Was JPM hedging, unhedging, or speculating?
No one yet knows exactly was JPM was up to in the credit derivative markets. But this hasn’t stopped a lot of people from linking the loss to their pre-existing views on the Volcker rule, TBTF, moral hazard, and the Fed’s low interest rate policies, etc. There was also more than a touch of Schadenfreude, as the golden boy of finance revealed his new black eye.
We will ultimately get the information from JPM about what it was doing and what exactly they thought they were hedging. Once we do we will be in a better position to judge whether the hedge was reasonable or constituted speculation in disguise, and whether there are broader policy implications.
But setting judgment aside, and after having following this issue for a while, I do have an educated guess as to what likely happened:
- We know that JPM is naturally long corporate credit through its loan book.
- We know that over the last 2-3 quarters of 2011 we were gripped by the fear of a European financial meltdown and a second recession in the US.
- We know that that the Fed’s swap lines and the ECB’s LTRO reversed this market view and crushed credit spreads lower, hurting those who had been buying protection in the previous months.
Against this backdrop, it seems likely to me that the aggressive selling of protection we heard about in April 2012 was actually the unwinding of the hedge that had been accumulated in 2011 and was by then deeply underwater.And given the way a bank’s loan book is held and priced, they couldn’t show commensurate gains to offset these losses.
This story fits the price action. Below is the one-year chart of the spread of the hedging instrument in question, the CDX.NA.IG series 9:
It is hard to imagine JPM coming out and announcing the loss while they still have the bulk of the loss-making position still on. Hedge funds and other banks—at least banks in the pre-crisis days—tend to gun for large, vulnerable positions in the hopes of profiting from the vulnerable party’s subsequent capitulation.
The story also fits typical big-bank behavior. It doesn’t ring true that a large bank would put on such a large speculative position in the current environment, given (1) the crisis we just went though (banks, like generals, tend to fight the last war and therefore the next mistake they make is likely a new one) and (2) we are very much in the middle of defining our new regulatory framework, and a mistake of this nature would be potentially crippling to a bank’s negotiating position in that process.
On the other hand, the natural human tendency of observers is to overstate the probability of the banks repeating the same mistake. This is often referred to as disaster myopia. Having lived through two bubbles now, I think it is fair to say one of the telling characteristic of financial bubbles is that in their aftermath there is a proliferation of people immediately declaring new bubbles (a bubble in bubbles). For similarly backward-looking reasons we are likely to overstate the probability of seeing similar issues now surface in other large banks.
Anything is, of course, possible. And I will withhold definitive judgment until the facts are in. But given the way institutions and people behave in the wake of a traumatic shock, the odds suggest that is was indeed a hedge gone wrong and that we are overreacting to it.
The far bigger issue that the JPM news obscured on Friday was the continued deterioration of the growth numbers in China. But more on that later….