Sunday, April 22, 2012

A Good Offense

Defense or offense?
Kind-hearted people might of course think there was some ingenious way to disarm or defeat the enemy without too much bloodshed, and might imagine this is the true goal of the art of war. Pleasant as it sounds, it is a fallacy that must be exposed: war is such a dangerous business that the mistakes which come from kindness are the very worst.

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If defense is the stronger form of war, yet has a negative object, it follows that it should be used only so long as weakness compels, and be abandoned as soon as we are strong enough to pursue a positive object.

— Carl von Clausewitz, Vom Kriege

Consider, Dear Reader, the question embedded in the mouse-over caption to the photo above: Should we consider a tank destroyer—a machine designed to destroy tanks—to be a defensive weapon or an offensive weapon? The Jagdpanther was designed and employed by the Wehrmacht during World War II primarily as a hunter-killer of Allied tanks. Heavily armored against frontal assault, highly mobile, and equipped with a powerful main gun fixed in a low-profile, turretless unibody chassis, the Hunting Panther was designed to lie in ambush for enemy tanks and knock them out in one-on-one frontal duels. Its design was ill-suited for infantry support, general patrolling, or massed attack across open country. Given that the tanks it opposed were usually employed in offensive thrusts, one could say the Jagdpanther was primarily a defensive weapon. And yet it was also a mobile cannon par excellence: a weapon purpose built to deliver armor-penetrating or high explosive shells against sundry targets mobile and fixed, none of which necessarily had to be an opposing tank. (Eighty-eight millimeter rounds could kill enemy infantry and destroy artillery emplacements just as neatly as they disabled tanks.) Of course the Germans could and did use the SdKfz 173 for offense. It was a weapon.

It is true that most weapons and implements of war are usually designed to be primarily offensive or defensive in nature. A shield’s primary use is to defend, a sword’s is to attack. And yet a sword can be used to parry; a shield can be used to bludgeon or chop. Offense and defense are different modes of use—that is, tactics—not intrinsic properties of the tools we employ.

The same is true, by analogy, of financial instruments and trades. A trade can be made for offensive purposes—speculation or investment1—or defensive ones, as a hedge. Speculation increases an investor’s risk exposure; hedging reduces it. And yet the same trade or financial instrument can be used in either way at different times and under different circumstances. Selling a thousand shares of Apple Computer can either be a perfect hedge, when it liquidates an existing long position, or rank speculation, when it initiates an open short sale. Context—and the other positions in an investor’s portfolio—is everything. This is very poorly understood by the common man or woman.

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Hence we get the recent spectacle of financial journalists and market participants falling all over themselves to condemn with morbid fascination the large scale market interventions of J.P. Morgan Chase’s London-based chief investment office. Adding to the camera-ready copy of these stories, this trading team reportedly roiling the markets with its enormous volume and net positions apparently enjoys the leadership of a man some call the “London Whale” and others “Voldemort.” An eager journalist on the financial beat could not ask for more.

Of course the solitary string of outrage which journalists and their hedge fund sources—pot, meet kettle—keep harping on is that somehow J.P. Morgan is using the trading activities of its CIO to circumvent the regulatory and moral limitations on proprietary trading by systematically important financial institutions embodied if not yet enforced in the Volcker Rule. Jamie Dimon, as befits the fiduciary duties which accompany his lofty pay grade and authority in J.P. Morgan’s executive suite, of course denies that the London Whale or any of his minnows are doing any such thing. I am sure it will disappoint the anti-capitalist firebrands in my audience to hear that, subject to further stipulations, qualifications, and cautions noted below, I feel compelled to give ol’ Jamie the benefit of the doubt here.

For the assertion, which Mr. Dimon seems to be promoting, that his chief investment office is putting on massive securities and derivatives trades to hedge the bank’s already existing underlying risk exposures makes complete sense. Have you looked at J.P. Morgan’s balance sheet lately, O Curious and Inquisitive Reader? As of March 31, 2012, the redoubtable House of Morgan boasted total investments (consisting of deposits with other banks, debt and equity instruments, derivatives, and securities) of $953 billion, net loans outstanding of $687 billion, and other assorted doodads which added up to an impressive-in-this-or-any-other-world-you-can-think-of 2.3 TRILLION DOLLARS of total assets. That’s a lotta simoleons, children.

And while the mysteries of generally accepted accounting principles, trade secrets, and legal smokescreens prevent a humble outsider such as Your Humble Bloggist from penetrating the veil of opacity to any meaningful extent, I think it’s safe to assume a hell of a lot of those bright, shiny assets represent proprietary risk trades which the House of Dimon put on for the sake of its beloved and long-suffering corporate, governmental, and investment clients. Most people just don’t seem to get it, but even normal, everyday corporate lending is proprietary investing. A bank creates an income-producing asset for itself by lending money to a client. Loans are risky assets: the borrower may not pay principal and interest back on time (or at all), and the lender exposes itself to market-based interest rate risk either directly through the form of the loan’s interest payment mechanism (fixed or floating) or indirectly via its own funding requirements (banks borrow money to lend it, you know) or both. A normal commercial lending bank is by definition shot through with all sorts of risk, even when it shuns the racier ends of the swimming pool like securities and derivatives trading or structured products.

