Explaining JPMorgan's Mess: The Illusion Of 2D Investing In A 3D World

| About: JPMorgan Chase (JPM)

Business Insider reported that JP Morgan (NYSE:JPM) recently "adjusted" the models they use to calculate their risk, or more specifically "value at risk," this in view of course, of the JPM's stunning announcement on their recent trading losses.

Simply put, the chief investment office allowed the maximum value at risk to go from $64 million in 2011 to $187 million in 2012. No big deal right?

Just so you know, value at risk (NYSE:VAR) is a relatively simple calculation. Once again, per JPM's 10Q:

The Firm calculates VaR to estimate possible losses for its current positions using historical simulation, which measures risk across instruments and portfolios in a consistent, comparable way. The Firm's VaR calculation is highly granular and incorporates numerous risk factors, which are selected based on the risk profile of each portfolio.

The simulation is based on data for the previous 12 months. This approach assumes that historical changes in market values are representative of the distribution of potential outcomes in the immediate future. VaR is calculated using a one day time horizon and an expected tail-loss methodology, and approximates a 95% confidence level.

This means that, assuming current changes in market values are consistent with the historical changes used in the simulation, the Firm would expect to incur losses greater than that predicted by VaR estimates five times in every 100 trading days, or about 12 to 13 times a year.

However, differences between current and historical market price volatility may result in fewer or greater VaR exceptions than the number indicated by the historical simulation. In addition, based on their reliance on available historical data, limited time horizons, and other factors, VaR measures are inherently limited in their ability to measure certain risks and to predict losses, particularly those associated with market illiquidity and sudden or severe shifts in market conditions.

Alright, I guess it's not so simple. But it should be simple. After all, CEO Jamie Dimon said it was just some "errors, sloppiness and bad judgment."

Sorry Jamie, you can't be "sloppy" when it comes to calculations that are "highly granular" and rely on values that are "representative of the distribution of potential outcomes in the immediate future."

2D thinking in a 3D world

I suppose I could discuss all the statistical mumbo jumbo about relying on 95% confidence levels and rehash all the many explanations of "tail risk," blah, blah, blah, but I'm sure you can find that information elsewhere.

I think I can simplify this. See this triangle?

Do the angles add up to 180 degrees? If you want to pass a geometry course, you'll have to accept that they do. You may even have to prove it.

But do real triangles in the real world work like this? No, they don't. Put a triangle on a real object, like a sphere, and they add up to more than 180 degrees.

I gotta think even Euclid knew this. He was a smart guy. He must have drawn a triangle on an orange or something way back when.

The thing about triangles is this, if you need to measure carpet for your weird triangular room or sod for your odd triangular back yard, 2D triangles work fine. On a small enough scale, who cares about the nano-scopic discrepancies?

But when you start measuring the big stuff, the distortions add up. A few dozen square miles aren't so square any more - at least on planet Earth, which is where we happen to live.

Yet JP Morgan is evidently relying on histograms that look like this (also from the recent 10Q):

Seems way too two-dimensional to me, especially when billions of dollars may be on the line. And way too few data points.

I once interviewed a professor of quantitative finance about a specific financial model. I asked him this question about 2D vs. 3D triangles in making assumptions about attributes that could be distorted at really large scales. He said I "had a point."

Maybe he was just being kind to someone who's not exactly an advanced math whiz. Or maybe I really do have a point. And that is that models and theories designed by 2D thinkers just don't cut it in the real world.

Or to put it another way, if you bet me that your metaphorical "triangle risk" theoretically maxes out at 180 degrees, I'll prove you wrong. Every time.

Unless you live in Flatland or something, I can blow that "triangle risk" up way past 180 degrees and you won't know what hit you - even if you're wearing 3D glasses.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.