Finance has become a low-margin, high-leverage business. This is not surprising in an environment in which trading volumes are exceedingly low and interest rates even lower. In any other industry, a slowdown in economic activity sends management scurrying to cut costs, develop new products, become more productive. In short, to innovate. Companies can throw money at new products, marketing campaigns or discounted pricing, but a slowing economy brings down demand. What we have today is a deleveraging economy, and that is even more challenging — limiting the options that CEOs can take to increase their company revenue.
The world of finance refuses to accept that reality. Whenever Wall Street is confronted with a decrease in profits, we see the same response: Increase leverage. We usually don’t hear about it until some market wobble causes the excessive leverage to blow up in someone’s face. This time, the novelty cigar was smoked by Dimon, and the damage was inflicted on his reputation. The losses, we learned, were a “mere” $2 billion, described as manageable.
Consider any major finance disaster of the past 30 years, and what you will invariably see is the result of trying to spin dross into gold. The magic of finance is that this can work for a while. The reality of finance is simple mathematics. Eventually, the probabilities play themselves out and the dice come up snake eyes.
One thing that makes the JPMorgan trade look especially foolish is that it’s nearly the same sort of recklessness that AIG exhibited: selling derivatives against zero reserves. As Doug Kass, who heads the hedge fund Seabreeze Partners Management, explained: “Under the knowledge of Dimon, the JPM investment office sold massive amounts of CDS [credit-default swap] premium on large U.S. corporations in 2011. Like AIG, they accumulated a large amount of reported profits in the three-year period ending 2011. In an equally familiar manner, the principals of the London investment office were handsomely rewarded. And so was Dimon.”
Gee, why does that sound so familiar?
So how long did it take after AIG blew itself up selling derivatives until some trader came up short making the same reckless bet? Less than four years.
The parallels to AIG continue to mount, including on the JPMorgan risk management committee. Astonishingly, Ellen Futter, who was a director at AIG, was also on the risk management committee at JPMorgan. It’s unclear what you need to do to get kicked off that committee, but the directorial equivalent of steering the Titanic into the iceberg apparently won’t do it.
Most financial debacles have a few things in common:
1 They vastly underestimate the risks involved;
2 They assume the future will look nearly identical to the past;
3 They use lots of leverage to generate profits without enough capital in reserve;
4 And everyone always pretends to be surprised when the trades eventually go bad.
As to Dimon’s statements, I am not sure which is worse: whether he knew about it and was not forthcoming, or whether he (as claimed) simply had no idea.
Regardless, the error at JPMorgan unwittingly reveals much about the present state of finance:
● Bankers remain imperfect, overreaching and bonus-driven participants;
● When using other people’s money, the promise of enormous bonuses is still weighed heavily toward excess risk-taking;
●No major U.S. money center bank has demonstrated an ability to manage proprietary trading risks. None.
●If traders have forgotten the lessons of the financial crisis less than four years later, what sort of reckless speculative risks will mis-incentivized persons be doing after 10 years?
● Trades that are so enormous as to be “credit index distorting” are not hedges but pure speculation.
● Within banks, apparently the word “hedging” loosely translates as “speculation.” Actual hedging of existing positions appears to be nonexistent.
● This trade was called “hedging for profits” — there is no such thing. That is speculation.
● Value at Risk (VaR) as applied by banks today is a mostly useless concept. This model is such that even minor deviations have devastating consequences.
●Dimon, formerly praised as the Capo di tutti capi of bank CEOs, apparently has been more lucky than brilliant. This past quarter, his luck ran out.
●Because of the enormous built-in leverage in derivatives, they are inherently dangerous. They remain financial weapons of mass destruction.
● “Too big to hedge” is a threat to the stability of the global economy.
● Wall Street in its current configuration is trying its hardest to be “unregulate-able.”
Although this was “only” a $2 billion loss, it easily could have been much greater. That banks such as JPMorgan are still putting on trades that distort indices is, quite bluntly, astonishing.
Back to 1998!
Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. You can follow him on Twitter: @Ritholtz