CEO Jamie Dimon’s faux-apologetic defense of JPMorgan Chase’s recent trading loss, now estimated at $3 billion and rising, prompts a variation of an old joke: How do you know when an investment bank’s CEO is lying? It is when his lips move to form the word “hedge.”
The fact that Dimon keeps repeating the word “hedge” even as he ostensibly is harshly critical of the bank’s failings is, in itself, an ongoing lie.
JPMorgan’s reported $100 billion position in “synthetic derivatives,” numerical indexes of over 100 different credit default swaps, was not a hedge. It was not intended to reduce the company’s risk. It rather was plain old speculation, willingly assuming great risk in the hope of great profit.
There is nothing inherently wrong with taking on risk in return for possible reward. Indeed, a modern economy would function much less efficiently if no one was willing to do it. But it does raise questions.
A private one is whether investors should buy stock in companies whose managers are unwilling or unable to monitor and manage the risks the company takes with their shareholders’ capital. The track record of big publicly-traded financial firms over the past 15 years makes it seem foolish to buy their stock. Yes, JPMorgan has done better than many other banks. But the sector as a whole has been terrible for investors while paying executives enormous sums.
The more important public question is whether a commercial bank that takes deposits from the general public that then are insured by the federal government, that has direct access to emergency borrowing from the Federal Reserve and that is one of a handful of dealers with the privilege of handling new issues of Treasury Bonds should be allowed to simultaneously make large and highly-leveraged speculative bets on derivative securities.
Defenders of Dimon argue that taking such positions, and sometimes realizing large losses on them, is a necessary and inherent aspect of modern commercial banking. Don’t swallow this. Yes, banks like many other businesses can legitimately use derivative securities to reduce risk. But that was not what JPMorgan was doing here.
True, the line between hedging to reduce risk and speculating to increase it is not always clear. But work in from the extremes toward the center and it is easier to discern what is going on here.
If a homeowner buys a policy covering fire, wind and liability exposure, she is reducing risk. Ditto for a small-business owner or farmer. And if a farmer expecting to harvest 50,000 bushels of corn this fall contracts the delivery price on a large fraction of that by late summer, he also is reducing risk.
The same would be true for an earthmoving contractor who uses a thousand gallons per day of diesel fuel and locks in a price from a supplier as soon as a large road contract is awarded. And ditto for a country elevator that executes futures contracts to sell whatever quantities it contracts to buy from farmers. All these clearly transfer risk from an individual or business that wants less risk to some counterparty willing to take on more risk in return for a fixed premium or the possibility of profit.
Finally, consider a small wind project wanting to borrow money to buy turbines. The only loans offered are at variable interest rates. But it is possible to buy an “interest rate swap” from a third party that effectively converts a variable rate loan into a fixed rate one. This is a “financial derivative” but it has a clear business purpose of reducing risk for a business with fixed cash flows.
Now consider a situation where a farmer decides that the corn price is going to fall, and contracts to sell 5 million bushels — 100 times his anticipated production — in November at a price specified now. This is clearly speculation. Ditto for the excavating business if it decides to buy 1 million gallons of diesel via futures contracts instead of the amount it actually will use, simply because it expects prices to rise. And if either decides that there is more money to be made in silver options than in growing corn or moving dirt, no one would call them hedgers.
Now, what if someone with a Ph.D. in math told the wind business that she had found a strong statistical correlation between cocoa production in West Africa and wind speeds on the Buffalo Ridge? Buying options on cocoa prices could serve to offset low electricity sales during prairie doldrums. At least that is what the six years of data available in a downloadable file seems to indicate. Would the turbine owners reduce risk by immediately buying such options? And what if they purchased cocoa options of $5 million for each month to “hedge” electricity sales of $200,000? Clearly not.
The idea that JPMorgan was hedging some specific risk in their business lending as a commercial bank by taking a $100 billion position on the variation between two different indexes of default swaps beggars belief.
One crucial clue to all of this is that, while Dimon went on Sunday morning TV to admit mistakes, JPMorgan disclosed precious few details about the actual positions it had taken. The reason seemed to be that they had not yet unwound those positions, and would suffer even greater losses if counterparties knew such details. That the losses now reportedly have risen from $2 billion to nearly $3 billion and are expected to rise even higher over time shows the degree to which this was a speculative position and not a hedge.
No homeowner or farmer loses anything by telling others they insured their property. No earth mover loses by letting on they locked in diesel prices. No commercial borrower loses by acknowledging they bought an interest rate swap to complement a bank loan. If letting other people know about your hedge ruins your hedge, then it probably never was a “hedge” at all.