Thursday, May 31, 2012

Texas Hedge

My first reaction to the JP Morgan loss was, if their "hedge operation" had become a "profit center" as reported, we know exactly what went wrong. (And, if they weren't playing with a government guarantee, who would care if they lost $2 billion and some hedge funds gained $ 2 billion?)

Andy Lo put it beautifully:

Yes, we can tell the difference [between hedging and trading]....There is one very simple question that you can ask — which has a definitive answer — about the small number of individuals who were responsible for managing this group at JP Morgan and putting on the specific trades that lost these large amounts of money. That question is: How were they compensated on an annual basis? Were they paid a salary and a bonus, and was the bonus a function of the profitability of the group, or was the bonus a function of the hedging ability of the group? If you can answer this question — and it definitely has an answer to it; it’s not a metaphysical question — you will have your answer as to whether it was proprietary trading or hedging. I don’t know the answer, but I know the answer exists, and I know that certainly the government can get that answer with a single phone call. 

Hedging is supposed to lose money when everyone else makes money. That can be measured. The risks of the entire bank, which hedgers are supposed to minimize, can be measured.

I think Andy knows the answer to this question. I suspect I do too, but maybe I'm being too cynical.

(Thanks for pointer from Arnold Kling)