Bank Hedges and Social Justice

by  Chidem Kurdas

To hedge or not to hedge? That’s the question for many an endeavor. Farmers hedge by selling their harvest ahead of time. Building managers hedge by locking in a price for heating oil or natural gas—last year many got it wrong, blindsided by the decline in the price of gas. Most hedges we don’t hear much about.

Until last week, the most infamous hedge was the set of complex trades put on by Goldman Sachs as protection against losses in mortgage securities in the property bust. Financially this worked and Goldman Sachs escaped the 2008 crisis relatively unscathed. Thereupon it became an object of loathing and mockery in the media, inspiring calls for higher taxes and greater regulation.

Now we have the failed trades with resultant loss of $2-$3 billion at JP Morgan Chase. This also inspired calls for greater regulation, in particular of bank trading, which appears to be offensive whether it makes money or loses money.

The JP Morgan Caper

by Jerry O’Driscoll   

J.P. Morgan Chase & Co., one of the nation’s leading banks, revealed that a London trader racked up trading losses reportedly amounting to $2.3 billion over a 15-day period. The losses averaged over $150 million per day, sometimes hitting $200 million daily. The bank states the trades were done to hedge existing risks.

How did this happen and what are the lessons? The two questions are related.

It appears the individual traded on the basis of observed relationships among various derivative indices. The relationships broke down. Such a breakdown has been at the heart of a number of spectacular financial collapses, notably that of Long-Term Capital Management in 1998 and a number during the financial meltdown of 2007-08.

In short, there is nothing new in what happened. Yet financial institutions permit their traders to make the same kind of dangerous bets. In a Cato Policy Analysis, Kevin Dowd and three co-authors examined some of the technical problems with standard risk models utilized by banks.  It is an exhaustive analysis and I commend it to those interested. The analysis goes to the question of how these losses happened.

Now to the lessons.

Menace to Savings and Small Businesses

by Chidem Kurdas

As the old adage goes, be careful what you ask for, you might just get it. After the 2008 crisis it became fashionable to complain that too much trading is going on. There were calls in this and other countries to restrict financial transactions. And it happened. One example is the rule named after Paul Volcker in the 2010 Dodd-Frank law, banning depository banks’ trading on their own accounts (and also forbidding them from holding significant hedge fund or private equity interests).

Regulators are still in the process of determining how to implement the Volcker rule but the potential impact is already discernible. Likely victims include millions of Americans who save for their retirement and smaller companies that need to borrow money.