The Volcker Rule and a Trade Gone Wrong

Now: does any of this really help the case for the Volcker rule?

At the end of January or the beginning of February 2012, Boaz Weinstein bought Markit CDX North American Investment Grade Series 9 10-Year Index (IG.9) credit default swaps, with a December 2017 maturity. He told the Harbor Investment Conference days later that these CDS’ were available at a “very good discount.”

He and anyone who took his advice were then on the opposite side of a trade with Bruno Iksil, the “London Whale,” surely by now the most famous whale since “Willy” jumped over the rocks to freedom.

As Tracy Alloway and Sam Jones have now detailed in a fine piece in the Financial Times, Weinstein was early in catching on to “disturbing oddities” in the way that index was trading.

Those oddities had their origin the previous summer, when Ina Drew’s operation, the Chief Investment Office of JPMorgan, decided that credit instruments were due for a correction. The bank had a lot at stake in credit instruments, so the CIO unsurprisingly sought to hedge by buying protection on particular tranches of subordinated credit. Then they hedged that position (a second-order hedge, if you’re keeping score) by selling protection on the above described index, IG.9.

The point was to create a position that would pay off in the event of a moderate credit market correction. Only a severe correction, it was thought, would hurt the IG.9.

The Problem

But the correlations didn’t work out the way the CIO thought they should, so to keep the two sides (the special tranches on the one hand and the broad index on the other) balanced, the CIO had to go ever more heavily into the marketplace in selling protection. This is how Iksil became the Whale.

By the time Weinstein spoke to the HIC, the logic of his purchase seemed pretty clear. Eventually the whale would have to ease off. It couldn’t keep all its weight on this trade indefinitely. Whenever the Whale did start to swim away, that good discount in price would disappear. So the time to buy was now.

Heck, even another arm of JPMorgan got in on this deal. A Morgan-sponsored mutual fund, the Strategic Income Opportunities Fund, bought about $380 million worth of IG.9 credit protection.

Iksil’s losses represented, then, the opposite side of the coin from the gains Goldman Sachs made on its Abacus trades. You’ll remember that Goldman has taken a good deal of heat for letting customers take the long side of bets on the credit worthiness of homeowners, while taking the short side of that bet itself. Goldman won, and those of its clients who took the other side lost. In the case of the Whale, likewise, JPMorgan ended up (more or less accidentally) taking one side of a bet for itself, while its clients in the Strategic Income Opportunities mutual fund ended up on the other side. This time JPMorgan lost, and the clients won.

Either way, it seems, pro-regulatory forces think it makes their case. If the bank loses, it’s “risking insured money” and needs to be more thoroughly regulated. If the bank wins, it’s violating a (retroactively imagined) fiduciary responsibility, and again it needs to be more thoroughly regulated.

This is “heads I win/tails I also win,” or – as Karl Popper usefully labeled it years ago, “reinforced dogmatism.”

Like Pornography

But just considering the Iksil situation on its own: how exactly does it support the case for the Volcker rule? Ron Resnick made the point here recently that it is difficult to imagine that government officials would have added value to the deliberations of the CIO.

A distinct point, though, is that the case in favor of the Volcker rule is that the line between speculation on the one hand and hedging on the other is a fairly clear one, that reasonable people “know it when they see it,” and that accordingly it is perfectly plausible to prohibit banks from engaging in the one when encouraging them to engage in the other. Paul Volcker himself has assured the Securities and Exchange Commission in this connection that as bank managements come to grasp the “philosophy and the purpose of the regulation” the difficulties of implementation will ease.

But the difficulties now faced by JPMorgan aren’t philosophical. They arise from nasty empirical details. As Lisa Pollack has explained, also for FT, it appears that the whale took the bearish view that curves like the above would flatten. Such a trade, Pollock noted, “is just fine in reasonable doses … if there’s enough liquidity in the market to support it.” (I thank Pollack for bringing the above curve to my attention.)

Doesn’t the story of Iksil’s trades as Alloway and Jones have set it out for us illustrate the problems with the Volcker rule? Iksil’s position started off as a straightforward portfolio hedge, and due to a mishandling of the multiplicity of instruments available, seems to have become a directional bet by degrees. This is not the sort of thing regulations can prohibit, so long as there is going to be a private sector banking industry at all. It is an incident of hedging, and everybody purports to approve of hedging!

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