Americans might have had enough of hedge strategists, but the truth is that investors use hedging strategies to protect investments. If investors have a portfolio that's long the S&P 500, it can buy S&P index option puts to protect that position in a bear market and lose less. If a farmer wants to protect from falling corn and soybean prices, it can lock in the price in the futures market, also a hedging strategy. If a U.S. corporation is worried the euro will weaken it can buy euro forex futures and options to protect its revenue stream. This is how the markets work every day. Derivatives exist for a reason, and the top executives at the biggest banks in the U.S. have managed to convince Congress, and the White House, that hedging is good because of those reasons. The flipside to their 'hedging is natural' narrative is that over regulating them through legislation like Dodd-Frank will take away protections the market has grown accustomed to. Hedging is good...except when it isn't.
As the world now knows, JP Morgan lost at least $2 billion in a hedging strategy gone woefully wrong. Their "Voldemort" trader, as he was known, often tore the thinly traded credit default swaps market in half with billion dollar investments being made in one fell swoop. It was like trading a penny stock at some points during the day, one trader said. JP Morgan used CDSs as a hedge against the bank's exposure to fixed income in Europe, Asia and in the U.S. It built up positions to cover failed positions until it became untenable and too costly to maintain.
"Hedging is fine, but when you have a complex and highly diverse portfolio like JP Morgan, you end up taking on too much risk and creating your own derivative products to manage those risks. In other words, the risk taking that we've seen on the high tech prop trading desks at Lehman Brothers and Bear Stearns in 2008 are alive and kicking at JP Morgan," said Lance Roberts, chief strategist at Street Talk Advisors, a $450 million investment advisory in Houston.
Roberts expects what many in the market are now expecting...that the $2 billion hedging loss at JP Morgan is much bigger. The likelihood of that blowout going to $4 billion is more than it being reduced to $1 billion. Competing traders in the CDS market could force the bank to pay an even higher premium to unwind its position now that everyone knows how badly JP Morgan wants to cut loose.
JP Morgan's CEO said it could take a year or longer to unwind those CDS contracts. The bank is flush with cash, thanks to its ability to buy Treasury bonds directly from the U.S. Treasury department at a discount and sell them back to the Federal Reserve for a quick profit. It has the money. JP Morgan is not going to be the next Lehman Brothers. But that might have more to do with its relationship with Washington at this point than anything else. A two billion dollar loss is just 2% of the company's market cap, so Voldemort and his boss, the recently humbled and now unemployed Ina Drew didn't take down the bank with its bad bets.
Seeing a bank fall in an election year would also be horrible for the Democrats. Lehman and Bear went bankrupt in late 2008. Obama was elected and carried traditional red states a month later. If the $2 billion becomes $4 billion, or worse, the government will like step in behind the scenes to save JP Morgan from itself.
There's an irony to this. John Pierpont Morgan made his money as a financial backer of industrial companies. The company that bears his name creates derivatives that have no bearing on the physical economy whatsoever.
The government bailouts also gave JP Morgan more money than it knew what to do with. When it bought the failed Washington Mutual bank in 2008, it picked up $308 billion in assets to manage and gave a lot of that to Ina Drew to manage in the derivatives market. Rather than invest in companies, it invested in one of the thinnest markets around.
Dimon has been lobbying Congress not to regulate the industry to death. He might not need to; the industry seems to be doing just fine strangling itself without Washington's help.
"We want to maximize the economic value of these positions and not panic or do anything stupid. We're willing to bear the volatility and that's life," Dimon was quoted as saying in Reuters article on Monday.
See: In JP Morgan Trading Bet Loss, It's Confidence Yields To Loss -- The New York Times
