Banks’ Hyper-Hedging Adds to Risk of a Market Meltdown
JPMorgan Chase & Co.’s lost billions remind us that modern finance has changed the world, and not in ways that we should celebrate. Nothing demonstrates this more than the use of hedging.
It is debatable whether hedging makes individual banks such as JPMorgan “safer,” and very debatable whether it makes them, on balance, more profitable over time. But even supposing that hedging does, or can, assist individual firms, their trading has an unseen and pernicious effect on markets overall. Just as football players armed with kryptonite-strength helmets hit more aggressively, leading to more concussions, hypertrading by firms -- each thinking of their own preservation -- has exposed markets to meltdowns and routs.
Market participants themselves are mostly unaware of their effect on the group because they have grown up in a culture that celebrates trading -- hedging, in particular. The attitudinal change, fostered by technology, has been gradual but vast, and only visible if one steps back and remembers how things were.
Let’s go back a generation, and drop in on the leading banker of the day (we’ll call him Old Jamie). Old Jamie lives in a world with few options for dealing with risk. Suppose that Old Jamie and his team are pouring martinis on a Friday afternoon when the house economist wanders by. “Sorry boss,” the economist says, “but Europe is looking bad. Some of our drachma, franc and lira loans might be underwater.”
“Well,” Old Jamie ventures, staring at his olive as if in search of a solution, “is there a way we can sell these loans?” “No, sir,” his economist says. “You see, other people think Europe is slowing down, too. To be honest, I read about it in this morning’s paper.” “I see,” says Old Jamie, who is thinking he will need a second martini. “Well, I guess we’ll have to take some losses.”
And in truth, Old Jamie had few alternatives. Today’s world is vastly different. Let’s review what has been reported about the present-day Jamie Dimon, chief executive officer of JPMorgan. This Jamie has loans in Europe, too. Last summer, you will recall, people were saying the Europeans owe too much money and don’t work enough to pay their debts. This isn’t news to anyone who has ever been to Europe, where the people spend most of their time discussing philosophy in cafes. But when some economists -- probably after having vacationed in Europe -- noticed this, they forecast a debt crisis and a recession. Instead of sitting on its prospective losses, as the old Jamie did, the new Jamie (or rather, his traders) bought insurance.
Of course, JPMorgan didn’t buy regular insurance, such as a policy from Allstate Corp. or State Farm. It bought credit-default swaps tied to an index of corporate bonds. If the bonds went south, according to what has been reported, JPMorgan would collect on its synthetic policy. But if they didn’t, the bank would keep making premium payments, in effect forgoing the profits from European and possibly other loans. (The exact strategy was complex and hasn’t been fully disclosed, but clearly the bank was worried about Europe and possibly spillover effects in North America, too.)
Now some months went by, and Jamie’s economists are not so worried anymore. By now their summer vacations are just a distant memory. So the bank decides it really does want exposure to corporate bonds -- storm clouds in Europe or not. It writes new contracts in which it will receive money if certain corporate bonds hold their own, but it will, of course, pay out if they go under. In a perfect world, the two sets of derivatives cancel each other out -- that is the meaning of the term “hedge.”
But the world isn’t perfect -- not even for a trader at JPMorgan. Certainly, the bonds underlying JPMorgan’s opposing hedges weren’t a perfect match, and on a net basis, the bank, it would seem, ended up with exposure to Europe. Now, on toward spring, people are getting nervous again. Maybe they are planning another vacation to Paris or Seville. European government and corporate bonds go back in the tank, and JPMorgan loses $3 billion and maybe more.
Give Jamie credit for describing complex trades with a word you’d hear on the playground -- “stupid.” He didn’t say what, exactly, he was referring to, but one can guess. That second set of trades -- when JPMorgan was using the derivatives market to sell insurance -- was clearly a speculation. And if I were writing the regulations to implement the Volcker rule, which prohibits proprietary trading by banks, I would bar any bank from ever selling a credit-default swap. If you want to gamble, go to a casino. If you want to sell insurance, get a license from the state commissioner (who, by the way, will regulate your capital).
