Why JP Morgan’s gamblers need to be spun off

By Felix Salmon
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.

20 comments

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Felix – this is trash journalism from you.
Geismar is CLEARLY stinking rich.
If he took home a mere 10% of the management fee on his $4.6bn fund then that’s a $9m year.

So a $1,000 tip to him, is the equivalent of a $10 tip to someone earning $90k per annum.

However, the more egregious point you are attempting and fail to make is that his gambling behaviour and risk appetite is somehow linked to they way he exercises his fiduciary duties to his investors.

He’s running a QUANT fund for God’s sake!

This a just jumping on a bandwagon saying “oooh, those evil hedge fund managers, look at them spending their money and gambling”…

You aren’t writing for the Daily Mail.

Posted by TinyTim1 | Report as abusive

The Volcker Rule was meant as a compromise between those in the consumer protection end of things who insisted that Glass Steagall be reinstated and the banks who wanted no regulation whatsoever. In retrospect, the compromisers played “win-win” in what turned out to be a zero-sum game and have been grossly taken advantage of.

The point Felix makes about the cost of capital is exactly on mark. The US taxpayer is subsidizing excess risk-taking on the part of the TBTF banks through lowering their cost of capital for all their activities. This makes no more sense than if we did the same for Mr. Geismar.

Banks have historically been backstopped to protect the functioning of commerce and the “real” economy. The contra argument is that all this risk slicing and dicing lowers the cost of capital for everyone. This is likely the fatal error in theory and what drove leverage and the global economy over the cliff.

Posted by martin66 | Report as abusive

TinyTim, I take the post differently. I don’t get that Felix is saying the hedge fund managers are evil, or criticizing their spending and gambling. He’s saying that the people who run and work for those funds tend to be aggressive risk takers. And, that in a corner of JP Morgan (and other banks), there is a group that is essentially run like those hedge funds, run by people with similar traits (willing to take outsized risks). He says, if hedge funds want to gamble, fine, let them, but since all of the money in a bank is fungible, and the government has to back up the banks, the banks shouldn’t have hedge funds.

It’s not trash journalism, it’s a valid point. You’re either a bank, making a few points matching deposits with loans, or you’re a gambling operation, betting that you know more than the people on the other side of the table. And let’s not have exposure to the latter.

Posted by KenG_CA | Report as abusive

I somewhat agree with TinyTim1. This really isn’t crazy behavior for someone who makes that much money – this is what someone who enjoys gambling and has lots (lots!) of money looks like. Blackjack played well gives only a 0.7% or so edge to the house. So he’s handing the house $70 per $10k wager, and from the description he’s enjoying the variance quite a lot.

Vegas is fun (for some) precisely because it lets you indulge in silly risk-seeking behavior in a fun setting. Would you also disqualify any hedge fund manager who goes skydiving regularly?

Posted by absinthe | Report as abusive

Funny isn’t it how the people who complain most about the taxes they should pay are very often also at the front of the queue when it comes to those wanting to be backed up by taxpayers money when they lose their bets.

I think the world economy has discovered the hard way that mixing deposit taking banks and casino banks was a mistake that benefitted the traders, sure, but not the government, not the taxpayers, and not even customers in many cases.

Posted by FifthDecade | Report as abusive

Felix: “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.”

why do you think this is silly? It’s what any rational gambler would do, reduce his bet if his bankroll is smaller.

Posted by niveditas | Report as abusive

TInyTime, nobody is saying it’s crazy behavior, but the second part of that sentence is the problem: this is what someone who enjoys gambling and has lots (lots!) of money looks like.

We don’t want to have to backstop gamblers who happen to work for banks. I don’t care about hedge fund managers, they can skydive, or go to Las Vegas every weekend, and so can bank employees, but I don’t want to have the government have to insure banks when part of their business model is gambling.

Posted by KenG_CA | Report as abusive

niveditas- It is silly, but not as silly as being Geismar’s apogist by trying to create a rational explanation for Geismar falling for a classic gambler’s fallacy.

Posted by AdamJ23 | Report as abusive

Since large deposits encourages more speculative trading and creates a too-big-too-fail bank, why not reduce FDIC coverage limits for those institutions no longer following Glass-Steagall?

If banks go back to the old 1980 FDIC $100k limits while depositors in institutions that follow Glass-Steagall get the full $250k coverage, seems like a win-win.

Banks should lose deposits (discouraging excessive proprietary trading) as customers seeking safety withdraw their money and put them into credit unions that can’t do proprietary trading.

Posted by NuprinBoy | Report as abusive

@NuprinBoy

Barry Ritholtz raises you one hundred with THIS:

http://www.ritholtz.com/blog/2012/05/sim ple-fdic-rule-change-can-end-tbtf/

Posted by crocodilechuck | Report as abusive

@NuprinBoy

Barry Ritholtz raises you one hundred with THIS:

http://www.ritholtz.com/blog/2012/05/sim ple-fdic-rule-change-can-end-tbtf/

Posted by crocodilechuck | Report as abusive

@NuprinBoy

Barry Ritholtz raises you one hundred with THIS:

http://www.ritholtz.com/blog/2012/05/sim ple-fdic-rule-change-can-end-tbtf/

Posted by crocodilechuck | Report as abusive

Mike Geismar has a degree in Mathematics from UVA, and is president of a quant hedge fund. Do you really think he believes this nonsense about the “law of averages,” or does that seem like something an idiot writer would say to explain a behavior he didn’t understand?

