrepancies went in the direction of return-smoothing (the great attraction of hedge funds is that their returns are more consistent, which is desirably interpretted as returns with less risk)
• Those funds with significant discrepancies were also those more likely to report smooth returns.
• Those funds with lower probability of getting caught (offshore funds and lesser frequency of audits) showed higher discrepancies.

All in all, the data is consistent with what you would expect if the advisors are being less than forthright. As the paper concludes, “our analysis showed that advisors mismark their stock positions in a way that is consistent with a pursuit of their own interests.”

Since the pricing differential is relatively small when measured accross all fund assets (0.22%), that means that the mispricing is probably eggregious at many funds while others are completely innocent of such an offense. The author’s data could be very valuable in identifying manipulators. More importantly, this should be a warning to investors (though no one seems to ever listen to warnings, they just blame others for their misfortune when no one caught it beforehand). Madoff was obviously a fraud, yet no one cared. There were several highly regarded, supposedly sophisticated, institutions which were feeding Madoff. There were plenty of other supposedly sophisticated institutions which couldn’t identify the risks in time. If the experts can’t do proper due diligence, should you trust their advice? Is your advisor able to do proper due diligence? My advice is to be far more wary than trusting when it comes to non-standard investments (things not traded on exchanges).

Link to the paper