How dumb rules can mitigate model risk

By Felix Salmon
May 11, 2012
Matt Levine has the smartest take.

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We’re still not much the wiser on exactly how the London Whale managed to lose $2 billion this quarter, but I think Matt Levine has the smartest take. (This is why the blogosphere is so great: it’s full of people who used to do this kind of thing for a living, rather than just people who write about people who do this for a living.)

The key thing to note here is that while the monster hit to the P&L is what got all the headlines, the real problem here lay with JP Morgan’s risk models. A hint of far out of whack they are is given in the difference between the bank’s earnings release, which showed $67 million of value-at-risk in the Whale’s division in the first quarter, and the new SEC filing, which showed that number as actually being $129 million. Here’s Levine:

This was attributed to modeling changes made over the last year, and someone asked on the call “why did you change the VaR model?,” but I’m not convinced that’s exactly the right question. This, I suspect, is not an issue of a thing called a “VaR model” that sits in a central location and spits out numbers for regulators and 10-Qs; rather, this looks like the CIO’s trading desk modelling the actual P&L and risks of the trade wildly wrong. That seems to me like the simplest way to lose a billion dollars without noticing it.

I’d put this another way. JP Morgan’s Bruno Iksil, it seems, managed to find an incredibly profitable way of hedging the bank’s positions. Like any other economically rational actor, when he saw a lot of dollar bills lying on the sidewalk, he decided to pick them up. But in Iksil’s highly-complex world, a dollar bill isn’t really a dollar bill. Instead, it’s the output of a model. And if a trader can’t trust his model, he’s flying blind.

The problem is that pretty much by definition, it’s impossible to model model risk. We now know that Iksil’s model was deeply flawed. And indeed the minute that the rest of the world found out about his positions, they didn’t really pass the smell test: it’s very hard to see how writing an enormous amount of protection on an off-the-run CDX index would hedge anything much.

This is where grown-ups like Jamie Dimon are meant to step in. If they see billions of dollars in super-senior mortgage exposure, or in off-the-run CDX exposure, they’re meant to say “I know that your highfalutin’ models say that these exposures are risk free, but I don’t understand how this isn’t risky, so go unwind this trade”. Dimon has historically been very good at that — very good at refusing to simply trust that superstar traders earning eight-figure bonuses are doing nothing that might blow up in their faces. In this case, however, for some reason, he had blind faith in Iksil — and in Iksil’s models, which proved to be very faulty.

A modern trading desk is a bit like a high-tech airplane: nearly all of the time, you’re better off trusting your instruments than trusting your gut. But at the same time, if your instruments are broken, then trusting them can lead you to fly straight into the ocean.

This is why Basel I turned out to be much more robust than Basel II. Your sophisticated platform needs to be built on a foundation of dumb rules: simple limits on how big any one position can get, on how much exposure you can have to any one counterparty, or in general on any trade which is based on the hypothesis that your desk is smarter than anybody else on Wall Street.

Those kind of rules won’t prevent all blow-ups, of course, but they’ll help. They would have prevented this one, and they would have put an end to Jon Corzine’s disastrous MF Global trades, as well.

The problem is that traders hate dumb rules, because they cap the amount of money they can make. And traders have enormous power at investment banks these days, because they make the lion’s share of the profits. That’s why it’s important that the CEO of an investment bank not be a trader. And certainly it’s crucial that the CEO shouldn’t have his own trading account and buy and sell from his Blackberry during meetings, as Corzine did. That’s just a recipe for disaster.


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I’m waiting for Dimon to blame the $2B loss on regulators. If only they would have let JP Morgan do what they want, because they are super-smart and won’t take big risks.

Posted by KenG_CA | Report as abusive

I posted similar thoughts at: 012/05/11/morgans-mess/
. . . also noting that the $129M was the average for the quarter. At quarter end, VaR was $186M in CIO and over $200M for the whole company. I don’t recall anyone on the call asking what VaR was today, though I’m curious.
You make an excellent point about model risk. One way to mitigate it is to use more than one model. Al Roker consults multiple computer models before giving us the weather forecast. Shouldn’t Jamie Dimon do the same?

Posted by RZ0 | Report as abusive

One nitpicks:
Traders make the most bonuses. As for profit, that all depends on how much money is left in the banks pocket when the prop desk is finally shut down. Until that time, they are still betting and all that “profit” is still on the table not safe in their pocket.

Posted by k9quaint | Report as abusive

I’m with K9 – depository institutions shouldn’t be doing this kind of thing. It was a flat-out, naked prop trade masquerading as a hedge – that’s likely how it got under the radar, if it ever did except in regulatory filings.

Nobody’s ever identified the position that was allegedly being hedged by this CDS position, have they? Bet there is none except JPM’s own outstanding debts.

Posted by MrRFox | Report as abusive

I don’t think it’s nearly impossible to model model risk. First, you start with how much money a more conservative model would cost the bank.

Posted by AngryInCali | Report as abusive

The best way to mitigate risk is to put it in one’s face. The answer is forcing banks to issue subordinated debt, bring back double liability common stock and by rule of law ban banks from engaging in risky activities outside of basic essential services like lines of credit, loans, check writing , currency conversion etc. There’s no model in existence that will make risky trading benign, I don’t care how you think you are hedging that risk.

Posted by Sechel | Report as abusive

The position they were supposed to be hedging simply became an excuse for them to put on the hedging trade itself. Dimon is too smart not to have known what was going on; everyone there had to be. When a hedge needs a hedge you’ve gone too far. They blew it, and they didn’t blow it because they were stupid, as Dimon is now trying to claim — they blew it because they were greedy and dishonest.

Posted by martin.gale | Report as abusive

It is really not so much about how dumb rules can mitigate risk, if that is what we really want (I’d happily settle for not having to pay too much taxes when banks fail) but that “smart” rules can potentiate risks by seeding confusion in a market where no one wants to admit to their peers that they do not understand one iota.

Posted by PerKurowski | Report as abusive

My whole impression about the issue is that the desk has already made a lot of money in the past few years. And it is going to make much more in the future. JD only sees it as a pullback of their trading strategy and the reason he seems to talk so frankly about it is that he is not least worried about his chair.
I do not know how much creative accounting they are capable of, but I my guess would be that the loss was much bigger before they had to go public with it (and maybe even partly covered with money from different parts of the bank?). 2 billion sounds like a lot of money to a regular joe, but 10 would seem kinda nasty even to some closer circle and better informed shareholders or board members.
As a fact check, I have not noticed any reports of any ‘consequences’ going on. Anyone fired? No. The trading desk put under scrutiny or split? No. We are still making money, let us do our job guys.
The only real problem for them seems to be that someone might see through their game where they have a huge boring banking business serving mainly to provide them with resources and a cover-up for acting as a super big hedge fund doing proprietary trading and making the real money in a few trading desks charged with super capable people and technology.
Losing money on hedging? That is literally an oxymoron.
A good joke over glass of wine for insiders already, I bet.

Posted by M11 | Report as abusive

Okay, have read some more great info on it on this blog and I have made some mistakes in my previous analysis. read first before commenting :)

Posted by M11 | Report as abusive