The below Bloomberg Law interview, or shall we say cage match, is just amusing. First, Chris Whalen tries to claim the reason JPMorgan Chase placed a bet that will lose $2 billion or greater is due to JPMorgan Chase being distracted by those pesky regulators. Yes, you will laugh out loud at this. You might notice, if you get past laughing, Whalen also amplifies that these types of derivatives trades, should be outright banned. That no amount of capital requirements can stop-gap potential losses. We agree.
According to the press reports of early April, he was selling credit default swaps on a portfolio of corporate bonds. Credit default swaps are derivatives that act like insurance products – the buyer of the swap receives a cash payment from the seller if the corporation that is the subject of the swap enters into a credit default. Messr. Iksil was betting that the credit condition of the corporations involved in his portfolio would improve over time. The buyers of this credit protection were betting the opposite – that these corporations over time would worsen in terms of credit quality, and likely be subject to credit rating downgrades. The buyers of this credit default swap index were large hedge funds, and the press implied that they were buying precisely because they wanted to be on the opposite side of Messr. Iksil’s trade.
Here in lies contagion, or the domino affect of many derivatives trades and their interconnectedness with the entire global financial system. We've seen it over and over again, with AIG credit default swaps, MF Global speculative bets on sovereign debt and going back to LTCM. One cannot have bilaterial obscure trades based on bad mathematical models and even computational complexities that make that derivative impossible to evaluate. Why are these things allowed? Because Wall Street wants them. They are like crack cocaine and the potential bonus high is so craved, Banksters ignore the risk, the fact the derivative's model itself is front loaded with risk and downside. It's bad enough to pull down the company making trades like this in some Wall Street financial drug addict crash and burn. The problem here is these types of flawed mathematical models can pull down the entire global economy, and Whalen's right, there ain't enough capital requirements in the world to back up such huge risks. These types of derivatives are called black swans for a reason and as amplified in these old interviews on the financial crisis, the mathematics underneath many of these models is simply, outright, dead ass wrong! What's it gonna take? One cannot have a speculative bet structure even exist which enables a bunch of hedge funds to gang up on you and force losses. No go, no way, it's bad, bad mathematical modeling, plain and simple.
How many times do we need to see a derivatives trade, utilizing credit default swaps go rogue, lose an astounding amount of money, yet outright banning these types of derivative trades never pops up in the conversation? Why not? Anyone with a math degree knows these things are fundamentally flawed yet billions are bet every day on them. Why? Are credit default swaps the great BP drilling rigs, who cares that they are fundamentally flawed and unsafe?
Seems at the moment, instead of confronting bad derivatives, the spin machine is out in full force to silence even describing the JPMorgan Chase trade accurately. Bill Black calls out the insanity of mislabeling these speculative trades as hedging, the latest snow job that's going on.
Financial institutions such as JPMorgan love to buy derivatives because they are opaque, create fictional income that leads to real bonuses and when (not if) they suffer losses so large that they would cause the bank to fail, they will be bailed out.
The Dodd-Frank Act's Volcker Rule was designed to solve the problem.
However, JPMorgan led the effort to gut the Volcker Rule and the provision that requires transparency. JPMorgan is the world's largest proprietary purchaser of financial derivatives -- precisely what the Volcker Rule sought to end. The bank claims that it does not engage in proprietary trading and that it purchases derivatives solely to hedge. That claim is an example of what Stephen Colbert meant when he invented the term: "truthiness."
A hedge is an investment that offsets losses in another investment. JPMorgan's supposed hedges aren't hedges under accounting rules because they haven't been shown to perform as hedges.
JPMorgan bought tens of billions of dollars of derivatives that increased its losses rather than reduced them. It calls these anti-hedges "hedges" -- in other words, it practiced "hedginess." The bank's approach to hedging is that it would like to purchase a derivative if it deems that derivative to be a hedge to something else and voila, it's a hedge.
The draft regulations of the Volcker Rule allow such faux hedges because JPMorgan lobbied to render the rule useless. JPMorgan asserts that these inherently unsafe and unsound anti-hedges are "hedges" as that term is defined in the draft regulations implementing the Volcker Rule. But if hedginess is permissible, the Volcker rule is unenforceable.
We're getting hearings, punditry, outrage and even open letters to Jamie Dimon, with the more astute focusing in on VaR models:
Here are five questions that an independent investigation should consider:
- What exactly was the trade? Who approved and reviewed the trade?
- To what extent were the mistakes encouraged or condoned by particular quantitative models — for example, those popularly known as value-at-risk?
- What did Mr. Dimon know and when did he know it? Was there disclosure to the board and to shareholders with appropriate timing? This is among the specific concerns raised by Mr. Kelleher.
- Does the board have adequate depth of experience along the relevant dimensions of risk management?
- What interactions did Mr. Dimon or any of his colleagues have with the Federal Reserve Bank of New York before and while these losses were incurred? Mr. Dimon is on the board of that institution, where his role is described as advisory. But on what exactly did he advise them in recent months and years, particularly with regard to risk management and capital levels in systemically important banks?
The OWS banking working group wrote Jamie Dimon a letter, yet is it the person, or the system, specifically the trading system that should be chastised?
Here is what we ask of you:
First, stop gambling with our money and our futures. Stop lobbying for deregulation — we are way past that now. Stop lying to us all by doing silly things like pushing proprietary trading into the treasury office and renaming it, or by pretending that there are no losses when there very clearly are, to the tune of $2,000,000,000 and growing. And, please, stop trying to convince us that nobody at JPMorgan Chase saw this coming. Ina Drew was offering to resign in April but you kept telling the world that nothing serious was amiss, a lie which could get you serious jail time.
Second, admit that your bank is too big to take risks that neither you nor anyone in your bank understands or is able to handle, and that the only thing that will stop you from misbehaving is strong, enforced, and uncompromised regulation.
Third, resign as Director of the Federal Reserve Bank of New York. It is inappropriate, and dangerous to us, for you to oversee the banking system or the economy when you have proven incompetent at overseeing your own bank — particularly since the Federal Reserve is investigating your bank and your behavior.
What we need are some real quants, acting as whistle blowers, to explain to regulators and politicians advanced probability, statistics and probability models. Quants need to step up and show how screwed and contagion laden these credit default swaps really are. Come on, if a trade has properties which enable billions of dollars of losses, something is wrong with this picture and such Wall Street crack cocaine trading vehicles simply should not be allowed. It's not TBTF that's so threatening, it is the interconnectedness, the contagion that is the real financial and economic threat.