In an interview, Andrew Lo says,
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.
My claim is that with principles-based regulation, you could be asking this question ahead of time during an onsite audit.
Pointer from Mark Thoma.
READER COMMENTS
MikeP
May 31 2012 at 7:56am
Spot-on.
When this hedging division showed up with $5B of income in a year, did Dimon say, “Please show me the losses in the rest of our divisions that your gain represents a hedge against.” If he didn’t get a very clear answer, then he should conclude that they are merely speculating, not hedging.
There’s nothing terribly wrong with speculating unless it’s on someone else’s dime. And certainly a $3B loss against annual gains of $5B is neither high nor unexpected when speculating. But hedging and speculating are different strategies, require different models, and are eminently auditable.
Sonic Charmer
May 31 2012 at 8:41am
I must be missing something. What does this have to do with “PBR”? Can the government not ask this question now (in the Pre-PBR Era?)
Mike Rulle
May 31 2012 at 10:01am
CIO is likely what the traditional Treasury function of banks were. I would guess most of the positions were of your basic yield curve carry and credit carry trades. It is perfectly reasonable to also have CIO use some portion of its capacity to offset macro moves in other parts of the bank. If one wants to call this hedging, be my guest. Diversification seems a better word.
But the issue was size. It reminds me, in smaller size, of the Ameranth blow up. The whale was pushing against the grain of the market. He was trying to force other traders out of their positions. We do not know whether they even knew that is what they were defacto doing. But JPM began to panic and started to force themselves out of their own positions. Perhaps they realized late they were so big they were pushing the market and did not want to be engaging in that activity.
So far, JPM is completely obfuscating what happened. They pretend by repeating how “stupid” the trade was, they are being open. The old expression “he is either an idiot or a liar” may be apt. Substitute criminal for liar, and one maybe understands why they keep emphasizing how stupid the trade was.
I do not think there was anything criminal. I also know it is likely not in JPM shareholder interests to completely reveal the trade at this stage. But I believe they are not stupid and also believe they did think it was a “tempest in a teapot”. I look forward to the final answer to this seeming contradiction. Maybe they did get lazy.
I also think losing 1% of equity is small. I wish my stock accounts worst disaster was a 1% loss. Think of all the non marks out their in the financial and non financial world that do not get recorded. The story is interesting, but overblown.
While incentives explain a great deal, Lo’s description is too linear and black and white.
TiamaT
May 31 2012 at 1:39pm
Falkenblog
Andy
May 31 2012 at 7:53pm
Bank examiners already have the authority to ask this question. They may not use that authority correctly, but that is a mark against pbr.
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