The ‘Perfect Hedge’ Remains Elusive at JPMorgan

At JPMorgan Chase, they called it “the icing” — as in the icing on the cake.

The bank’s chief investment office — the one that incurred the $2 billion trading loss — was responsible for managing the firm’s risk.

It was supposed to place trades, including by hedging, to keep the firm from losing money.

But part of the group’s job may have been at odds with its stated goal of reducing risk: it was also supposed to turn its “hedging” trades into a tidy profit. That’s the part they called the icing.

As investors, regulators and policy makers try to deconstruct the trading blunder at JPMorgan, it is worth revisiting the debate over the very definition of hedging.

That definition is a crucial ingredient in the long-running battle in Washington over the proposed Volcker Rule, legislation aimed at curbing banks from making speculative bets. Or to put that in plain English, separating the casino from the bank. Yet the law leaves wiggle room for Wall Street firms to make trades as long as their intent is to “hedge” the firm from potential losses. (The banks, often led by JPMorgan, fought hard for that wiggle room.)

Critics of the language in the bill have long contended it is a gaping loophole that allows firms to continue to make speculative bets under the guise of it being part of a “hedging” program.

Indeed, JPMorgan’s problem trade increasingly makes it seem as if it was not a “hedge” at all but a speculative bet. That’s the only way to account for the $2 billion loss. If it was a perfect hedge — when one asset goes up in value, the other goes down — the bank would have neither made nor lost any money.

And therein lies the problem: hedging by its very nature is at some level a gamble. It is never perfect.

“I don’t think you can hedge without taking a risk,” said Dina Dublon, a former JPMorgan chief financial officer who worked at the firm for 22 years alongside Ina Drew, who ran the chief investment office and tearfully resigned on Monday. Ms. Dublon left JPMorgan in 2004 and now is a board member of Microsoft, Accenture and PepsiCo. Ms. Dublon said that Ms. Drew always managed her group with the intent of hedging, but also being a “profit center.” And up until this failed trade, she did it quite successfully.

Paul Hsi, head of United States credit research at Morgan Stanley, put the hedging debate this way: “The idea of risk management is an oxymoron. You can try to measure the amount of potential risk in your portfolio, but the only way to really ‘manage’ risk is by either taking more of it or taking less of it.”

It’s also worth noting that this “mess” is not actually much of a mess for the firm in terms of dollars and cents; the firm is still expected to make $4 billion this quarter. The reason that JPMorgan’s loss matters at all is the larger context: if this bank, known for being the best risk manager on Wall Street, could lose this amount of money on a bad trade, what about other firms?

In the process of writing and rewriting the Volcker Rule over the last two years, the banks pushed hard to be allowed to hedge risk related to “market-making” and to “portfolio hedging.” Market-making is when a firm acts as buyer or seller to help facilitate a trade for a client. The banks actually made a persuasive case that if they are going to take risks for clients, they should be able to seek to hedge each trade individually.

However, they also sought an exemption for something much more expansive: “portfolio hedging.” In other words, they wanted the ability to try to hedge their entire firm’s portfolio against macroeconomic factors. And that’s where JPMorgan’s botched trade comes in.

So let’s discuss how JPMorgan got in this mess in the first place. Here’s an overly simplistic primer, but you’ll probably get the idea: The company’s chief investment office originally made a series of trades intended to protect the firm from a possible global slowdown. JPMorgan owns billions of dollars in corporate bonds, so if a slowdown were to occur and corporations couldn’t pay back their debt, those bonds would have lost value.

To mitigate that possibility, JPMorgan bought insurance — credit-default swaps — that would go up in value if the bonds fell in value.

But sometime last year, with the economy doing better than expected, the bank decided it had bought too much insurance. Rather than simply selling the insurance, the bank set up a second “hedge” to bet that the economy would continue to improve — and this time, traders overshot, by a lot.

Jamie Dimon, the bank’s chief executive, said of the trade on “Meet the Press”: “We know we were sloppy. We know we were stupid.” Senior executives at the bank say privately that the trade should have never been made; they even concede that it looks like a proprietary trade — which the Volcker Rule would explicitly prohibit — rather than a “hedge.”

“The key conceptual point is probably whether the transactions would have been viewed as true hedges under the final version of the Volcker Rule,” Douglas J. Elliott, a fellow at the Brookings Institution, wrote on Monday. “In theory, this was an intelligent risk-reducing activity, if executed sensibly, as was apparently not the case here. Incompetence of execution would presumably not trigger the Volcker Rule, if the intent were truly to hedge.”

But nearly four years after the financial crisis, we shouldn’t have to worry about whether a series of mistaken trades (and I’m being polite) can create a hole in a balance sheet and a risk to the system. (The good news, by the way, is that in the case of JPMorgan, the bank is large enough to withstand the loss.)

We shouldn’t need to try to divine whether a bank is really seeking to “hedge” its risk or making a big bet.

“The notion that you can very clearly draw a line between propriety risk-taking and hedging is a very difficult notion to implement,” Ms. Dublon said.

Ultimately, if there’s any lesson at all in this story, it is a lesson we all already know: you can’t have your cake and eat it — and the icing — too.