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.

The UBS $2 Billion Loss: This and the Banks Want Easy Capital Standards?

Here we go again. Another big bank, this time UBS AG, reports an elephantine loss attributed to unauthorized trading. In this instance, the big boo boo was allegedly made by a derivatives trader identified in the press as Kweku Adoboli. It seems just like yesterday that Societe Generale 'fessed up to a $6.7 billion loss from its own rogue trader, Jerome Kerviel. Then, there was Nick Leeson at Barings bank, Yasuo Hamanaka at Sumitomo Trust, and John Rusnak at Allied Irish, among others, who have attained notoriety for generating leviathan trading losses. The big banks just don't seem to move up the learning curve when it comes to risk management.

It's no surprise that both the UBS mess and the preceding scandals involved lightly regulated markets. Bad behavior is always more likely when there are few hall monitors. But the banks themselves have the primary obligation to watch over their people and preserve their assets. They keep failing.

One has to wonder if the inevitability of government support makes it easier for bank executives to short sheet the risk management budget. Top management knows that no matter how massive losses get, the government will not allow a major bank to fail. Experience teaches that top management will generally not suffer much from one of these financial tectonic events. Some embarrassment, yes, and perhaps a modest haircut off one's bonus. But loss of employment and legal sanctions seem to be out of the question. So, why invest large sums in risk management systems when that would only reduce the amount of net income used to determine executive bonuses?

In addition, truly effective risk management would likely mean lower levels of risk taken. That would probably reduce income. It would also reduce losses. But management compensation tends not to be diminished as much by losses as it is leveraged by gains. So top executives are incentivized to take risks, and collecting outsized gains if the risks pay off. And if the risks fry the bank's butt? That would be a shame for shareholders.

Risk management is not just a problem for trading. One sees weak risk management in recent mortgage-related problems. Alleged poor underwriting standards for mortgage-backed securities may cost some big banks tens of billions each. The robo-signing foreclosure scandal will cost yet billions more.

And then there's Europe's sovereign debt crisis. Europe's major banks were the doofusses that financed the profligacy of Greece, Ireland, Portugal, et al. How the . . . heck . . . did they manage to put the world's financial system and economy at the edge of the abyss? Didn't they have controls that suggested diversification--not exactly a novel concept--might be in order?

For the past half-decade or more now, the world's largest banks have repeatedly imperiled prosperity worldwide. At the same time, they are coddled with bailouts, subsidies, and explicit and implicit government guarantees. Yesterday's announcement by Germany and France of support for Greece, and today's announcement by the Fed and other major central banks offering emergency dollar loans to Europe's commercial banks, are just the latest in a long line of handouts. Europe's banks have been facing growing customer runs, and more government munificence was deemed appropriate. Banks are like kids that never lose a soccer game, no matter how far behind they fall. No wonder they don't act maturely.

The regulators' proposal to end this cycle of wealth transfer from taxpayers to bank executives has been to raise capital standards. The so-called Basel III standards, which are in the process of being implemented, may require major banks to more than double the amounts of capital they hold, compared to the ineffectual Basel II standards. Banks are pushing back as vigorously as they can. Increasing capital means downward pressure on executive compensation, and that can't possibly be, can it? Some regulators may be wavering. The $2 billion loss reported by UBS is a timely reminder that there actually is a purpose to increasing capital standards--and in fact it's a good purpose even though it may likely decrease bank executive compensation.

We must not be lulled into thinking that the $2 billion loss by UBS will motivate banks to clean up their risk management messes. Prior scandals didn't, and this one won't. There surely are more rogue traders who haven't been caught yet. When their losses get big enough, they will be. Bank shareholders will pay the price, and taxpayers may have to pony up another bailout. Even though the Volcker rule will, if ever implemented, make it harder for U.S. banks to self-destruct from unauthorized proprietary trading, international interbank linkages will preclude insulation of the U.S. financial system from the failures of foreign banks.

Truth is we'll never get rid of too big to fail. It's a tax on the citizenry that cannot be repealed, Tea Party or no Tea Party. The next best thing would be to proceed with increasing capital standards. Only when banks are forced to pay, at least in part, for the costs they impose on society, will they begin to stop acting like welfare queens.

Did Goldman Sachs Really Lose $90 Million from the CDO It Constructed for Paulson?

Goldman Sachs claims it lost $90 million from holding a piece of the synthetic CDO that it constructed for John Paulson & Co., a transaction now famous as the subject of the SEC's recent enforcement action against Goldman. Can we take this claim of a $90 million loss at face value? Goldman has persistently asserted it was well-hedged against AIG risk, and didn't need the billions it garnered when the U.S. Treasury bailed out AIG's creditors for 100 cents on the dollar. One wonders why Goldman, if it were a good corporate citizen dedicated to doing God's work, didn't decline the money it didn't need, especially when so many middle class taxpayers are badly stretched. But on Wall Street, money talks and good deeds walk. It's fine if John F. Kennedy declined his presidential salary because of his family's wealth, but Wall Street isn't in Camelot.

