Friday, May 11, 2012

They Never Learn

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.

1 comment:

  1. Hedera:

    There's no doubt that all investment is inherently insecure, at least in the way you characterize it.

    But a lot of the extreme levels of value are really illusions. Our houses weren't really worth what the market said they were worth at the height of the real estate boom. But they aren't worth as little as them seem to be at this moment. The truth lies somewhere in the middle.

    The true value exists as a median between opposing trend-lines, though that median is only reflected intermittently in the market. That may sound like mathematical double-talk, but unless you trade your assets in a very narrow time frame, you deal in averages over time, i.e., you bought your house to live in for decades, not as an investment to flip after a year of camping (though this is what drove much of the real estate bubble--people flipping properties). This doesn't mean that the market is a zero sum game, with losers (and losses) equalling winners (and gains).

    Prudent investing produces modest gains. This has always been true. It isn't exciting, and it won't make you rich, or at least not rich fast.

    When we were kids, banks loaned money to mid-size businesses and individuals to invest in ventures, or homes, or cars. Mostly, that doesn't happen any more, because the probable returns aren't sexy enough.

    In the Age of Greed, brokers and traders wanted to up the ante, and invented new "instruments" designed to leverage valuations. In the 1990's, under Clinton, the Congress turned back the clock by removing the fire-walls between banking and investment banking. That was the signal that the lid was off, and things could heat up fast. And heat up they did.

    Now the banking and brokerage industries are fighting against regulations which would put us back on a secure footing with respect to safe practices. Despite our having "saved" the banks from their own recklessness, it's back to business as usual, with our Federal Gov't capitulating to their demands right down the line.

    I've often said that Americans are stupid. They'll buy anything with a little prodding. But the new paradigm is lobbying. Our Congressional representatives aren't promoting our interest, they're buying campaign finance funds through special interest selling of favors (votes).

    Our financial future doesn't look bright.