Comments on: How does JP Morgan respond to a crisis? A slice of lime in the soda Sun, 26 Oct 2014 19:05:02 +0000 hourly 1 By: Frwip Thu, 17 Jan 2013 04:32:12 +0000 Wow, wow, wow, wow…

Using a Monte Carlo simulation and averaging the outputs for a non-linear system is kind of missing the whole point of Monte Carlo simulations in non-linear systems.

Monte Carlo simulations are useful for, say, nuclear reactors. A nuclear reactor is a linear system from the POV of neutron transport. So Monte Carlo simulations can yield an accurate picture of the state of a running reactor as a superposition of many single particle simulations (google LANL MCNP).

In a non-linear system, Monte-Carlo simulations are useful to quickly explore the parameter space and sniff around for non-obvious, mmm, trouble, based on the assumption that the state space of most systems, even strongly non-linear systems, tends to be continuous. But you never, ever superpose states in a non-linear system. And a financial model is never linear (for they all have at least one very strong, very stateful non-linearity called ‘insolvency’).

And yes, the unfortunate conclusion is that financial models are more dangerous than nuclear reactors. Wall Street urgently needs a NRC of its own.

By: y2kurtus Thu, 17 Jan 2013 03:33:41 +0000 To this mid-level rube banker from the deepest part of the Maine woods the “task force report” reads like a company trying to make some very simple mistakes look complex. The “whale trades” out of the CIO have always been explained / justified as a hedge against the investment portfolio.

Hedging a risk does not ever under any circumstance generate a profit. Hedging reduces profit or losses. You have a position A which you think will make money, (in this case the 300 billionish in completely sensible bonds that were entirely appropriate for JPM to be holding with excess short term deposits.) To offset the risks of position A you have hedge B, the net very long CDS position. Nothing remotely hard to understand about that. Large bond portfolio that I am required to mark to market so I want to hedge the risk and I know that this will cost me some of the money I earn holding the bonds.

You don’t have to go any further than page 7 of the executive summary:

“…the traders hoped that the combined effect of these additions would allow them, among other things, to EARN premiums…” you can stop right there knowing everything you really need to know. JPM wanted the cake and to eat it too. Their completely appropriate hedges were costing them many hundreds of millions of dollars. They knew this going in… but at some point they grew tired of paying 9 or 10 figures for insurance.

If only they could use their clearly superior risk management models, trading acumen, and sterling reputation to earn just a little of their premium back…

…if you want to read further (and the report really is porn for wantabe wonks like me) then continue on to page 37:

“e-mails on January 30, the same trader suggested to another (more senior)trader that CIO should stop increasing “the notionals,” which were “becom[ing] scary,” and takelosses (“full pain”) now; he further stated that these increased notionals would expose the Firm to “larger and larger drawdown pressure versus the risk due to notional increases.” While the documentary record does not reflect how, if at all, the more senior trader responded to these concerns, the traders nonetheless continued to build the notional size of the positions through late March.”

Kid Dynamite has covered this better than I ever could. When you find yourself suddenly deep in a hole and you have no idea how you got there the very first thing you should do IS PUT DOWN THE FREAKING SHOVEL.

So JPM did the opposite on two obvious decisions:

A.) they tried to shuffle exposure so cute that they could somehow make money instead of paying money to insure an asset.

B.) when some of them realized the totally, glaringly, stupidly, obvious flawed strategy… rather than SLAM on the breaks and tell mom and dad the bad news… they put the petal to the metal thinking that somehow they could trade their way out of the unholy mess they got themselves in.

By: f.fursty Thu, 17 Jan 2013 02:11:48 +0000 I wonder if the next post-crisis report will be better than this one?

By: Auros Thu, 17 Jan 2013 00:41:08 +0000 The point of all this is that calling this event an “eight sigma” event, or anything else to do with a normal distribution, is folly. The risks associated with banks’ assets are not normally distributed. A risk simulation (including a Monte Carlo) that generates a bunch of random scenarios in which parameters are varied normally may be useful in some circumstances, but it should absolutely not be your guide to what the “worst case scenario” is. Not even the lowest percentile, or tenth of a percentile, in your Monte Carlo is the worst case scenario. If you want the worst case, you sit down with some creative pessimists — like the guy who did the nine scenarios for things like an oil shock — and draw up what you think are the very worst plausible cases. Then you simulate something that’s much worse than even that. And even then you’re probably underestimating the potential damage.

By: seanmatthews Wed, 16 Jan 2013 21:04:51 +0000 You keep using that word ‘Monte-Carlo’. I do not think it means what you think it means.

By: TGDC Wed, 16 Jan 2013 20:41:40 +0000 “There is no reason to assume that these events are normally distributed on the parameters used…”

It’s much worse than that. There is very strong that these kind of events are NOT normally distributed. Financial markets are known to enter very strong positive feedback loops at the tails and if you have a positive feedback loop you definitely won’t have a normal distribution. (The strongest kind of feedback loop, perhaps, being the predatory trading behavior of other hedge funds once they realize you’re vulnerable and will eventually have to capitulate.) Which, of course, we all know since this kind of event or even larger happen multiple times per decade not once every 10 billion years. The fact that they even measure things with concepts like standard deviation is a huge red flag that they are smart enough to have memorized their way through Statistics 101 but not nearly smart enough to understand what they’re really dealing with.

By: AlkalineState Wed, 16 Jan 2013 20:23:52 +0000 JP Morgan declares: “This failure is not our fault. It’s cuz Obama!”

By: Chris08 Wed, 16 Jan 2013 18:58:44 +0000 Playing and gambling with immense sums of money is inherently risky. That is why the institutions that do it should be made small enough so that if their guesses go wrong, as they often do, the damage is limited. Obama had a chance to get the banks under control at the time of the TARP bailout but Geithner, to whom he listened too much, prevented that. See the recent Frontline documentary on the issue. Obama was, and still is, too fearful of Wall Street. I think he fears being seen as (horrors) a “radical” black. Little good it does him as you can see from incessant and numerous comments on Yahoo News, etc., calling him a “socialist”. Millions of Americans apparently think bowing to Wall Street is what “socialists” do.

By: QCIC Wed, 16 Jan 2013 17:49:52 +0000 All this just comes down to the basic rule of Wallstreet:

I make a high risk high reward bet where if I win I become fabulously wealthy. But if I lose, it is my employer who takes the loss (and the taxpayers), and I only lose my job, not any of my previous pay which was predicated on the idea of this bet performing.

By: skeptometric Wed, 16 Jan 2013 17:23:48 +0000 How can you have a crisis-response strategy when the crisis is bad literally beyond your wildest imaginings (eight sigma if the original analysis was correct, which it was not)? At that point the whole enterprise has been shown to be invalid; it should never have been undertaken. It should have been realized that the risks of excess leverage are normally underestimated – the high payoffs distort the analysis. This is why there is regulation – these decisions can’t be left up to those who stand to profit.