In a previous post A simple remedy for a Wall Street danger, James M. Stone talked about the danger facing banks who try to take large “hedging”  positions in financial derivatives that are supposed to nearly balance each other out and minimize risk.  The risk is in the imbalance between the two sides of the hedge.  If that imbalance is smaller than the original risk, then the risk has been made smaller.  If the imbalance is bigger than the original risk, then the risk has been made larger.

The “hedging” positions on each side of these trades have become so huge, that the likely imbalance itself is big enough to sink the bank.  The total notional value of these hedges is as much as 240 times the size of the bank’s equity.

From Wikipedia we have the definition, “The notional amount (or notional principal amount or notional value) on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument. This amount generally does not change hands and is thus referred to as notional”  Note that when they say that the amount does not generally change hands, they use those weasel words to disguise the fact the this amount could need to change hands under extreme circumstances, such as a financial collapse.

I understand all this, but there is still a nagging question. Hedging is supposed to minimize risks.  A perfect hedge neither makes money nor loses money under any circumstance.  Why would banks engage in these huge transactions that put the entire bank at risk of going out of business?  I would have thought that any hedge transaction that is meant to offset the risk in any normal bank investment, would not be larger than that investment itself.  There is something going on here that I don’t get.

Well, the answer to that question is in the article The ‘Perfect Hedge’ Remains Elusive at JPMorgan.

In the process of writing and rewriting the Volcker Rule over the last two years, the banks pushed hard to be allowed to hedge risk related to “market-making” and to “portfolio hedging.” Market-making is when a firm acts as buyer or seller to help facilitate a trade for a client. The banks actually made a persuasive case that if they are going to take risks for clients, they should be able to seek to hedge each trade individually.

However, they also sought an exemption for something much more expansive: “portfolio hedging.” In other words, they wanted the ability to try to hedge their entire firm’s portfolio against macroeconomic factors. And that’s where JPMorgan’s botched trade comes in.

So let’s discuss how JPMorgan got in this mess in the first place. Here’s an overly simplistic primer, but you’ll probably get the idea: The company’s chief investment office originally made a series of trades intended to protect the firm from a possible global slowdown. JPMorgan owns billions of dollars in corporate bonds, so if a slowdown were to occur and corporations couldn’t pay back their debt, those bonds would have lost value.

To mitigate that possibility, JPMorgan bought insurance – credit-default swaps – that would go up in value if the bonds fell in value.

But sometime last year, with the economy doing better than expected, the bank decided it had bought too much insurance. Rather than simply selling the insurance, the bank set up a second “hedge” to bet that the economy would continue to improve – and this time, traders overshot, by a lot.

Jamie Dimon, the bank’s chief executive, said of the trade on “Meet the Press”: “We know we were sloppy. We know we were stupid.” Senior executives at the bank say privately that the trade should have never been made; they even concede that it looks like a proprietary trade – which the Volcker Rule would explicitly prohibit – rather than a “hedge.”

The point is that hedges are meant to reduce risk.  A purchase of a derivative like a credit default swap which may be used to hedge is not a hedge transaction at all when not balanced.  It can make huge profits for a bank.  The “risk management” departments of banks were named for the function that they used to provide when they were initially created.  They were supposed to mitigate risks, but not make any profit themselves. In fact mitigating risks usually means lowering profits. Banks have learned that these “hedging” transactions, when unbalanced, can lead to huge profits for the banks.  Since the “risk management” departments were experts in making these kinds of derivative investments, why not have these departments actually make money instead of just losing money while mitigating risks?

It may not be obvious to the smart bankers what seemed only too obvious to me.  If mitigating risk is a profit diminishing operation in the long run, then if you expect to make profits over the long run, you are not doing risk management anymore.

I guess the temporary success in making huge profits in the “risk management” departments blinded these executives to the obvious.  Well, actually, no.  This would be far too generous an interpretation to make.  The executives were hoping that they could fool the regulators or at least fool the politicians who voted on  funding the regulators, or let the politicians fool their constituents.  After all, if the house of cards came falling down, the banks might go under, but the executives would walk away with the fortunes they made before the collapse.  So they could be fully cognizant of the risks that they were making their banks take, and it would still make sense for them personally to have the banks take this risk.

You might even relate the bankers’ brazen behavior to what Eliot Spitzer had to say in the video of my previous post, Striking fear in Wall Street’s heart.