Pundits are being very quick to latch onto JPMorgan Chase's (NYSE:JPM) announcement of large losses in its treasury department's credit hedging operation as a justification for implementing the Volcker rule against proprietary trading. A more analytical understanding of risk management and its limitations might lead one to a different conclusion: that this incident points out the absolute futility of the Volcker rule.
JPM provided few details of the source of the losses-understandably because it cannot get out of its positions immediately and risks increasing its losses if rivals know what those positions are. Later disclosures may well put the situation in a different light. Putting the few pieces of the puzzle that there are together, what seems to have happened is this: the treasury department, which can take a firmwide, macro view of risk and seek to make macro hedges, decided that it could do something about the fact that the bank was long credit risk, as banks are by their very nature. It made a macro-hedge, going short credit to counterbalance its naturally long credit position. So far so good, one might say. It sounds like a hedge. Regulators apparently bought the story, as they were supposedly privy to the details of risk positions. But then, according to CEO Jamie Dimon's explanation, seeing that credit was generally improving in the economy, the bank thought better of its short position, and sought to undo it. Putting two and two together, and remembering reports traders had circulated a month ago about JPMorgan was being the "London whale", or an overwhelming force, in a small, specialized corner of the credit derivatives market , one could surmise that JPMorgan was using these derivatives to go long credit again, counterbalancing its short position.
If this is the case, then the "hedging" strategy looks like a proprietary trading strategy. JPM was simply taking views on which way credit spreads were headed. The fact that they had a natural long position in credit could not be the real motivation. If it were, then because that long position is essentially perpetual, the hedge should stay in place, not be put on and taken off with changing market conditions.
The lessons for risk management (so far) are at least two, one broadly philosophical and the other technical. Philosophically speaking, and above all, risk management is an art; one that involves an ability to view situations from above and ask common sense questions. Particularly for a CEO, who is after all the chief risk officer, the question should be "how does this fit with the overall strategy of the firm?" Why would the firm want to hedge credit risk, when a bank is the best institution to efficiently take credit risk? The returns it earns are its reward for taking credit risk. Why would it want to hedge that risk, thereby paying away the rewards? And if that CEO should find that the hedge takes on a "risk on," "risk off" pattern, he or she should really smell a rat.
It is difficult to always tell when a hedge is really a hedge, even when one has an intimate knowledge of the specifics. If the CEO, the Chief Risk Officer, and the regulators could see this strategy as a hedge, then it is unlikely that the enormous regulatory constructs that would need to be built around the Volcker rule, with the mountains of prescriptive rules to be followed, will be able to take the required philosophical perspective to critique any strategy in a holistic way. They will more likely get lost in the weeds.
The more technical consideration is one that really good traders know instinctively. It is what Goldman Sachs (NYSE:GS) says in its risk management discussions. One never wants to be so large in any one market that he/she would affect market pricing if he/she wanted to liquidate the position. That is apparently a lesson JPMorgan is learning now. Hedging is expensive so it is tempting to take leveraged bets, maybe with complex derivatives. It looks as if the complex trades made by the "London whale" are now so large a part of that specific market that they are going to take a few quarters to unwind. While JPMorgan is not discussing the nature of the trades, in an effort not to betray its unwind strategies so that competitors can take advantage of them, it appears that some traders know already-as evidenced by the fact that JPM's stock had been falling more rapidly than other banks' over the last month before the announcement. Markets are not kind. They will likely continue to bet against the bank and make unwinding the position very difficult.
Even in this technical consideration, there is a philosophical lesson to be learned. Traders in the market had tried to warn about the concentrated bets. So sure was Jamie Dimon that his people were on top of the situation that he dismissed the evidence as a "tempest in a teapot" brewed by those who did not see the whole picture. Humility is important when dealing with complex markets. No evidence should be dismissed, because at the end of the day, every player in the markets is vulnerable and no one appears to retain a lasting edge for sophistication or good execution indefinitely. A risk manager is ultimately a sleuth that must keep all ears open to the least clues. There can be no rule book.
JPM has lost much more than $2 billion today. It has lost its reputation for superior execution. The losses may climb but there is no reason to think that this is a sign of a broader set of losses to come. That is market overreaction. JPM can certainly easily absorb these losses from a financial perspective. The question is, can it retain its premium multiples. That depends on whether markets can be so genuinely surprised that risk management is a difficult art that no bank has mastered.
Disclosure: I am long JPM.