This becomes especially clear when you consider the funding side of a normal bank. J.P. Morgan did not create or purchase all those assets with $2.3 trillion in loose change it just had lying around the house. It borrowed over $2.1 trillion from anyone it could get its hands on—retail and commercial depositors ($1.1 trillion), corporate lenders ($726 billion), and trade creditors, plus $182 billion from gullible common shareholders—and went shopping. The bank is, to use an industry term of art, leveraged up the wazoo.2

But this is just the ordinary magic of a traditional bank’s business model: borrow cheap, flexible funding from as many naive savers as you can muster, and lend it out at higher rates to the desperate and underfunded. The magic—and the returns—come from the fact that the risks a modern bank assumes on the funding and the lending side are very different, often highly volatile, and incommensurate with leaving early on Thursday for afternoon golf. Identification, management, and control of borrowing and lending risks are core to the activities of lending banks. That is what they get paid for; that is how they earn their returns.3

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Now given that Jamie’s Army is brooding over something slightly more than umpty bajillion dollars of proprietary investment assets tottering precariously on their balance sheet, you can be damn sure that I and everyone else with a natural aversion to Stone Age living conditions sure as hell hope J.P. Morgan is hedging the shit out of those assets. You can also be sure that a loan book of $687 billion and an investment portfolio a cat’s whisker shy of a trillion dollars offers numerous and substantial opportunties for its risk management group to put on enormous hedging trades in the markets. I would be shocked to learn that J.P. Morgan wasn’t moving the markets.

The only caveat to mention is that hedging is a tricky and mercurial thing. As I alluded above, the only “perfect” hedge for a trade or position is to unwind it completely, with the original counterparty or one who carries no residual risk. You can perfectly hedge your purchase of 1,000 shares of Apple only by selling them completely, for cash. The same is true for each and every individual financial asset: it can only be completely and irrevocably hedged by unwinding that particular asset or, as is sometimes done in the derivatives market, by immunizing it with an identical, offsetting mirror-image asset with the same counterparty. Anything else introduces one or more forms of what is broadly known as basis risk. Basis risk can take many different forms: credit risk, from different counterparties; interest rate risk, from different durations (e.g., long vs short); collateral risk; and, overarching and encompassing most of these, correlation risk. The latter is easiest envisioned in the case where an investor hedges her portfolio of individual stocks against a general market decline by buying a notional amount of S&P index puts equivalent to her portfolio value. But her success will depend entirely on how her individual stocks behave in relation to the portfolio hedge. If they move down in lockstep with the S&P, she will have protected her portfolio’s value, but if they decline while the S&P stays flat or rises, she will have suffered the worst of both outcomes, loss on both her portfolio and her protective puts.

The trick is that portfolio hedging is normally far more efficient and cost-effective than hedging each and every individual position in a risk book. While this concept seems to befuddle the occasional journalist, it seems to have penetrated even the thick skulls of the rule makers in Congress, who have carved out aggregated position hedging from activities banned by the Volcker Rule. After all, if one looks at commercial and universal banks as entities which manage the mismatch of assets and liabilities in their business for fun and profit, one can see that, in some important sense, it is the job of such financial intermediaries to generate returns by managing basis risk. In the argot of the market, banks are long the basis risk of financial intermediation.

But by that very token, examining the risk portfolio of a large financial institution can never be as simple as totting up each individual portfolio position and netting it against its very own particular hedge. Banks and investment banks manage risk across multiple dimensions, and one hedge or set of hedges may have (partial) hedging properties for numerous unrelated positions. They do so dynamically, too, since the basis risk which was well understood yesterday may diverge or uncouple drastically tomorrow. Market crashes and financial panics seem to have the nasty effect of driving return correlations to one across all financial assets and asset classes, which can bollocks up an otherwise nifty risk model no end. The monitoring and control function of regulators is made more problematic by portfolio risk management practices, too, since a trade which looks like a sensible and effective hedge in the context of the overall risk book may look like the rankest proprietary speculation in isolation. Needless to say, the counterparty to a trade by a big commercial or investment bank usually doesn’t have the beginning of an inkling of a whisper of a clue why and for what purpose Big Mondo Bank is calling him up. And you can forget about journalists.

In like fashion, a Russian tank commander on the outskirts of Warsaw in 1945 probably didn’t have the least notion whether the Jagdpanther fired its 88 at him because it was attacking, defending, or just range finding. Sorry to say, the reason didn’t matter much if an antitank round blew him to smithereens.

Fortunes of war.

1 For the purposes of this discussion, I consider “investment” and “speculation” to be one and the same thing. Both entail the assumption of risk in pursuit of return, as opposed to hedging, which entails the reduction of risk. That investment has a respectable connotation in our current culture and speculation does not is none of my concern. All investment—which constitutes a bet upon an uncertain future—is speculative. It would be wise for everyone to remember this.
2 Although by the standards of its industry, its profligate European peers, and the wild-eyed lunatics in pure investment banking, J.P. Morgan is downright conservative in its leverage ratio. The absolute numbers are what give any prudent person the bends. It’s all how you look at it.
3 Never forget, children: risk and return are conjoined twins. You can’t have one without the other. If you can’t identify the risks underlying a particular return, you’re either missing something, or I have a very attractive bridge crossing the East River I would like to sell you.

© 2012 The Epicurean Dealmaker. All rights reserved.