The unconventional hedge, redux | FT Alphaville

The unconventional hedge, redux

FT Alphaville’s resident credit expert Lisa Pollack is on the case regarding JP Morgan’s “egregious” loss announced on Thursday.

But, as we wait for her analysis, here’s a great little snippet from Kid Dynamite with regards to what counts as a viable hedge and what doesn’t in this crazy financial world of ours.

It goes some way to confirming our point that the 21st century hedge can have little to do with what you might understand as the underlying exposure, mainly due to the process of centralisation and correlation modelling.

Kid Dynamite’s expertise, we should point out, comes from years spent trading on the sellside of a major bank (which remains nameless) — where he specialised in ETFs, index arbitrage, program trading, index related trades, etc. — and then at the internal hedge fund of the same bank, this time on the buy side.

His anecdote relates to the day his big boss came over and asked him to short $1bn worth of IWM — coincidentally one of the most shorted equity ETFs out there — as a hedge for his overall division.

It took him a while, needless to saybut here’s the point he’s making:

My point is that The Boss chose IWM as an attempted hedge for the exposure under his umbrella of prop traders NOT because we were all long IWM – none of us were – but because it figured to be correlated to our exposures, with an even higher beta (which is to say that if I lost money on a billion dollar long portfolio, The Boss would expect to make even more money on a billion dollar short IWM position – this was by design, as his hedge was much smaller than our aggregate long notionals).

Which brings us to JP Morgan ($JPM – no positions). I’m not going to pretend that I can give you any insight as to the level and details of JP Morgan’s credit exposures. I think that’s the real problem with our banks – they are way too friggin’ complicated to understand for even the most seasoned of financial analysts (a group in which I am not placing myself, by the way). The latest 10Q is a mere 176 pages, but that’s because they reformatted it to put double the text on each digital “page.”

The bottom line here is that JPM has a group, CIO, which acts kinda like The Boss in my story did, only they are looking at a bank the size of JP Morgan with TRILLIONS of dollars of exposure, not a handful of prop desks with less than ten billion in exposure. The “hedge” put on by this group didn’t do the job it was intended to, hence the losses reported today.

We think that sums up the situation nicely, and it echoes a lot of what we’ve been saying all along. A smart hedge is a cost efficient hedge, and one which performs based on correlation and understanding of basis risk. There’s always a proprietary risk to every hedge.

It’s the nature of trading.

Related links:
Banks as volume gobbling monsters
– FT Alphaville
Stardate April 13, CIO sector, JP Morgan reporting VaR
– FT Alphaville
JP Morgan’s giant unwitting catalyst trade – FT Alphaville
You Say “Voldemort” Like That’s A Bad Thing – Dealbreaker