Now, the other part of JPMorgan’s trade, the initial one, when it purchased credit-default swaps, is a little more interesting. What JPMorgan and other banks say is that this isn’t speculating, it is risk reduction: hedging. And the Volcker rule, apparently, would permit such trades.
Of course, JPMorgan doesn’t own the exact bonds it is buying insurance on. It is buying protection on some corporate bonds that it thinks are almost always -- well, usually -- going to move in the same direction as the loans on its books. Of course, there is always the chance that JPMorgan doesn’t own such a portfolio of loans and that it is just speculating. Certainly, that is what some -- actually, most -- people in the CDS market are doing. But let’s assume Jamie is doing what he says: hedging.
Here’s the problem. In the era of Old Jamie, if someone in Europe wanted to borrow money, and if Jamie was a conscientious banker, he had to think long and hard about whether the customer was a good risk. In all likelihood, those customers would be with him for a long time.
Relaxing Credit Standards
The new Jamie, and the people working for him, don’t have to worry quite so much. They know that if they become uncomfortable with the loans they can always hedge them in the derivatives market. I have heard this offered as a defense of credit-default swaps from executives of JPMorgan. Were it not for the ability to hedge, they wouldn’t make all the loans they do. Hedging becomes an excuse for relaxing credit standards.
There’s another problem. When JPMorgan hedges, it doesn’t get rid of the risk. That only happens when the customer repays the loan or, say, improves its balance sheet. JPMorgan’s hedges didn’t make the risk disappear; they merely transferred it to someone else.
Jamie had an escape hatch, but hedging doesn’t offer an escape for markets as a whole. To sum up, thanks to these instruments, banks take more risks than they otherwise would and thus more risky bets are collectively owned by society. Only now the traders who set the market price are removed from the credit itself. In the past, Jamie and his team knew the borrower and evaluated the credit (the original J.P. Morgan Sr. famously testified that an individual’s “character” was the basis of credit).
JPMorgan still issues loans but with half an eye on their “hedging” potential, that is, on the willingness of traders who may be halfway around the globe to assume the risk. These traders are less well-placed to evaluate the risk. They don’t know the customer and, of course, they haven’t the faintest concern for character. By habit and preference, their involvement is apt to be brief.
They assume risk by writing a swap contract in the full knowledge that they can unwind it via another swap days or even hours later. Someone may get stuck with the bad coin but, each trader is certain, it won’t be him or her. So the approach of these traders is inherently short-term -- too short to invest the time and effort to evaluate the risk. Too short, we might say, to really care.
The plasticity of modern finance -- the ease with which institutions can transfer risk -- is a major cause of the heightened frequency of meltdowns and increased volatility. As with a saloon in which each gunslinger comes armed (and with the safety catch released), markets resemble a shooting gallery in which risk takers, each in the name of self-defense, put the group in peril.
Faith in the ability to transfer risk (such as from mortgage bank to securitization firm to investors) was a major contributor to the housing bubble. In that case, transferring risk was a polite term for passing the hot potato. American International Group Inc., which famously sold credit-default swaps, was simply the firm holding the most potatoes.
I doubt it’s possible to revert to the world of Old Jamie. Pundits criticize banks for investing in bonds and putting on hedges instead of making loans. In reality, modern bankers make no distinction. They live in a supple world, where every loan, trade or hedge is simply an exercise in risk transference. Inundated with data -- much of it ephemeral -- they are prone to overreact and overtransact, tilting their behavior away from analysis of long-term credit risk and toward the mentality of traders.
Bankers are no different from investors in their short-term focus. We are horrified when bankers lose $3 billion, but the hedging mentality has also corrupted investors who shrink from a commitment, finding shelter in a hedge, which Wall Street peddles in many varieties, including the hedge of extreme and excessive diversification.
To be meaningful, reform would have to change the culture, as well as the rules, but here’s a start: Shut down the credit-default swap pits. Let bankers ply their trade without the deceptive safety of hedging. Let the speculators bet on something else.
(Roger Lowenstein is the author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” He is an outside director with the Sequoia Fund. The opinions expressed are his own.)
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