Too Big To Learn A Lesson: JP Morgan Assfucks Itself

[CountDeMoney]

JPMorgan discloses $2B in losses in 'flawed' hedging strategy

By Martin Wolk

JPMorgan Chase, the nation's largest bank, said Thursday it has lost $2 billion in a complex hedging strategy over the past six weeks and could lose more.

In a conference call to analysts and investors, CEO Jamie Dimon said the 'flawed' hedging strategy was "poorly constructed, poorly reviewed, poorly executed, and poorly monitored."

As a result, the bank expects to lose $800 million in its corporate segment this quarter, compared with previous estimates that the segment would post $200 million in profit. Some of the hedging losses were offset by taking $1 billion in previously unrealized gains from the bank's portfolio.

"The portfolio has proved to be riskier, more volatile and less effective as an economic hedge than we thought," Dimon said in the call, which was monitored by msnbc.com. "There were many errors, sloppiness and bad judgment."

The company's shares plunged more than 6 percent in late electronic trading after the loss was announced. Other bank stocks, including Citigroup and Bank of America suffered heavy losses as well.

Dimon said the bank suffered losses as a result of a strategy to hedge against global credit risk. He declined to specify further.

He said the bank is working through the problems but expects continued volatility, and losses could grow.

"Hopefully this will not be an issue by the end of the year," he said.

He said some of the losses were a result of the volatile market environment. Markets have been roiled recently by concerns over Europe, which has slipped back into recession.

The losses are still a relatively small amount compared to the approximately $200 billion portfolio managed by the company's chief investment office, where the hedging strategy was executed.

[Valmy]

Eh it was not like there was any reason to think hedging on derivatives was a risky strategy.

[Grey Fox]

Why is this allowed, who does it benefit?

[MadImmortalMan]

Eh it was not like there was any reason to think hedging on derivatives was a risky strategy.

It's all about the "Value-at-Risk" profile. Which is a fundamentally flawed method of proving to the SEC that you're safe. The problem is that all securities are risky, and ones that you think are offsetting each other can in fact both go down at the same time.

[Tamas]

It's not like they won't be bailed out, so why shouldn't they risk 2 billion in 6 weeks?

[Tamas]

Eh it was not like there was any reason to think hedging on derivatives was a risky strategy.

It's all about the "Value-at-Risk" profile. Which is a fundamentally flawed method of proving to the SEC that you're safe. The problem is that all securities are risky, and ones that you think are offsetting each other can in fact both go down at the same time.

ain't that the truth

[CountDeMoney]

At least the industry self-regulates itself to the extent that they're going to fire the trader in London that did it. 

[DGuller]

Not this shit again.  I just took an exam on this very topic, and one of the many items were case studies of various derivative disasters.

[viper37]

Why is this allowed, who does it benefit?

it is allowed because no one, especially those using it, understand how it works precisely.

In school, all they teach you is how to do the math.  But no one except the math genius who created the derivative properly understand his own model.
And then it replicates down the chain as you have derivatives on derivatives on derivatives. On simply weird products like ones paying on weather.  7 days of sunshine, it doesn't pay, 6 days or rains, it pays.  It looks like a nice way to provide insurance for your portfolio wich contains derivatives on rice and wheat, but then you made a simple mistake calculating the true costs of your position.  And since you don't want to lose your job, you try to cover your tracks with more exotic derivatives that no one really understands.  But then things don't go according to plans, and you lose 2 billions.

Sometimes, you make your bank crash.  See the Barrings case.  The guy used derivatives to offset his position.  2 more weeks and he would have been back in the money, recovered all his losses.  But alas, there was an earthquake in Kobe.  Stock market crashed.  Deeply.  Bankruptcy.

And you look at the recent cases of bank failures, it's very similar.

Yet, if you regulate it, you can make things worst than they are.  You could regulate against fast food because it's bad for your health.  But then, you lose a lot of job opportunities for teenagers and a convenient way for people to eat when they are short on time.

Same goes for derivatives.  Most of these are actually pretty useful for big financial instutions.

the problem seems to lie in a basic misunderstanding of the products themselves.  Many bank managers, who have never studied finance, seem to believe they can eliminate the risk by carefully using derivatives while in fact all you do is shift the risk around.  Eventually, someone, somewhere has to pay for this.  There's no free lauch on the market.

[The Brain]

Tax dollars are cheap. Blow is expensive.

[DGuller]

the problem seems to lie in a basic misunderstanding of the products themselves.  Many bank managers, who have never studied finance, seem to believe they can eliminate the risk by carefully using derivatives while in fact all you do is shift the risk around.  Eventually, someone, somewhere has to pay for this.  There's no free lauch on the market.

You have to be careful with free lunch arguments.  Let's say every day, you take the trash out before leaving the house to go to work.  One day you realize that all those brown bags you were throwing out every day actually contained lunch that your wife prepared for you.  Not throwing away the brown bag does literally give you free lunch now.

Derivatives can in fact reduce effective risk, by transfering it from entities who can't handle it for various reasons to entities that can.  Insurance contracts are a very crude form of a derivative, and insurance contracts can in fact greatly minimize the risk that matters.  Of course total fire losses are going to be the same (ignoring moral hazard), but these losses would cause far less disruption due to capitalization and diversification of those whose outcomes are uncertain.

[MadImmortalMan]

Plus the regulators don't know shit about it. The bank just pulls up their portfolio's VaR numbers to show they're super-hedged and everything evens out and the SEC dude goes "durrrr ok". They don't question the math behind the VaR and the bank can do what it wants. 

[viper37]

Derivatives can in fact reduce effective risk, by transfering it from entities who can't handle it for various reasons to entities that can.  Insurance contracts are a very crude form of a derivative, and insurance contracts can in fact greatly minimize the risk that matters.  Of course total fire losses are going to be the same (ignoring moral hazard), but these losses would cause far less disruption due to capitalization and diversification of those whose outcomes are uncertain.

the insurance contract shifts the risk from you to your insurer.  In return, the insurer shifts the risk to re-insurer, wich will shift the risks to the market by using all kind of investments and derivatives accross the world to avoid getting hit too hard by a natural disaster in one place.

While covered for a huge single event, the insurer is still exposed to a ton of smaller event.  If the insurance company decides to ignore this because it has shifted most of its risk away to the re-insurer, they are in fact even more exposed to risk.

Wich is what happens with financial institutions.  Eventually, they tend to forget they are still exposed to risk, they don't make it disapear.

[viper37]

Plus the regulators don't know shit about it.

wich is why making rules based on these people's advice is the worst possible scenario.

[DGuller]

the insurance contract shifts the risk from you to your insurer.  In return, the insurer shifts the risk to re-insurer, wich will shift the risks to the market by using all kind of investments and derivatives accross the world to avoid getting hit too hard by a natural disaster in one place.

While covered for a huge single event, the insurer is still exposed to a ton of smaller event.  If the insurance company decides to ignore this because it has shifted most of its risk away to the re-insurer, they are in fact even more exposed to risk.

Wich is what happens with financial institutions.  Eventually, they tend to forget they are still exposed to risk, they don't make it disapear.

You're ignoring the diversification effect.  It takes a lot less capital to cover 1 million houses against a peril of fire, compared to 1 million times the amount of capital need to cover one house. 

Catastrophes are slightly different in that regard, because then risks are correlated, so there is a systemic risk component that you can't diversify away just by law of large numbers.  That's what reinsurance is for, mainly.  However, rare catastrophes are generally not a big part of insured losses.  It's everyday occurences likes fires and car accidents that form the bulk of them, and those are easily diversifiable.