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Deus Ex Macchiato says a lesson from the JP Morgan CIO scandal is that they weren’t hedging.
I had bought the firm’s line that the original portfolio was a macro hedge against the loan book. It is now clear that while that might, in the mists of time, have been the original motivation, the CIO’s office had turned into a prop trading center by 2012.
Sorry but: Had turned into? (Note: “CIO” stands (stood?) for “Chief Investment Office”.)
As my readers know, I don’t believe (because I’m so cynical not because I’m some sort of bank-apologist) that there is a meaningful distinction between ‘prop trading’ and whatever other awesome Volcker-approved things banks are imagined to do. Maybe I’m just stupid but to me, live risk is live risk, PnL is PnL, and these are businesses. So what are the incentives and what behavior is rewarded? Please, you do the math.
That said, let’s pretend I go along with the reigning wisdom that ‘prop trading’ is a thing, that banks only sometimes do, and which we can ban or regulate away. I assert that it’s still wrong to say we Learned From All This that they may have started out hedging but ended up prop trading. They (like everyone else) were hedging, and prop trading – both/and, not either/or – all along. These are just not mutually exclusive activities.
Let me try to illustrate why. I haven’t been following this saga in every detail, but the general picture is clear enough, so let’s go down this checklist of what I think are publicly-known aspects of this position and its timeline. If you are a believer in the ‘started out hedging but then became prop trading’ party line, please tell me when you think they ‘stopped hedging’ and ‘started prop trading’:
- They were told part of their mandate was to hedge a portfolio of legacy bonds and whatnot.
- They went short (bought protection) on some shorter-dated CDX High Yield tranches: expensive but levered first-loss corporate credit insurance.
- American Airlines had a credit event, and they pocketed some $400+ million in credit protection payouts on those tranches.
- Then they were seemingly told to reduce capital and/or reduce the position, but in a way that preserved the free-lunch cheap optionality that geniuses like Ina Drew make their genius careers telling underlings to construct, and hit upon trying to do so by way of a round-trip through, among other things, CDX IG9 longs.
- This involved a bunch of (not exactly unpredictable) risks, and the short story is, they lost money.
From the way commentators are talking I guess they think step 4 is where it all went wrong: step 4 was ‘prop trading’. You shouldn’t ever be allowed to hedge 2-year HY tranche-equity shorts with 5-year IG9 longs! That, specifically, should be against the rules. Or that sort of thing, anyway. It’s totally easy to tell that sort of thing from other sorts of things. I’m sure regulators will be able to write regulations about it just fine.
Let me ask you this though: why was step 2 kosher? How on earth is step 2 any different from step 4? In step 2 they hedged their [whatever] portfolio with an apparently highly levered and very large (index-equivalent) position of HY equity shorts. (Around this same time – I believe – a lot of bank research reports (including perhaps from JP Morgan?) were advocating to their clients that short-dated HY equity tranche longs were a great bet. Hmmm.)
And then American Airlines defaulted and JP Morgan made a sudden windfall from those counterparties/investors. So wait, O reformists, why was that ok? I’m presuming the whatever-portfolio that CIO was ‘hedging’ with their HY shorts did not specifically include $500mm+ worth of AMR bonds. So technically, if you want to be a purist about all this (and everyone seems to), step 2 wasn’t a hedge at all. Evidently, in step 2 JP Morgan CIO went naked levered short AMR (and of course Dynegy, and ResCap, and TXU, and whatever other high-yield companies are in those baskets) jump-to-default risk to the tune of $400mm+.
Where oh where was all your outrage then, Internet? Why wasn’t that a ‘prop trade’ that should be banned by wise sage and clever regulators? Because it made money so that’s ok?
If you believe in ‘prop trading’, and try to define it coherently, then I claim you HAVE TO call that a ‘prop trade’ TOO. But then there is no end to it. You have to call BANKING a ‘prop trade’. And that’s my point.
