What's Hedging, and How Did JPMorgan Lose $2 Billion by Doing It?

It's hedging, as in hedging a bet.

(Still yet another reminder that, at the end of the day, finance is mostly a fancy way of saying gambling.)

Some of the earliest (and most useful) hedges were in agriculture. A farmer would plant a crop in the spring, but wouldn't sell it until the fall. At that point, the price for his crop might be much higher (great news) or much lower (bad news) than he anticipated. The farmer, however, didn't want to speculate in commodities; he just wanted to sell his crop for a reasonable price.

Beginning in the 19th century, the future markets allowed him to do so. A farmer growing corn, for example, could sell all of his crop for $2.00 a bushel -- in April, when he was just putting seed in the ground. As he would not be harvesting his crop until, say October, this kind of transaction is called a forward transaction, as performance of the contract -- both paying the cash and delivering the corn -- don't  happen in the here and now. And because this kind of forward contract is standardized and traded on an exchange, this forward is actually a future. (So all futures are forwards, but not all forwards are futures.)

In October, though, the price might be $3.00 or it might be $1.00. But the farmer doesn't care, as he established a sale price of $2.00 in April. In financial terms, he hedged market risk (the chance that the price of his commodity would move against him) by selling futures on his crop. 

The idea of hedging moved into securities, where it spawned one of the more popular and profitable trading strategies -- the long/short strategy. The investor reviews companies within a given industry and tries to identify two things -- the most over-priced stock (e.g., the one least likely to increase in price), as well as the most under-priced stock (e.g., the one most likely to increase in price). 

Retail investors typically only look for the latter. People would buy Apple, for example, thinking that Apple would increase in value. But the long/short strategy is both a safer and, potentially, more profitable trade. So the hedge fund (as mutual funds can't really engage in short-selling, only hedge -- hey, there's that word again! -- funds engage in this kind of trading) would buy Apple (the long part), and borrow shares of Research in Motion (which makes the ill-fated Blackberries) to short-sell. 

The hedge fund ends up winning in these three scenarios:

• AAPL goes up, and RIMM goes down.
• AAPL goes up, and RIMM goes up -- but not enough to offset the gains made with AAPL.
• AAPL goes down, but RIMM goes down even more.

The hedge fund loses in these two scenarios.

• AAPL goes up, but RIMM really takes off.
• AAPL goes down drastically, and RIMM only does down a little.

And the hedge fund gets creamed in one scenario:

• AAPL goes down and RIMM goes up.

The problem with this trading strategy is that when the bets go south, they really go south. Fundamentally, this bet is on the spread between AAPL and RIMM. If the spread increases -- for whatever reason -- the bet is a winner. But if the spread moves against you, you get killed. This is what did in Long Term Capital Management, back in the '90s. 

With our agricultural example -- which is a true hedge -- the farmer was able to get rid of all of the market risk associated with his investment (his crop). Financial hedging just can't do that. A perfect hedge in the financial world would mean both buying and selling an identical amount of the identical securities, which makes no sense economically. So in the financial world, investors always look for imperfect hedges, meaning something which reduces risk, but doesn't eliminate it. Everything will be fine except -- again -- when both the original long investment and the hedge go against you. 

So what did JPMorgan do? According to Bloomberg: 

A JPMorgan Chase & Co. (JPM) trader of derivatives linked to the financial health of corporations has amassed positions so large that he’s driving price moves in the $10 trillion market, traders outside the firm said. 

The trader is London-based Bruno Iksil, according to five counterparts at hedge funds and rival banks who requested anonymity because they’re not authorized to discuss the transactions. 

... 

The trader may have built a $100 billion position in contracts on Series 9 (IBOXUG09) of the Markit CDX North America Investment Grade Index, according to the people, who said they based their estimates on the trades and price movements they witnessed as well as their understanding of the size and structure of the markets. 

The positions, by the bank’s calculations, amount to tens of billions of dollars and were built with the knowledge of Iksil’s superiors, a person familiar with the firm’s view said. 

And it didn't turn out so well.

JPMorgan Chase, which emerged from the financial crisis as the nation’s biggest bank, disclosed on Thursday that it had lost more than $2 billion in trading, a surprising stumble that promises to escalate the debate over whether regulations need to rein in trading by banks. 

Jamie Dimon, the chief executive of JPMorgan, blamed “errors, sloppiness and bad judgment” for the loss, which stemmed from a hedging strategy that backfired. 

The trading in that hedge roiled markets a month ago, when rumors started circulating of a JPMorgan trader in London whose bets were so big that he was nicknamed “the London Whale” and “Voldemort,” after the Harry Potter villain. 

To be fair, this one incident doesn't really mean a lot to JPM, which made $19 billion last year. But it does support the argument for the Volcker rule, which limits how much money a bank can risk in the kind of proprietary trading JPMorgan engaged in. The bad news is that the Federal Reserve is delaying implementation of the Volcker  Rule for (at least) two more years, until 2014.

The other way to limit the amount of money in play, and the one which we strongly prefer, is to limit the amount of leverage banks can use. Banks hate this idea as much as, if not more than, Volcker Rule, because both are serious restraints on the banks' ability to make money.

This is true. But the federal government will always be called on to clean up financial crises, so it's more than fair for them to limit the amount of harm that banks can do to themselves. This, oddly, is how the federal government hedges its risk.