When is a derivatives hedge not a hedge? It’s when a lying bank CEO say that it is one!
CEO Jamie Dimon’s faux-apologetic defense of JPMorgan Chase’s recent trading loss, now estimated at $3 billion and rising, prompts a variation of an old joke: How do you know when an investment bank’s CEO is lying? It is when his lips move to form the word “hedge.”
The fact that Dimon keeps repeating the word “hedge” even as he acts at being harshly critical of his own bank’s failings is, in itself, an ongoing lie.
JPMorgan’s reported $100 billion position in “synthetic derivatives,” numerical indexes of more than 100 different credit default swaps, was not a hedge. It was not intended to reduce the company’s risk. It rather was plain old speculation, willingly assuming great risk in the hope of great profit.
There is nothing inherently wrong with taking on risk in return for possible reward. Indeed, a modern economy would function much less efficiently if no one was willing to do it. But it does raise questions.
True, the line between hedging to reduce risk and speculating to increase it is not always clear. But work in from the extremes toward the center and it is easier to discern what is going on here. If a homeowner buys a policy covering fire, wind and liability exposure, she is reducing risk. Ditto for a small-business owner or farmer. And if a farmer expecting to harvest 50,000 bushels of corn this fall contracts the delivery price on a large fraction of that before the actual harvest, he also is reducing risk.
The same would be true for an earthmoving contractor who uses a thousand gallons per day of diesel fuel and locks in a price from a supplier as soon as a large road contract is awarded. And ditto for a country elevator that executes futures contracts to further sell whatever quantities it contracts to buy from farmers. All these clearly transfer risk from an individual or business that wants less risk to some counterparty willing to take on more risk in return for a fixed premium or the possibility of profit.
Finally, consider a small wind project wanting to borrow money to buy turbines. The only loans offered are at variable interest rates. But it is possible to buy an “interest rate swap” from a third party that effectively converts a variable rate loan into a fixed rate one. This is a “financial derivative,” as dissed by Warren Buffett, but here it has a clear business purpose of reducing risk for a business with inflexible cash flows.
Now consider a situation where a farmer decides that the corn price is going to fall, and contracts to sell 5 million bushels — 100 times his anticipated production — in November at a price specified now. This is clearly speculation. Ditto for the excavating business if it decides to buy 1 million gallons of diesel via futures contracts instead of the amount it actually will use, simply because it expects prices to rise. And if either decides that there is more money to be made in silver options than in growing corn or moving dirt, no one would call them hedgers.
Now, what if someone with a Ph.D. in math told the wind business that she had found a strong statistical correlation between cocoa production in West Africa and wind speeds on the Great Plains? Buying options on cocoa prices could serve to offset low electricity sales during prairie doldrums, she says. At least that is what the six years of data available in a downloadable file seems to indicate. Would the turbine owners reduce risk by immediately buying such options? And what if they purchased cocoa options of $5 million for each month to “hedge” electricity sales of $200,000? Clearly not. The idea that JPMorgan was hedging some specific risk in their business lending as a commercial bank by making a $100 billion bet on the variation between two different indexes of default swaps beggars belief. One crucial clue to all of this is that, while Dimon went on Sunday morning TV to admit mistakes, JPMorgan disclosed precious few details about the actual positions it had taken. The reason seemed to be that they had not yet unwound those positions, and would suffer even greater losses if counterparties knew such details. That the losses now reportedly have risen from $2 billion to nearly $3 billion and are expected to rise even higher over time shows the degree to which this was a speculative position and not a hedge. No earth mover loses by letting on they locked in diesel prices. No commercial borrower loses by acknowledging they bought an interest rate swap to complement a bank loan. If letting other people know about your hedge ruins your hedge, then it probably never was a “hedge” at all.
Economist Edward Lotterman teaches and writes in St. Paul, Minn. Write him at ed@edlotterman.com.
