Thursday, May 31, 2012

Texas Hedge

My first reaction to the JP Morgan loss was, if their "hedge operation" had become a "profit center" as reported, we know exactly what went wrong. (And, if they weren't playing with a government guarantee, who would care if they lost $2 billion and some hedge funds gained $ 2 billion?)

Andy Lo put it beautifully:

Yes, we can tell the difference [between hedging and trading]....There is one very simple question that you can ask — which has a definitive answer — about the small number of individuals who were responsible for managing this group at JP Morgan and putting on the specific trades that lost these large amounts of money. That question is: How were they compensated on an annual basis? Were they paid a salary and a bonus, and was the bonus a function of the profitability of the group, or was the bonus a function of the hedging ability of the group? If you can answer this question — and it definitely has an answer to it; it’s not a metaphysical question — you will have your answer as to whether it was proprietary trading or hedging. I don’t know the answer, but I know the answer exists, and I know that certainly the government can get that answer with a single phone call. 

Hedging is supposed to lose money when everyone else makes money. That can be measured. The risks of the entire bank, which hedgers are supposed to minimize, can be measured.

I think Andy knows the answer to this question. I suspect I do too, but maybe I'm being too cynical.

(Thanks for pointer from Arnold Kling)


  1. The important thing about the trade is that Jamie Dimon has admitted that JP Morgan itself did not understand the trade or the risks it posed. If they did not understand that trade, how many other trades do they have sitting on their books that they do not understand?

    Every time someone proposes regulating Wall Street, Wall Street comes back and claims they understand the risks they running - it turns out they don't.

    1. and of course the regulator would know them, just as they always did

    2. No - the regulator would not know the risks either which is why some of those trades (basically most derivatives) should be simply outlawed.

    3. hah! let's outlaw econ blogs. I don't understand any of them

  2. It's not clear that JP Morgan didn't understand the risks, is it? It seems they thought they had some very clever people running a speculation shop with a "hedging shop" sign in front and thought that shop could make a lot of money. The shop bet wrong, and lost money. That happens when you speculate. It can even happen if the people you hire really are clever and over a decade do make you positive profits.

    And if you run a speculation operation like that, the best way to do it is to put a money limit on it (if you do worry about risk or about your traders' bankruptcy constraint), write the appropriate compensation contract, and get out of the way. The CEO shouldn't interfere in daily operations.

  3. p.s. Of course, any speculation shop is based on the premise that you are smart enough to find people smart enough to beat the market. That's contrary to efficient markets theory. It's a bad idea for most corporations to set up speculation shops, but maybe JP Morgan is enough cleverer than average for speculation to be profitable.


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