Hedges and Hedgehogs

I'm traveling for the next couple of days and will be off the air. Some interested readers have written to me and asked what I think about the OCC's memorandum in support of its motion for summary judgment, filed last Friday, in the ongoing lawsuit by United Western Bank to overturn the FDIC receivership into which it was placed over a year ago. A couple of people sent me copies of the memorandum, and I thank them for it. However, I was traveling over the weekend and will be again tomorrow, and given my schedule and typical commitments in the week before a holiday, I won't review all 87 pages of it until this weekend. I know it comes as a shock to those readers who expect me to shoot from the lip, but I'd like to take some time to parse this one and see how it responds to the plaintiff's motion and supporting memorandum. That shocking desire to be prudent in my analysis won't likely be repeated frequently.

However, I will respond in typical fashion to several requests for comment on the recent hedging loss by JPMorgan Chase. Jamie Dimon is still taking heat for it and rightly so. It was a public relations disaster and a black eye for banks of all sizes due to the fact that so much of the bank-hating public wants to occupy everything other than a library, and lumps community and regional banks in with the largest of the large on Wall Street. That said, the financial effect on the bank was not earth-shattering. It temporarily hurts profits, but does not imperil the bank. It's puzzling to me that a purported "hedging" position could suffer a $2 billion to $5 billion loss. That sounds like a speculative trade, to me, although it appears that Chase's public spin is that it was a horrendously executed epic fail of a botched hedge.

Whatever the intended transaction might have been, hedges aren't designed to "eliminate" risk, they're designed to "reduce" risk. If properly considered and executed, they should cap losses at predetermined limits assuming certain worst-case scenarios occur. If those scenarios do not occur, then in many cases the bank has paid for protection it didn't ultimately "need," just like insurance. On the other hand, some perfectly proper hedges can result in some gain for the hedger if circumstances turn out to be go the other way. It shouldn't be a huge profit (if the transaction is a true hedge of downside risk), but there can be gains realized. The only hedge that completely "eliminates risk" is "don't make any investments." You have to take some risk to make some return.

Someone should tell that to Barney Frank. He was interviewed by MarketWatch last Friday and displayed a woeful lack of knowledge.

Q: Another area some lawmakers are concerned about is the way the Federal Reserve and other regulators interpret the Volcker rule, which is designed to prohibit speculative trading by big banks. Some senators say the regulators’ proposal allowing for portfolio hedging is a large loophole for continued speculative trading.

A: A portfolio hedge is not a hedge; it is a speculative bet. A hedge is aimed at being neutral on a particular asset, aimed at neither losing or gaining. They are trying to make money. The hedge is to take the risk out. I agree that is a problem.

It is so much more complicated than that, Barney. However, a simple answer to your simple answer is to tell you that you wouldn't know a hedge from a hedgehog. In that respect, however, we'll have to give Barney the fact that he's no different than most members of Congress. That lack of knowledge never stops them from opining, though, does it?