Sunday, May 13, 2012

JPMorgan: Markets Moved in a Way We Didn't Expect

On Friday, I wrote:
As more details come out, I suspect we will learn that the model used to create this trade included the assumption that some variable would not move beyond certain parameters, that is, a variable was assumed to be somewhat constant.  And viola, reality smacked that idea around a bit and blew up the portfolio.
On saturday, WSJ reported:
Behind the losses: unusual movements in the relationships between various derivative indexes focused on investment-grade and junk-bond corporate debt, both in the U.S. and Europe, according to someone close to the matter.
As I said during my speech at the Fed:
Please allow me to begin with methodology, I hold the view developed by such great economic thinkers as Ludwig von Mises, Friedrich Hayek and Murray Rothbard that there are no constants in the science of economics similar to those in the  physical sciences.

In the science of physics, we know that water freezes at 32 degrees. We can predict with immense accuracy exactly how far a rocket ship will travel filled with 500 gallons of fuel. There is preciseness because there are constants, which do not change and upon which equations can be constructed..

There are no such constants in the field of economics since the science of economics deals with human action, which can change at any time. If potato prices remain the same for 10 weeks, it does not mean they will be the same the following day. I defy anyone in this room to provide me with a constant in the field of economics that has the same unchanging constancy that exists in the fields of physics or chemistry.

And yet, in paper after paper here at the Federal Reserve, I see equations built as though constants do exist. It is as if one were to assume a constant relationship existed between interest rates here and in Russia and throughout the world, and create equations based on this belief and then attempt to trade based on these equations. That was tried and the result was the blow up of the fund Long Term Capital Management, a blow up that resulted in high level meetings in this very building.

It is as if traders assumed a given default rate was constant for subprime mortgage paper and traded on that belief. Only to see it blow up in their faces, as it did,  again, with intense meetings being held in this very building.

Yet, the equations, assuming constants, continue to be published in papers throughout the Fed system. I scratch my head.

Indeed,there are no constants in the world of human action, when you set up equations with variables and assume some of those variables are  constant within certain parameters, and then trade on those equations, and use huge leverage on top of it AND expose yourself to unlimited risk, you are setting yourself up for potential major league portfolio destruction.

It happens time after time, once I  literally saw a broker carried out on a stretcher, after he blew up his family money by selling way out of the money call options with a days expiration left. His trading worked day, after day, week after week and month after month, until one day the stock he sold calls against was taken over. His losses were in the millions, the family portfolios were completely destroyed.

I have seen the same thing  happen to a bank. These kinds of trades can be very tempting, because for a long time you can bring in lots of $$$$s.  But when that variable that a trader is treating like a constant starts to dance, the variable is going to dance on the traders head and career.

Personally, I never trade where there is unlimited exposure. If I am bearish on a stock or the market in general, I would rather buy a put option. It may cut back on my profit, but if a variable starts to dance it won't take me out of the game, the way a short position could.

And when a variable starts to dance, it can dance for much longer and a greater distance than any trader can ever imagine.

1 comment:

  1. "Way out of the money call options with only a day left"

    There may be an element of that with CDX IG Series 9, which originated in September 2007. Most corporate debt is five year, which means maturity in 2012. So there's a short term aspect to JP Morgan's synthetic credit trading.

    Any investor wishing to hedge their investment can do so with credit default swap specific to the corporate instrument they hold. They don't need to buy a basket of derivatives covering 121 North American companies. That makes it more like a call option, a bet/wager on the North American economy.

    Four companies in IDX face credit challenges, Radian, MBIA, Sprint Nextel, and R.R. Donnelley & Sons.

    Companies outside CDX IG 9 that sustained a credit event include AMR, Dynery and Eastman Kodak.

    I have three questions at this point. Which companies outside the four cited by FTAlphaville face credit difficulty & possibly default?

    Who, outside hedge fund traders, wants to buy CDX IG 9 and might JP Morgan push their trash to clients?

    How might jilted hedge fund traders gang up on JP Morgan? Credit default swaps played a role in Lehman's fall. Lehman's peers were merciless in demanding capital calls.

    The Wall Street casino remains alive and unwell.