Even with a hedge investment, there’s a risk of loss

“A billion here, a billion there, pretty soon, you’re talking real money.”

That quotation is usually attributed to the late U.S. Sen. Everett Dirksen even though researchers have not found a record of his ever having said it.

Whether he ever said it or not, the quote sounds authentic, just like the gentle, humor-edged wisdom that the senator so often used to get his point across to his colleagues and the public. There is little humor in Washington, D.C. these days and even less wisdom.

Two billion dollars isn’t the imposing sum that it was in Sen. Dirksen’s time, some forty years ago, but it is still a lot of money. It certainly was large enough that when it was lost by JPMorgan Chase in its trading operations that the bank’s CEO, Jamie Dimon, reported it personally and publicly.

Whether the $2 billion trading loss was a large enough amount to justify politicians’ pronouncements, an FBI investigation, a Congressional investigation, and a whistling teapot of righteousness in the news media is another question.

To put the $2 billion in perspective, it was a tiny fraction of the bank’s bond and loan portfolio that the trading operations were trying to protect. When the protection process turned around into a big loss it was surprising, of course, but it can happen, especially in today’s financial markets.

JPMorgan Chase’s efforts to protect the value of its bond portfolio took the form of “hedging,” a process of buying and selling securities to offset the risks of holding those bonds. It is theoretically “easy” but very complex in practice — and the math can really turn around and bite you. It is very unforgiving.

There is no escape from risk in this world, and financial markets are no exception. Even if a bond portfolio contains exclusively U.S. government securities, there is an inherent interest rate risk. When interest rates go up, bond prices go down; that is their nature and their math. The ideal hedge against this risk would be to purchase something whose value would go up when interest rates went up.

When a bond portfolio contains other bonds — corporate and debt instruments from other countries — there is an additional risk factor, the credit risk or risk that the issuer will default and not pay off when the bond matures. This same risk applies to a bank’s loan portfolio, for there are some customers who will default, especially if there is a significant downturn in the economy.

Most of $2 billion that JPMorgan Chase lost was apparently in its efforts to hedge against the credit risk that would increase if Europe’s economy went into a tailspin. To protect itself the bank was buying and selling credit default swaps, a derivative that offers some protection against deadbeat borrowers and bond issuers.

It sounds pretty simple and straightforward, except that it isn’t, and JPMorgan Chase’s particular hedging plan made it even more complicated. Hedge trades involve derivatives, which have their own market value, which can create gains and losses within the risk hedging process itself.

The complexity of the math used to calculate derivatives’ market value is one part of the problem. Another is what trading transactions look like to regulators and to management.

Peter Wallison was a Congressional page in his teen years, and later a White House counsel and U.S Treasury counsel. He is currently the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute and in a recent interview he said, “A bank has to be able to protect itself from market swings, and hedging is one of the important ways to do that. It is very difficult, however, to tell the difference between a hedging trade and a proprietary trade. They look the same from outside. This is the essence of what’s wrong with the Volker Rule. If it’s not possible to differentiate between a prop trade and a hedging trade, it’s not possible to write a regulation that prohibits proprietary trading but permits hedging.”

The same problem confronts bank management, especially the risk management officers. And it is not made any easier by the traders themselves, who are not only fiercely competitive but very resourceful when it comes to devising ways to increase their compensation. They also at times seem to enjoy constructing trading strategies that confound and befuddle bank management.

Where does that leave us? We should probably stop fooling around with the Volker Rule because it is either a regulatory nightmare or a dead end. What we should do instead is demand better reporting of trading operations and overall risk assessments by banks themselves. It’s a better starting place and, by getting shareholders involved, far more likely to bring about positive change.

James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Herald Business Journal.