So, I’ve finally gotten out from behind the wheel of a car long enough to post something a bit meatier on the JP Morgan Whale Fail. As I predicted in my earlier post, the case is already generating much debate about the implications for the Volcker rule, and could conceivably impact the rule’s final content.
Jamie Dimon claimed in a conference call on Thursday afternoon that the trade, while flawed, was consistent with the Volcker rule’s proposed hedging exemption. I wonder whether that’s really the best rhetorical tack to take. If true, it will simply lead to calls for a stricter final rule, or renew calls for more drastic solutions, such as breaking up large, systemically important institutions.
For example, Sheila Bair is calling for a more narrow definition of the hedging exemption to the Volcker rule, and Barney Frank (who has to be one of the funniest guys on the hill) quipped that, though Jamie Dimon has spent months complaining about the $400 million that financial reform compliance will cost JP Morgan, the firm managed to lose five times that amount in a matter of weeks “entirely without any help from the government.”
In dispute is whether or not the Whale’s positions, about which few details are known at this point, was a hedge, which would be permitted by the Volcker rule, or a proprietary trade, which would not be. Dimon’s position is that the trade was simply a poorly-designed hedge gone awry -- people make mistakes, people made them here.
I’m skeptical of that explanation, though it could turn out to be true. Lisa Pollack at FT Alphaville has done a great job of speculating about the nature of the trades, based on a variety of public documents and statements. It’s a very complicated story and I won’t try to replicate it here, but you can head over to Alphaville if you’re interested in the nitty gritty. In brief, her theory is that JP Morgan was betting that the CDX.NA.IG.9 — a credit index that was launched in 2007 — would flatten.
There seem to me to be a couple of different possibilities here. One is that, as claimed by Dimon, the position started out as a hedge against JP Morgan’s credit exposure. Perhaps, though intended as a pure hedge, the design of the hedge was flawed from the start. Or perhaps the “hedge” had a bit of a directional bet built into the design. Notice that scenario one would appear to comport with the spirit of the Volcker rule, whereas scenario two does not.
However, Dimon’s contention appears to be that the error (assuming there was one) arose later, in connection with rebalancing the hedge:
The original premise of the synthetic credit exposure was to hedge the company in a stress credit environment. Our largest exposure is credit across all forms of credit. So we do look at the fat tails that would affect this company. That was the original proposition for this portfolio.
In re-hedging the portfolio, I've already said, it was a bad strategy. It was badly executed. It became more complex. It was poorly monitored.
So that brings up two other scenarios: one, the rebalancing, while intended to maintain a pure hedging position, was flawed; or two, the rebalancing was purposely off-kilter a bit, in order to take a directional position. Again, I’d think that one scenario meets the spirit of the Volcker rule and the other does not.
All of this to me simply highlights the difficulties confronting effective Volcker rule implementation and enforcement, about which I’ve written here on many occasions. Poorly constructed hedges may quack like a prop bet, but in order to effectively address the concerns underlying the Volcker rule, and other Dodd Frank reforms, regulators will have to be able to tell the difference before the firm announces a $2 billion loss.