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The financial system wasn't fixed after 2008, and it won't be fixed anytime soon.
The unexpected $2 billion – or is it $5 billion? — loss incurred by JPMorgan Chase (NYSE:JPM) "whale" trader Bruno Iksil shows only too clearly the flaws in Dodd-Frank and other regulatory activity.
Big banks are still taking risks they simply don't understand. Worse, there's no reason to believe the regulators understand them, either.
While the banks do employ "quant" mathematicians to analyze risk, the problem is the quants are also paid to help maximize the profits from the banks' trading desks.
Not only is this a bit of a conflict, but they are working off a market model that has failed repeatedly in the past.
It's a dangerous mix for investors and taxpayers alike.
The Failed Trade at JPMorgan (NYSE:JPM)
JPM's trade that failed had been to build up a major bullish position on corporate debt defaults — in other words, betting there wouldn't be many of them.
In a sensible financial system JPM would do this simply by going out and lending lots of money to corporations, or by buying their bonds.
However, according to The Wall Street Journal, in the magical fun palace of today's trading room, JPM achieved this instead by buying an obscure credit derivatives index known as CDX.NA.IG.9.
The key is that this is a "mature" index. Conceived of 10 years ago, the index JPM bought only had 5 years of life remaining.
In other words, not only did JPM use this foolish roundabout as a way to take a position on credit, but it did so through an old index, which could be expected to be less liquid than a newer index that attracted the most trading volume.
Then sharks began to circle.
Naturally, hedge funds spotted the unusual trading patterns and price anomalies in CDX.NA.IG.9, and piled in to take advantage of JPM's eventual need to unwind these trades.
That's one of the problems with trading that is distinct from a long-term investment; eventually you have to unwind the position.
Whereas you can hold a bond to maturity and a stock forever, collecting dividends, instruments such as credit default swaps, let alone indexes on credit default swaps, have to be sold as well as bought.
JPM's loss on this position was originally estimated at $2 billion, but is now admitted to have the potential to rise to $5 billion or more.
You can expect all of the hedge funds that bought contrary positions will extract their "pound of flesh" in the unwinding process.
Perhaps the most disquieting aspect of this fiasco is that no laws appear to have been broken.
It was not a case of a "rogue trader" hiding his positions from the risk management system. The risk management system simply failed altogether.
Risk Management?…Not Hardly
There appear to have been two problems with JPM's risk management.
First, it assumed that two quite different instruments "hedged" each other, so that large balancing positions could be taken out on both without great risk.
Second, it relied on the obsolete and theoretically unsound "Value at Risk" (VaR) metric to measure its overall exposure.
VaR was already discredited by its complete failure to control risk in the 2008 collapse, when securitized mortgage debts behaved completely differently from what the model predicted.
As early as August 2007, Goldman Sachs CFO David Viniar said the market was experiencing "25-standard-deviation days" one after another.
That statement in itself should have been sufficient to discredit the VaR system. Under its assumptions, such days should have a near-zero probability of occurring in the entire history of the universe.
But the reality is that financial markets are not "Gaussian" in the technical term, or even close.
Extreme outcomes are much more likely than predicted by Gaussian models like VaR, and highly leveraged positions can lose much more money than predicted by a VaR system.
As I set out in my book "Alchemists of Loss," co-authored with Professor Kevin Dowd, VaR and similar systems should be scrapped forthwith.
But you don't need to have read "Alchemists" to have understood this. Others have said it, although I like to think not as well!
The fact that JPM was still using the discredited VaR indicates that its top management did not understand how to manage risk, or indeed what the risks in exotic derivative products were.
Maybe the bank's quants understood the risks that were being run. But if so, they didn't speak out, since they wanted to keep their jobs and not offend the politically powerful top traders like "the Whale."
As citizens and taxpayers, there is one conclusion to be drawn from this.
