Tuesday, May 15, 2012

Models Behaving Badly: How the Dames Started Dancing and Blew Up JPMorgan's CIO

Zero Hedge has a somewhat technical but awesome breakdown of how JPMorgan CIO blew up.

Of note is point 10:

Nov2011: Fed/ECB start coord. global easing program -> starts to crush correlation as systemic risk is 'supposedly' removed from system. 
And here comes the critical aspect of our story!

The actions of the Fed/ECB/rest-of-world with massive and unprecedented easing efforts was perceived by the market as a tail-risk crushing event - i.e. they removed the systemic risk from the system once again.

Look at the chart above to see what happened to the short-term correlation (red arrow) - it was squelched to levels we had not seen before.
Ah yes, a variable that is assumed to be a constant (within parameters) starts  to dance outside the parameters. Sounds like we have seen this before.

And a recap at point 22:
Summary: JPM tail-risk hedge imploded thanks to Central Banks' Systemic Risk reduction - unintended consequence...

The key factor is that if systemic risk had remained in even a 'normal' range of possible regions based on history, then the JPM CIO office would have had no need to over-hedge their tail-risk hedge position, no greed-driven need to press the momentum, and no need for such an epic collapse as we are seeing now.

The point is - this was a trader/manager with a good idea (hedge tail risk) that was executed poorly (and with arrogance) but exaggerated by the unintended consequences of the Central-Banks-of-the-world's actions (and 'models behaving badly' as Derman would say).


  1. I wouldn't mind having a few models misbehaving with me! :-)

  2. This is related to what I was talking about at about 8 minutes in:


  3. You econometrics guys are all alike.