Swapping Stories

Boy, talk about history rhyming!

When JP Morgan announced that they had lost $2 billion via mismanaged hedges, I wasn’t surprised. Yes, it’s a large number. But JP Morgan has a $2 trillion balance sheet and a $5 trillion swaps book—and they may be ¼ of the credit default market. After news surfaced a month ago of some of their trading positions, losses seemed inevitable, as smaller, more agile trading firms were able to position themselves against the outsized positions taken by the JP Morgan trader dubbed “The London Whale.”

The hedging strategy was “ineffective, poorly monitored, and poorly constructed” according to CEO Jaime Dimon. Dimon has now become the poster boy for hubris. A few short months ago he was dubbed the pinnacle of high finance and the King of Wall Street, bestriding the junction of Main Street, Wall Street, and Pennsylvania Avenue like a Colossus. Now he’s explaining to cub reporters why his sophisticated risk management team allowed a position to morph over time and get out of hand.

Trading losses happen. Usually they’re constrained by limits and common sense, although not always.
I remember managing a foreign exchange desk some years ago. My traders had gone long dollars and the market went against us. My instinct was to cut our losses, but I deferred to the traders who had initiated the position. As I left for an evening event, I told them to close out the trade before they left for the night.

How surprised I was to get a phone call at 5:30 that morning informing me that they had stayed the night and the loss had quadrupled! My decision then was clear: close out half the position now, and half later. My point is that all trades can go wrong, and large trades can go very wrong. Traders often justify their positions with mental gymnastics—after all, my traders never went home, so they followed my instructions, right?

Dimon has to reassess his limits, but also reassess JP Morgan’s strategy. They’ve been successful because they managed risk better than most. But that reputation is over. With Washington regulators closing in and the vultures circling, Morgan’s fortress balance sheet turns out to have a breach. They need to fix it.

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