Why does that bother me? Because Star Traders(tm) make their careers doing just that very thing, and everyone’s just fine and dandy with that. Here’s another example: Goldman and certain other banks went short a ton of ABX (subprime mortgage synthetic index protection) in ’06-07. I guarantee you they were not somehow hedging their holdings of the specific subprime bonds that comprised the various ABX tranches on a delta-1 basis. They were making a call that the subprime bubble was going to pop, using the largest/most liquid instrument available to them to express that view. And:
- They were right!
- So they made a buttload of money.
- Where are they now?
- They are Managing Directors now, that’s where.
- In fact, even the most juniorest of the junior guy who happened to be on the desk at the time that the short-ABX call was made by his then-boss is probably an MD now.
- And everyone’s just cool with that. No Internet outrage about ‘prop trading’, no Senate hearings, no Volcker puritanism.
Again: the only difference between those people and the ‘London Whale’ is that the ‘London Whale’s trade happened to go against him – in large part because of shady leaks to insider/connected press by hedge funds.
Here’s a thought experiment: if JPM CIO had pocketed their American Airlines windfall in late 2011, and then quietly triangulated their way out of that position some other way (via a more diversified set of index longs, or hell via the S&P 500), what would have happened? Some things are pretty obvious. First, none of us would be talking about any of this. Second, the traders involved would now be making 2x as much as they already were. And Ina Drew would be appearing in glossy magazine lists of ‘powerful, strong Wall Street Women’.
If your outrage about ‘prop trading’ depends selectively, like Maxwell’s Demon, on whether the position happened to make money, I claim there’s a fundamental problem there. And so continually pointing regulators in the (ridiculous and impossible) direction of Banning Doing Trades That End Up Losing Money Later is a misuse of commentators’ talents and advocacy. More to the point, the result will be counterproductive and destabilizing because – just like rating-based capital rules – it will lull everyone into a state of self-satisfied (and well-paid) complacency. And they’ll deserve their high pay, because once Doing Trades That Lose Money Later has been successfully banned, then banks will be safe because all their trades, by regulatory fiat, can only end up making money! That will be great, for everyone involved.
Until the next crash, when it’s not.
UPDATE – BONUS RHETORICAL QUESTIONS FOR ANTI ‘PROP TRADING’ CRUSADERS – Who did JP Morgan lose all that money to, by the way?
These were derivatives. Their $6bln loss was someone else’s gain. Most reporting mentions only the hedge funds.
But there were also banks that took profit on the event. Right?
Banks that (a) knew full well about JP Morgan’s position, (b) saw that the IG9 skew was out of whack as a result, (c) took the view that it was due to normalize sooner or later, (d) intentionally built up a position in the other side at the same time they were pitching such a trade to their clients (and, in some cases, not so subtly blabbing about the ‘London Whale’ to them), (e) (in some cases?) helped leak/background-confirm the position to Bloomberg News to try to help squeeze JP Morgan, and (f) pocketed a nice short-term profit for little risk?
(Or possibly in some cases just banks with bad index traders, or CDO traders, or whoever, who had inadvertently built up a big wrong-way position in IG9 shorts, and opportunistically used the event to cover at a profit?)
Related question: What, pray tell, were all those other banks ‘hedging’ when they got short IG9 and/or took on the skew (index minus single-names), in the months prior to the ‘London Whale’ becoming front-page news?
Related related question (since the answer of course is ‘nothing really, they just like money‘):
Wasn’t that, therefore, ‘prop trading’ too?
So, moralists: Where is your outrage?
Where are the in-depth Financial Times post-mortems and timelines on the decision process of other banks to randomly go short IG9 for no particular reason and to hedge nothing in particular, in late 2011 and early 2012? Where are the Senate investigations and John McCain questions about it? Where is the sage hand-wringing and regulatory suggestions re: how to stop such nefarious activity, by the usual Wall Street-savvy bloggers?
I’ll tell you where. Nowhere that’s where. Why? Cuz those guys made money that’s why. Make money and all is forgiven. Period and end of story.
If your moralistic banking principle requires the hindsight of being able to answer the question ‘Did the trade make money?’, I suggest it’s not really a principle at all, but one variety or another of facile opportunism.
Oh but never mind me, I’m clearly a wacko out on the fringe of accepted opinion, who has no idea what he’s talking about on any of this. No idea at all.
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