In the fall of 2008, I wrote a couple of posts (The Sorceror's Apprentice, What a Week) about the joys of credit-default swaps (CDSs), a wonderful financial instrument which lets you take out insurance against the issuer of a bond going broke and failing to redeem the bond. The amusing thing about CDSs was and is that you don't have to own the bond to buy the CDS - in effect you can bet on a bankruptcy that you have no other stake in. This instrument was part of what brought down the world financial system over the next two years.
I'm therefor Not Amused to discover that JP Morgan Chase has just lost $2 billion through the actions of a rogue trader (nicknamed "The London Whale") who was betting on - guess what! - right, CDSs.
This isn't the first time a large bank has lost a huge amount of money due to the actions of a single inadequately supervised idiot, or does anyone else remember the name Nick Leeson? Nick Leeson's bets brought down Baring's Bank, which had successfully done business as a merchant bank since 1765. The bank was broken up and no longer exists. I'll be interested to see what happens to JP Morgan Chase, especially since it is one of the 4 or 5 "too big to fail" companies that the U.S. Government has evidently decided they'll have to subsidize.
It is true that Nick Leeson was trading currency futures, while the London Whale, whose name is Bruno Iksil, was trading CDSs. But they both made the same mistake. They told themselves they were "hedging," which is supposed to be a respectable activity for a bank. As Wikipedia puts it, "A hedge is an investment position intended to offset potential
losses that may be incurred by a companion investment. In simple
language, Hedge (Hedging Technique) is used to reduce any substantial
losses suffered by an individual or an organization." Sorry, as practiced by these loosest of cannons, hedging is just another word for gambling: you have investment A, which may go down, so you also buy investment B, which you expect to go up. Do you know it will go up? No, you don't. This is gambling. The house always wins in gambling; I suspect Mr. Iksil forgot that JP Morgan Chase is not the house. The market as a whole is the house. And ultimately, nobody wins.
The other issue here is, why did nobody at JP Morgan Chase know what this wildcard was up to? Questions are popping up all over the press; I linked Yahoo Finance, but just Google "jp morgan loss" to see the scope of this. I hope we'll see an answer to that in days to come.
In March 2009, I wrote an article called Evaluating Risk, which summarized a much longer article in Wired Magazine on "the formula that killed Wall Street" (except, of course, Wall Street isn't dead). Bankers and investors have been plagued by risk for centuries. In recent decades, brilliant mathematicians have thought that they could measure risk mathematically, and they developed this formula which was supposed to measure risk and reduce it to a single, simple number. Thereafter, the financial industry assumed they had control of risk. And the whole subprime mortgage crash happened because bankers thought they could divide risk up and pass it off to others so it wouldn't hurt them.
This was a lie. The formula didn't cover all the possible assumptions. We will continue to be plagued by this sort of crash until "Wall Street" finally admits that what they do is gambling, and that the risks ultmately cannot be controlled. That means crashes will be around for a long, long time. Because they do not learn, as this mess shows yet again.