Why JP Morgan’s gamblers need to be spun off

May 25, 2012

There are two stories often told of hedge fund managers, and they’re pretty much diametrically opposed. In the popular imagination, such managers are risk junkies, putting on massive bets in the hope that they’ll have huge payoffs, making a fortune for their investors and even more so for themselves. But that’s not the story told to — and bought by — big institutional pension funds and insurance companies and endowments, who lap up stories of state-of-the-art risk management, carefully-calibrated hedges, aggressively maximized Sharpe ratios, and returns which not only beat the stock market but do so with significantly lower volatility along the way.

So which is true? Read Lawrence Delevingne’s account of how Michael Geismar gambled away his time at the SALT conference in Las Vegas, and it’s pretty clear that the hedge fund manager of popular imagination is a very real creature indeed. He throws $1,000 tips around like confetti, he books a $20,000 private jet home on a whim, he wins and then he loses $70,000 and then he just keeps on playing, and ends the conference up $710,000 or so.

“He was jumping into the pit screaming ‘we’re going to need more chips over here!’” O’Leary recalls, laughing. “It was insane.”

The young dealer was visibly sweating with tens of thousands of dollars now being bet on every round of cards. A small crowd had formed around the table. At one point a casino pit boss came over, worrying that the players Geismar was backing up weren’t actually betting their own money. The table quickly convinced the man they were, and play resumed. The pit boss conferred with a superior, who O’Leary recalls saying “We’re never going to win our money back, but screw it, let’s let it roll.”

Well, yes. This is why SALT will always be in Vegas, and why Vegas will always welcome SALT with open arms. I’m sure the casinos made very good money on SALT even after accounting for Geismar’s winnings, and they’ll probably make money from Geismar too, on net, over time. If nobody ever won big money, no one would gamble at all. But in the end, the house always wins — and all of these hedge-fund managers are smart enough to know that. And still, left to their own devices, what they do is gamble, and they even layer on silly “risk management” techniques which don’t reduce risk at all — in this case, after a losing hand, Geismar would bet a little less, reckoning that somehow “laws of averages” would help him as a result.

Delevingne’s story makes for great reading, but it’s also pretty much impossible to imagine why anybody would invest in hedge funds in general, or Geismar’s hedge fund in particular, after reading it. SALT is the brainchild of our old friend Anthony Scaramucci, of course — and while I’ve definitely met people who like Scaramucci, or are charmed by him, I haven’t met anybody who thinks that Scaramucci’s fund-of-funds is near the top of any list of the best places to invest money. Whatever you think of gladhanding and gambling, they’re not really the kind of behaviors you’re primarily looking for in a fiduciary.

All of which brings me, inevitably, to JP Morgan’s Chief Investment Office, which, the WSJ reports, has been making all manner of highly-risky bets, including bets on LightSquared. There’s lots of hair-splitting in the story about whether or not the bets are funded with excess deposits, but ultimately money is fungible, and in any case the reason that JP Morgan can fund this Special Investments Group so cheaply is just that it’s a big commercial bank which is too big to fail. And if it’s entirely right and proper to look askew at hedge funds exhibiting symptoms of gambling addiction, we certainly shouldn’t stand for JP Morgan Chase to be engaging in anything like that behavior.

This is a Volcker Rule question, of course, but it’s not only a Volcker Rule question. There’s a much deeper issue here as well — which is whether big commercial banks should have hotshot trading desks staffed by the likes of Achilles Macris and Bruno Iksil at all. Both Peter Eavis and Jonathan Weil have new columns decrying the opacity of JP Morgan’s public disclosures: the bank seems to make it as difficult as possible for its owners to find out just how much risk it’s taking and where. And not just its owners, either: the owners’ representatives on the board, JP Morgan’s risk committee, is deliberately staffed by muppets.

There’s a good reason for that, of course: hedge funds need to operate in secrecy, because if the market can work out what their positions are, it will move sharply against them. JP Morgan’s CIO is a hedge fund in all respects except the fees it charges, and clearly the CIO (and the CEO) want its activities to be effectively unsupervised. That’s almost certainly the reason that the CIO is effectively based in London: it’s largely outside the scope of US regulators, there, while UK regulators tend not to care too much about the actions of foreign banks, when those actions don’t present a big risk to the UK economy.

So here’s another principle, which might be helpful alongside the Volcker Rule, in any principles-based regulatory regime: if you’re a too-big-to-fail commercial bank, you shouldn’t have any desk which needs to operate in secrecy in order to do its job effectively. In practice, as Sheila Bair says, that means that JP Morgan should be broken up. If hedge funds want to gamble, fine, let them do that. But not when they have an implicit US government guarantee.


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