In the just concluded Spring 2012 semester I coordinated the Senior Seminar for Economics. In one of our sessions we read some stuff on Global Warming and what to do about it. For this session I invited the Environmental Studies Senior Seminar class to join us – to expose students who have different world views engage in some healthy inter-disciplinary conversations seemed worth the organizational trouble. About a minute into the discussion, Econ. majors got into a spirited discussion about what the appropriate discount rate should be in the climate change policy arena. One of my Econ. students took it upon himself to educate everybody by dropping terms like Internal Rate of Return, and Risk Free Return, and… you get the picture… His lack of knowledge was masked by the level of confidence with which he misinformed the class. The Environmental Studies majors all seemed impressed with this student’s technical knowledge, and requested that we not get so technical. I’m not sure how they felt when I informed them that what they heard wasn’t technical or right, it only sounded technical. It was my opportunity to tell my students that if someone’s first line of explanation is peppered with jargon, and said quickly and with a dismissive flourish, then they should be careful. Methinks the past explanations about Wall Street fiascoes and the present problem with what happened at JPM are being explained the way my student explained the discount rate. It can be done more simply.
I have an advanced degree (given the amount of time I took to get it, you can call it a Very Advanced degree) in Economics. While I might not have the intelligence and ability to concoct synthetic financial instruments to hedge against risk, and certainly do not have the inclination, time, or motivation to do so, I shed modesty aside and claim that if someone tells me what these instruments do, I am capable of understanding what they do, and can explain what they do in simple terms. When I heard about the JPM $2 billion losses, I wanted to know what happened.
I first turned to sources at my immediate disposal. Trust me, the folks at the New York Times either don’t know how to explain what JPM did, or if they do know, they are working real hard at keeping it a secret from us. So I turned to my friend Google and made two queries of it – ‘what were the trades where JP Morgan lost money’, ‘and explain the JP Morgan hedge’.
After ploughing through a bunch of sites with much gobbledegook, I hit upon two sites which shed some light on what JPM did. (http://www.marketplace.org/topics/business/easy-street/jp-morgans-loss-explainer AND http://ftalphaville.ft.com/blog/2012/04/06/951941/hedge-funds-and-the-whale-credit-index-edition/). Thank you Heidi Moore and NPR.
So What Happened?
Let’s cut to the chase. Let’s begin with some key terms. For our purposes four terms matter.
- Companies who want to raise money in the market sell bonds. A bond simply says, you give $ X today, and sometime in the future I will return $Y to you. Clearly $Y must be greater than $X, and with your basic high school compound interest formula you can find the interest rate that you will be receiving on the money you lent said company.
- Now it is possible that a company will default on a bond – default meaning that they just don’t pay you back.
- An index is essentially an aggregate score of performance of a basket of assets. The Dow Jones Industrial Average is an index of the stock values of 30 leading companies. A student’s GPA is an index of his performance in the courses he has taken. Markit CDX.NA.IG.9 (it’s just the name of an index – see below why I chose this one) is an index of a number of corporate bonds – note, Markit is the company which made up the Index, and the rest are the details (NA – North America, IG – Investment Grade, etc.) on the index. For more on Markit click here). In the simplest sense, the value of the Index will go down if companies default (just as your GPA falls if you do badly in a class), and the Index will rise if the companies do not default.
- A Credit Default Swap (CDS) is a financial instrument which lets you bet whether companies who borrowed money from you will default. Buying a CDS is betting that a company will default on its obligations to pay. If the companies default and you bought a CDS you get paid. Now you can bet either way – you can either bet that companies will default (buy a CDS) or they won’t (sell a CDS), and depending on what happens, one guy wins and the other loses. It is just like betting that your local sports team will win or lose – depending on what happens and how you bet, you will win or lose.
So much for the terms.
JP Morgan, through a fellow by the name of Bruno Iksil bet that the companies in Markit CDX.NA.IG.9 would not default. He sold CDS, and lost – plain and simple. Put simply he took a bet on the direction of the Markit CDX.NA.IG.9 index, and it didn’t go his way, and the paper losses piled up. It is at this point that the sophistication and gobbledegook can be introduced to obfuscate the crux of what happened – he speculated, he bet, he gambled, … and he lost. To describe it in any other way is simply complicating the story in ways that are unnecessary. It’s what you do when you do not know, and/or want to obfuscate.
Calling A Spade A Spade
When the press reports on this they call these ‘sophisticated trades’ – poppycock! In future, read sophistication as “I don’t know what the hell the guy is doing, and individual traders think they know more than the next guy and can manipulate the difference in knowledge to make a fortune and so come up with financial instruments which blow up in their face”.
Another word that has been used to explain these transactions is the word hedge. Simply put, a hedge is what we all understand a hedge to be – finding a way to soften the blow in case a bet you took goes wrong. I am amazed at how often in the last five years I have heard about folks who have lost their shirts after they hedged. I know I’m no financial wizard, but it seems to me that to lose big because of a hedge is a contradiction in terms – you hedge to avoid losing big. It seems to me that there is a simple way you can hedge against any bet you take – buy an insurance policy. And if someone is not willing to sell you an insurance policy based on the risk you are taking, then you are just assuming too much risk and must stop. Nothing sophisticated about insurance – so there must be something wrong with it. What do I know?!