J.P. Morgan's Big Problem

The baseline problem underlying J.P. Morgan's recently announced $2 billion loss on a credit default swap bet gone bad is that big banks face virtually all economic risks. Banking, as conducted by major money center banks, cuts across essentially all economic sectors, all lines of commerce, all financial instruments, and all asset classes. There are some exceptions. For example, big banks rarely dabble in penny stocks or business startups. And they tend to limit their exposure to junk bonds. But they directly or indirectly play in almost all sandboxes in the economy.

The essential conceit of contemporary financial engineering is that risk somehow can be controlled. It is believed that if you find a clever enough math whiz with an MBA from a sufficiently fancy school, s/he can fashion a derivative for any purpose that will magically (albeit for a fee) transport risk to a distant land from which it will never return. With such magical powers, one need not be prudent and limit exposure to risky assets. One need only have a smart enough financial engineer to fashion a seemingly appropriate hedge.

Derivatives can work, and work well, when the risk they're meant to mitigate is narrow and well-defined. For example, futures contracts for red winter wheat serve salutary purposes when appropriately used by farmers, grain companies and speculators.

But when derivatives are deployed to mitigate wide-ranging and vaguely defined risks, their limitations come into play. Press reports indicate that J.P. Morgan's management directed its chief investment office to mitigate the risks of economic deterioration in Europe. This, to say the least, is a rather large, complex and wide ranging problem. Things in Europe can go downhill for a variety of reasons, not all of which are easily defined or predicted. The murkier a situation, the more difficult it becomes to fashion appropriate hedges. And if the hedges aren't entirely appropriate, their imperfections may have be hedged in turn. Reports in the financial press indicate the mandate from J.P. Morgan's management seems to have morphed into a net position that bet on improved financial health for a number of major corporations. Such a bet wouldn't seem the intuitively obvious way to hedge against a downturn in Europe.

As with all financial firms, J.P. Morgan's most important asset is its reputation. Since the 2007-08 financial crisis, its reputation has been golden. J.P. Morgan avoided unduly large real estate risks. It bought Bear Stearns at the government's behest, quelling incipient panic in the financial system. Its earnings were relatively stable, compared to its competitors. While the latter downsized to ditch hinky assets and offload risk, J.P. Morgan became the largest bank in America.

But such golden reputations become a burden, because the market expected J.P. Morgan to remain golden. Given that big money center banks face virtually all economic risks, this becomes a harder and harder job as time passes. Skilled risk managers and corporate executives might be able to anticipate most risks most of the time. But no one can predict all risks all the time, and a financial institution facing the length and breadth of economic risks borne by major money center banks will stumble sooner or later. Indeed, the longer a bank's winning streak, the greater the chance the next quarter will be a bad one.

Management sitting on a winning streak will understandably want to keep the streak going. But they must consider whether or not they can. Not all risks can be hedged or managed. Much of the "hedging" that goes on in the financial markets consists of using apples to hedge oranges. The two sides of the hedge are not mirror images of each other, but approximations. If the approximations are pretty close, a well-capitalized firm can get by. But that "if" gets bigger and bigger as derivatives positions get larger and as some derivatives are used to hedge risk factors in other hedges (which may have been the case at J.P. Morgan). When risk managers and management fail to recognize that the magic doesn't work in all situations, they get a morass.

Recognizing one's limits is an ancient and highly effective means of risk management. Not taking a risk, or offloading it, eliminates the possibility that it will later bite your butt. Being the biggest bank doesn't necessarily mean that you're the best bank. Appreciate that derivatives are imperfect financial instruments, and because of their newness, their imperfections are imperfectly understood. Given the inability to comprehend all risks or hedge them, having a shipload of capital may be best way for a bank to safeguard its future.

Banks typically trade at comparatively low multiples of earnings per share. That's because of the plethora of risks financial firms typically face. The siren call of the derivatives market is that, for a fee, a bank can hedge its way out of problems instead of having to manage them. These sirens have claimed a number of victims since the 2007-08 financial crisis, and now they appear to have lured J.P. Morgan onto a rocky coast.