Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

JPMorgan London Whale and Macro Hedges

Last week, the US Senate Permanent Subcommittee on Investigations released a staff report on the London Whale trades in which JPMorgan Chase lost $6.2 billion last year. The 300 page report puts together a lot of data that was missing in the JPMorgan internal task force report which was published in January.

Unsurprisingly, the Senate staff report takes a very critical view of the JPMorgan trades which the bank’s chairman described in a conference call last May as a “bad strategy … badly executed … poorly monitored.” Where I think the staff report goes overboard is in describing even the original relatively simple hedging strategy that JPMorgan adopted during the global financial crisis (well before the complete corruption of the strategy in late 2011 and early 2012).

The staff report says:

A number of bank representatives told the Subcommittee that the SCP was intended to provide, not a dedicated hedge, but a macro-level hedge to offset the CIO’s $350 billion investment portfolio against credit risks during a stress event. In a letter to the OCC and other agencies, JPMorgan Chase even contended that taking away the bank’s ability to establish that type of hedge would undermine the bank’s ability to ride out a financial crisis as it did in 2009. The bank also contended that regulators should not require a macro or portfolio hedge to have even a “reasonable correlation” with the risks associated with the portfolio of assets being hedged. The counter to this argument is that the investment being described would not function as a hedge at all, since all hedges, by their nature, must offset a specified risk associated with a specified position. Without that type of specificity and a reasonable correlation between the hedge and the position being offset, the hedge could not be sized or tested for effectiveness. Rather than act as a hedge, it would simply function as an investment designed to take advantage of a negative credit environment. That the OCC was unable to identify any other bank engaging in this type of general, unanchored “hedge” suggests that this approach is neither commonplace nor useful

I think everything about this paragraph is wrong and indeed perverse.

  1. What the crisis taught us is that tail risks are more important than any other risks and far from criticising tail hedges, policy makers should be doing everything possible to encourage them. That the US regulators could not find any other bank that implemented such tail hedges speaks volumes about the complacency of most bank managements. It is those banks that deserve to be criticized.
  2. We do not need correlations to size or test the effectiveness of macro hedges. Consider for example hedging a diversified equity portfolio with deep out of the money puts. For a complete tail hedge, the notional value of the put would be equal to the value of the portfolio itself. A beta equal to one might be a perfectly reasonable assumption for a diversified portfolio since a precise estimate of the tail beta might not be very easy. There is no need to compute a correlation between the put value and the portfolio value to determine the effectiveness of the hedge. Even the correlation between the index and the equity portfolio is not too critical because in a crisis, correlations can be expected to go to one.
  3. A put option of the kind described above is not an investment designed to take advantage of a stock market crash. Viewed as an investment, the most likely return on a deep out of the money put option is -100% (the put option expires worthless), just as the most likely return on a fire insurance policy is -100% because there are no fires and no insurance claims.

I think the problem with the JPMorgan hedges as they metamorphosed during 2011 was something totally different. The key is a statement that the JPMorgan Chairman made in the May 2012 conference call after the losses became clear:

It was there to deliver a positive result in a quite stressed environment and we feel we can do that and make some net income.

Sorry, tail hedges do not produce income, they cost money. Any alleged tail hedge that is expected to earn income under normal conditions is neither a hedge nor a speculative investment – it is just a disaster waiting to happen.

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