I actually know Mike. We have been in casinos together and we have talked about gambling. It is true that he likes to press his bets on wins and cut back on losses, but I am certain he doesn’t believe it changes his expectation. At most, it shapes his distribution a bit in the short term, giving him bigger wins at the expense of more frequent losses. That seems like the sort of distribution I would go for too, if I enjoyed the big wins the way Mike does.

Also, Tiny Tim’s point about relative net worth is well taken. The guy bought in for 10k. Sure that’s a lot of money, but that is nothing for Mike. Do I believe if he’d lost it he would have rebought? Yep. Maybe even twice. But would he have dropped 700 grand? There is no chance. He wants to give himself the shot at the big night, and if loses, oh well, he only risked what he could afford to lose. He is in no way analogous to an exec at a big bank making bets backstopped by the government.

Posted by Felagund | Report as abusive

“I actually know Mike. We have been in casinos together and we have talked about gambling.”

I DON’T know Mike Geismar. I DO know that I’ve seen a whole lot of this sort of hagiography in my time. LTCM was run by geniuses — until it wasn’t. Jamie Dimon knew everything about what JPM was doing — until he didn’t. AIG were very carefully about balancing risks — until they weren’t.

These companies didn’t fail because their execs didn’t understand basic probability. They failed because their execs thought they had all the info they needed to build an accurate probability model — and were wrong.
The issue, in other words, is not one of knowing “how to shape the distribution”, it is one of
(a) being overconfident that you understand EVERYTHING relevant to the situation and
(b) getting a rush from winning — and thus allowing that to color your judgement.

Nothing in all these justifications for Geismar suggests that he is immune to these two flaws, on the contrary they suggest that he is precisely the sort of individual who has these flaws in massive quantities.

Posted by handleym99 | Report as abusive

For the most part the big banks can’t spin off their trading arms or hedge fund like units because without their big strong balancesheet and too big to fail stautus the cost of funds and collatteral requirements would eat most of the profits.

JPM made a stupid mistake. They lost 2 or 3 billion dollars. They have suspended their 15 billion dollar buyback program.

Shocking as it is to read JPM is a stronger bank because of the loss. They will probably be the first SIFI to hit the Basel III cap requirements.

Posted by y2kurtus | Report as abusive

@Y2Kurt – about this -

“Shocking as it is to read JPM is a stronger bank because of the loss.”

If the loss rises to $7Bil, will JPM be stronger still? They may have learned something from the loss and be “better” for it, but “stronger”?

Anyway, what does it matter? Neither AIG nor Bear nor Lehman nor LTCM was an insured deposit-taking institution when each of them shook the system to its roots.

WaMu, Countrywide, IndyMac and others were, and didn’t get involved in structured products at all. That didn’t count for much, did it?

Posted by MrRFox | Report as abusive

@MrRFox-

I guess it depends on how much of the 15 billion authorized share buyback JPM had already used prior to announcing they would suspend it after the trading loss. If for instance they had already used 5 billion and decided to keep the remaining 10 billion in capital and the loss swelled to 7 billion then where does that leave us? Looks like they might still be 3 billion ahead to me Mr.Fox!

Your point regarding WaMu, Countryide, Indymac is a good one… all made most of their money selling their crappy loans to the Goverment Agencies. Those GSE’s did like half of all mortgages pre-crisis. Today I think that number is something like 90%… problem not solved.

Posted by y2kurtus | Report as abusive

@y2kurtus, has anybody suggested that this gamble puts JPM at risk of failing?

If I were a shareholder, I would rather have $7B spent on a share repurchase than $7B spent on covering trading losses. Since I am not, it isn’t my concern. I agree they aren’t going to need a bailout for this.

And the crappiest loans weren’t sold to the GSE, they were sold on the private securitization market. Why? Because they didn’t qualify for even the minimal GSE standards. Not sure we could have had a bubble (certainly not one that severe) if the GSE lending standards were the only game in town.

Posted by TFF | Report as abusive

TFF, you said “If I were a shareholder, I would rather have $7B spent on a share repurchase than $7B spent on covering trading losses. Since I am not, it isn’t my concern.”

I had that exact thought (the second sentence) about Lehman and Bear Stearns and AIG in 2008. Yeah, they probably aren’t going to need a bailout (even if MrFox is right and their losses are far greater), but what if this is another canary in the coal mine? I just have no faith in anybody in that industry any more.

Posted by KenG_CA | Report as abusive

AdamJ23, you think the Kelly betting is a “classic gambling fallacy”?

Posted by niveditas | Report as abusive