Since the big banks don't understand what risks they are running, and it's quite clear that regulators don't understand them either, the only solution for institutions "too big to fail" is to restrict what they can do.
Bonds, stocks, forward foreign exchange and maybe simple interest rate swaps traded on an exchange should be the limit of what these institutions are allowed to do.
Anything more exotic should be left to the hedge funds, which should be allowed to go bust without any disgraceful bailouts like that of Long-Term Capital Management in 1998- -which was in retrospect a major cause of the 2008 debacle.
As investors, the message is also clear: we should avoid the financial sector, at least the "too big to fail" banks and big insurance companies.
Investing in them would be like investing in General Motors (NYSE:GM) if all its cars kept exploding instead of just a few.
Truly, the global financial system is Unsafe at Any Speed!
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I know a regulator at the CFTC, which is supposed to be writing regulations to prevent this sort of loss. They understand the risks, but are constantly being thwarted by Members of Congress, mostly Republicans, intervening on behalf of the banks. The Wall Street crowd has a risk management plan: Pedal to the metal for big profits and bonuses. If there is a crash, let the taxpayers absorb the loss. Romney has said he approved of the financial industry bailout under Bush, although he opposed the auto industry bailout (I guess it didn't help HIS friends), and would presumbly push through another one if the banks want it. Wall Street is hedging their bets by contributing $1,300,000,000 so far to elect Romney.
Good article. Thanks. Couldn't have happened to a more deserving bunch than JPM. VaR..what a joke.
Of course, you could turn your remedy around and just allow the banks who are currently indemnified against catastrophic loss to simply fail. You know…the way it's supposed to work in the free market model. Gamble all you want with shareholder money, but you don't get a dime of bailout when your idiot trades go bad. THAT would end the gambling.
Yeah, I know, fat chance. The Fed was created to bail out the bankers. Its job is to be the lender of last resort. So, I guess we need to END THE FED before we see sanity return to banking.
Hmmm…what a lovely idea, Care to get on board Martin?
Surely the answer to this problem, both in the US and Canada, is to split the Stock Brokers (now called `Investment bankers') away from the Banks—as they had been years ago.
Then the brokers could go broke (as they regularly did) without affecting the Banks.
I have no doubt that many top level banking and equity fund managers don't understand how to manage risk, or what the risks in exotic derivative products are – although I suspect your other rationale hits the nail on the head, better than any other; namely:
“Maybe the bank's quants understood the risks that were being run. But if so, they didn't speak out, since they wanted to keep their jobs and not offend the politically powerful top traders like "the Whale."
When you work in a system that has conditioned you to completely disregard common sense, your instinct and your ‘gut feelings,’ and rely instead on smoke and mirrors and pie-in-the-sky illusions, it’s inevitable that JP Morgan-style fiascos will continue to reoccur and grow even worse, all the more if regulators are afflicted by the same disease. Add into the mix fear for your livelihood, your reputation and your family (and, who knows, maybe even your life in some instances) and the future looks bleak indeed.
Imagine yourself doodling on a 12-inch canvas for a few seconds. You would have no trouble making out the lines and their intersections. Continue doodling for half an hour and you would probably still be able to, albeit with a little more difficulty. If you had been doodling for 100 years, do you think you’d be able to make head or tails of what’s on that canvas? To a large extent, that’s what the global financial system is like.
If you had a backer with "un-limited " resources, such as the Financial Institutions have in the Administration, why would you stop making bets that could make you a fortune overnight?
Both parties in Washington are to blame. They all have their hands out to the banks for campaign money. Obama attened a 38K per plate fund raiser at the home of the CEO of Blackrock. These guys talk out boths sides of their mouths. We must have publicly funded election to clean out the sewer that is Washington.
will millions of americans with a medical problem that seems to require a joint i predict that banksters betting on romney will be money down the tubes too.
Correction: It was the FORD pinto that kept exploding and was "unsafe at any speed", not a GM product. GM has other problems.