Considering how well Goldman supposedly was hedged against AIG risk, it's hard to imagine it wasn't hedged against the decline in the mortgage markets. After all, e-mails quoted in the SEC's charges make clear that Goldman expected that decline. And Goldman evidently greatly reduced its overall exposure to real estate and mortgages even before and while it put together ABACUS 2007-AC1. From a risk management standpoint, one would expect that when Goldman unexpectedly got saddled with a piece of the ABACUS deal, it would have hedged itself. Certainly, it wouldn't have knowingly carved out a piece of its risk profile and left its interest in ABACUS 2007-AC1 naked long. So did Goldman really lose $90 million? Its accounting and risk management records might make for interesting reading in this regard.

If Goldman was in fact hedged against its ABACUS exposure, or was able to take advantage of general hedging in the mortgage and real estate sector to offset its ABACUS losses, then its claim of a $90 million loss could be false or misleading. Ordinarily, $90 million, more than lunch money to most people, ain't squat sit to Goldman Sachs. But Goldman's vaunted reputation is on the line. Claiming this $90 million loss as an indication of its innocence, if there really isn't such a loss, just might step over the line. The SEC has sanctioned a public company for making a misstatement in connection with its defense of an investigation. See SEC Press Release No. 2004-67 (May 17, 2004)(captioned, "Lucent Settles SEC Enforcement Action Charging the Company with $1.1 Billion Accounting Fraud"). Given how Goldman's stock has gyrated with the back and forth among news stories about the case, a misstatement by Goldman about the strength of its defenses could conceivably step over the line and itself be potential grist for the SEC's enforcement mill.

Back to hedging. A fun question might be to ask what Goldman, as a market maker, did with the RMBSs that related to ABACUS 2007-AC1. Goldman, like other large banks active in the mortgage business, might have made markets in those RMBSs. The SEC complaint alleges (and essentially all news sources agree) that the RMBSs underlying ABACUS 2007-AC1 dropped in value very quickly after the deal was done, hammering the long side of the deal. If Goldman was a market maker in some or all of these RMBSs and dropped its quotes muy pronto, one would have to wonder why it was so unafraid of imposing losses on its own holdings in the ABACUS deal. The answer could well be that it was well-hedged on ABACUS and dropped its bids because it didn't want to buy doggy RMBSs from someone else trying to hit its bids.

Although the derivatives markets were, and still are, murky on the best of days, records of Goldman's quotes may exist in documentation maintained by institutional investors who were seeking market valuations for accounting purposes. Big compilers of market data like Bloomberg and Reuters may also have relevant information. Of course, Goldman should have records of its own quotes. But independent verification would be de rigueur, now that the parties are dancing in federal court. The discovery process (i.e., the process in litigation of collecting and exchanging evidence) in SEC v. Goldman is likely to begin presently. Perhaps the SEC's litigation team will find some interesting stuff.

Robber Barons Redux in the Derivatives Market?

A recent story from Bloomberg.com reported that two large banks, Goldman Sachs and J.P. Morgan Chase, are using their market power to secure extra large helpings of collateral in derivatives transactions with hedge funds. http://www.bloomberg.com/apps/news?pid=20601109&sid=af6uIAFTSorY. For example, Goldman reportedly obtained $110 billion more in collateral on derivatives transactions than it paid out. In effect, it got $110 billion in low cost funding that it could reinvest at a profit. J.P. Morgan Chase netted $37 billion in a similar way.

On one level, we're glad that hedge funds dancing in the derivatives market are subsidizing Goldman and J.P. Morgan. Otherwise, the Fed might feel compelled to print more money to ensure plenty of cheap funding for the too large to fail.

But the Bloomberg story states that these two behemoths of the financial markets had their way with counterparties because of their market power. In the post-2008 financial markets, there are only a few firms that offer some derivatives products sought by hedge funds, and those few evidently make their customers pay full freight and perhaps more.

On the level of economic theory, oligopolistic behavior is undesirable because the oligopolists extract "monopoly rents" from their customers--i.e., profits above the level that a truly competitive market would provide. This misallocation of economic resources enhances the power of the oligopoly, which can use that power to further entrench itself and secure more monopoly rents. To restate the point in plain English, oligopoly power allows the already megawealthy to become even more indescribably rich.

Surely we taxpayers, who have already subsidized Wall Street to the tune of multi-billions, are gratified to learn that those clever kids at Goldman and J.P. Morgan Chase can look forward to even more wealth. But let's also consider the impact of this collateral disparity on market risks. The derivatives market has a zero-sum quality. If a risk is transferred from one party to another, it doesn't disappear. It simply lands in the second party's lap, who must then figure out what to do with the hot tamale. In a similar way, if more, rather than less, of the hedge fund community's funding is transferred to money center banks, that leaves less for the hedge funds. Prudent hedge fund managers, after having their arms twisted by bank counterparties for extra collateral, would shrink their asset bases in order to keep risk levels in line with their reduced circumstances.

But this is Wall Street. Profits talk and prudence walks. Reduce your assets, and you reduce your money making potential. Do we really think that, just because GS and JPM have reduced their risk levels, their counterparties will do so as well? Or might it just possibly be that their counterparties would simply live more dangerously?

We've seen this video before. It was called The Grasping Counterparties Who Ruined AIG's Entire Day. Recall that AIG reached the brink because its derivatives counterparties, with the largest being Goldman, demanded more collateral than AIG could deliver. Surrounded by a pack of ravenous counterparties, AIG would have been torn to shreds except that the federal government appeared in the nick of time with $180 billion to drive (or rather, buy) off the wolfpack. Goldman claims it was fully hedged from AIG risk. But in order to do God's work it took the taxpayers' money anyway.

If Goldman's and J.P. Morgan Chase's counterparties are now at greater risk, where would that risk fall if the markets turn sour? It's possible that the derivatives markets have become more fragile because of the increasing concentration of market power in the hands a few money center banks. Locating any such fragility is difficult, because the absence of financial regulatory reform leaves us with only the fog of opacity of the derivatives market, circa 2008--well, 2010. Of course, if there is a blowup, the Fed can always print some more money. And that's okay, because there never, ever will be any inflation again. At least, that seems to be close to what some high ranking government officials have told us and they couldn't be wrong, could they?

Risk Management: Should the Investment Banks Have Remained Partnerships?

To state the obvious, investment banks have a risk management problem. Merrill just wrote of $8 billion and its CEO abruptly retired. Bear Stearns' president left under a cloud this past summer, and questions now swirl around its CEO. Questions also swirl around the CEO of Citigroup. Senior executives at a number of banks have hit white water in their careers. An analyst downgrade of Citigroup today contributed to a 362 point drop in the Dow Jones Industrial Average.

These are supposed to be smart people. And they're supposed to have smart people working for them. How could it be that they'd record losses in the hundreds of millions or billions--and just for one quarter? You'd think they'd have effective risk management systems, not only because that's part of their jobs, but also because the consequences can be so great.

But are the consequences so great? Stanley O'Neal, the now retired CEO of Merrill, reportedly left with $161 million. You could buy a jet and a yacht with that much money and still have plenty left over for caviar and champagne. Chances are many other departed executives didn't end up homeless and selling apples on the sidewalk. Of course, they suffered embarrassment and probably some loss of income. Their careers may have been sidetracked for a while. They may have to hold onto the leased Mercedes instead of upgrading to a Bentley. But peanut butter and crackers remain scarce in their diets.

Once upon a time, investment banks were partnerships (specifically, what lawyers would call general partnerships). Legally speaking, this meant each partner was liable to the full extent of his personal wealth for the firm's debts. If the firm had catastrophic financial results, a partner's coop apartment on Park Avenue was at risk. As were his Cadillac, art work, watches, china, savings, and investments. In other words, he could lose everything he had.

All of the partners were bound to pay the debts and liabilities that every other partner incurred on behalf of the firm. If a partner on the trading desk made some bad bets on bonds using margin and lost money, the partners in the mergers and acquisition department were at risk for payment of the margin debt. And if the partners in M&A gave some ill-conceived advice about the value of a deal, and wound up having to settle a class action lawsuit, the partners on the trading desk were at risk for paying the judgment in the class action lawsuit. All of the partners were bound by and bound to each other.

Consequently, the partnerships took risk management very seriously. When the fellow in the office next door can deprive you of your home, and you can deprive him of his, both of you will carefully evaluate the risks of your activities against the rewards. Downside risks concentrate the mind wonderfully, and partnerships concentrated on risk management.

Fast forward to 2007. All of the investments banks have become corporations. The ownership of corporations is embodied primarily in their common stock, which provides limited liability to shareholders. You can lose the amount of money you invest in the stock, but you can't lose more than that. The limited liability feature of corporations has allowed them to accumulate vast amounts of capital. It's the characteristic that, first and foremost, encourages investors to commit their capital to the corporation.

But investors hate to lose the money they've invested in the stock. Even if they won't lose their homes, cars and big-screen TVs, they still feel the pain of downside risk.

The top executives that run the major investment banks, however, are heavily insulated from the risks of doing a poor job. Compensation agreements provide golden and even platinum parachutes. Failure is punished by dumping shiploads of money on the poor performer. Executives are given the incentive to take excessive risk. How else will they make more money than by failing?

There is no possibility that the major investment banks can be reconstituted as partnerships. They're too big and far flung. Furthermore, they've lost the special culture of mutual trust blended with mutual scrutiny that successful partnerships have. Instead, their massive risk management failures present corporate governance problems of the first degree.

Management is the first line of defense in risk management. Management has failed. The Board of Directors are the next line of defense. By all appearances, they have failed, having placed too much reliance on management. Granted, CDOs and other asset-backed securities are complex. But it's the responsibility of the Board to supervise management, and, in particular, to prevent management from damaging the corporation. Directors should change executive incentives, so that management suffers real and painful financial losses if the company suffers losses. Heads I win, tails you lose executive compensation agreements reward taking excessive risk. If so-called top tier executive talent won't sign up without such protection, don't hire them. These executive compensation arrangements haven't been producing top tier financial results; try something different. Pass real risk of loss onto the CEO and concentrate his or her mind wonderfully.

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