Was JPM hedging, unhedging, or speculating?

No one yet knows exactly was JPM was up to in the credit derivative markets. But this hasn’t stopped a lot of people from linking the loss to their pre-existing views on the Volcker rule, TBTF, moral hazard, and the Fed’s low interest rate policies, etc. There was also more than a touch of Schadenfreude, as the golden boy of finance revealed his new black eye.

We will ultimately get the information from JPM about what it was doing and what exactly they thought they were hedging. Once we do we will be in a better position to judge whether the hedge was reasonable or constituted speculation in disguise, and whether there are broader policy implications.

But setting judgment aside, and after having following this issue for a while, I do have an educated guess as to what likely happened:

  • We know that JPM is naturally long corporate credit through its loan book.
  • We know that over the last 2-3 quarters of 2011 we were gripped by the fear of a European financial meltdown and a second recession in the US.
  • We know that that the Fed’s swap lines and the ECB’s LTRO reversed this market view and crushed credit spreads lower, hurting those who had been buying protection in the previous months.

Against this backdrop, it seems likely to me that the aggressive selling of protection we heard about in April 2012 was actually the unwinding of the hedge that had been accumulated in 2011 and was by then deeply underwater.And given the way a bank’s loan book is held and priced, they couldn’t show commensurate gains to offset these losses.

This story fits the price action. Below is the one-year chart of the spread of the hedging instrument in question, the CDX.NA.IG series 9:


It is hard to imagine JPM coming out and announcing the loss while they still have the bulk of the loss-making position still on. Hedge funds and other banks—at least banks in the pre-crisis days—tend to gun for large, vulnerable positions in the hopes of profiting from the vulnerable party’s subsequent capitulation.

The story also fits typical big-bank behavior. It doesn’t ring true that a large bank would put on such a large speculative position in the current environment, given (1) the crisis we just went though (banks, like generals, tend to fight the last war and therefore the next mistake they make is likely a new one) and (2) we are very much in the middle of defining our new regulatory framework, and a mistake of this nature would be potentially crippling to a bank’s negotiating position in that process.

On the other hand, the natural human tendency of observers is to overstate the probability of the banks repeating the same mistake. This is often referred to as disaster myopia. Having lived through two bubbles now, I think it is fair to say one of the telling characteristic of financial bubbles is that in their aftermath there is a proliferation of people immediately declaring new bubbles (a bubble in bubbles). For similarly backward-looking reasons we are likely to overstate the probability of seeing similar issues now surface in other large banks.

Anything is, of course, possible. And I will withhold definitive judgment until the facts are in. But given the way institutions and people behave in the wake of a traumatic shock, the odds suggest that is was indeed a hedge gone wrong and that we are overreacting to it.

The far bigger issue that the JPM news obscured on Friday was the continued deterioration of the growth numbers in China. But more on that later…On other advertisements, checkout loans bad credit no guarantor if you want to make some fast cash.

Why we misinterpret Chinese RRR cuts

A quick comment on China’s RRR cuts: The underlying mechanics of Chinese RRR cuts and their implications for the country’s monetary policy stance still seem to be misunderstood.

A Chinese RRR cut is NOT like a rate cut in the developed world. And it does not necessarily signify an easing of the monetary policy stance. If you want to understand whether China is increasing or decreasing accommodation you only need to look at one thing: China CNY Monthly New Loans. The Bloomberg ticker is CNLNNEW.

The transmission mechanism of monetary policy in China is too crude at this stage of development to judge the stance of monetary policy by interest rates or reserve requirements. In China, it is all about credit controls. By hook or by crook, the Chinese target a quantity of credit. Whether they get there by regulations, open market operations, rate changes, or moral suasion matters little: the acid test it the rate of increase in the quantity of credit.

Here’s a snapshot of the time series:

So, last month, in the wake of several RRR cuts since last December, the quantity of RMB loans came in at 682B, versus a survey estimate of 780B. In other words, the money supply is roughly flat since all the RRR cuts began in December. RRR cuts are not a reliable predictor of future credit growth.

Why not? The mechanics in China work like this. China targets growth in the stock of RMB credit. Last year the target was 7.5T Yuan. As of this year the authorities have stopped publishing their target, but most analysts think they are aiming for between 8 and 8.5T Yuan. (FWIW, this would imply an increase in nominal GDP growth between 7 and 13 percent if you assume no monetary deepening).

There are three basic ways in which they can “finance” this growth in the stock of credit. One, they buy T-bills in OMOs (open market operations). Two, they receive balance of payment inflows (current account surplus plus capital account inflows). Both of these sources increase base money. Three, they can lower the RRR for banks to free up resources for lending. This doesn’t increase base money but increases the multiplier. The net effect of these three levers determines the change in liquidity in the system with which banks can expand lending.

The reason the RRR cuts have taken on less meaning in the current context is that they have been mostly offsetting the diminution of China’s balance of payment inflows. Once upon a time China’s trade surpluses were so large and the capital inflows so strong that BOP inflows provided more than enough base money to fuel any amount of credit expansion the China authorities desired. In fact, there were excess inflows that China had to sterilize. Now the trade surpluses have diminished and the speculative inflows have cooled (in fact, we have even seen net outflows at various point in time). If RRR were not cut, there would be an effective tightening of liquidity conditions. (This diminution of BOP inflows is also why the Chinese have been buying fewer US Treasuries.)

The bottom line: you need to know what is happening in with the constituent elements of base money before assessing whether an RRR is accommodative or just offsetting other developments. And, in the final analysis, only the growth rate of the stock of RMB credit will tell you the unambiguous truth.

So, the next time you hear an equity analyst trumpet the arrival of an RRR cut to bolster his bullish case, make sure you check the overall context and draw your own conclusions.

Intro to my Behavioral Macro microblog

I’m a money manager with roots in policy economics. I worked at the US Treasury under both a Republican and a Democratic administration. I did a tour of duty at the International Monetary Fund as well. For most of the 90s, I was a sovereign debt specialist/negotiator—when emerging market debt crises were the center of the financial universe. Since then, I’ve managed real money and fast money, mostly focusing on global macro. As a result I come at markets from both the perspective of a policy guy and a market guy, which all too often is like oil and water. My initial grounding was in sovereign credit risk and global fixed income. I am very active in currencies.

When I first came to the markets, I was taken aback by how superficial the market’s understanding of economics was. Not stupid, but superficial in the most neutral sense of the word. This was particularly true in emerging markets. It seemed that guys would have a hunch, based on price action or intuition, and then would reverse engineer a story that to them would explain what they saw or felt. In other words: the conclusion comes first and the investment hypothesis would then follow.

But these guys made money—at least, for the most part. To me, this did not compute. How did guys who didn’t even understand basic macroeconomic identities or dynamics successfully manage money? I was highly skeptical of EMH (the Efficient Market Hypothesis) well before I came to the markets. But from my first contact with animal spirits I realized that I had still vastly overestimated man’s abilities to be that textbook rational maximizer of utility.

All this got me thinking and reading. I started to consume books on technical analysis and, importantly, behavioral economics—a discipline that didn’t exist when I went to grad school. A conclusion soon started to emerge: good risk management was far more important than good ideas in money management (more on this later). And a good understanding of market psychology, positioning, and technical analysis were central to risk management.

Exploring the growing literature on behavioral economics and finance also helped me put labels on the many ways in which the standard economic and financial models failed capture the actual behavior of economic agents. This was hugely liberating. By identifying the systematic ways in which the efficient market logic fell short, it validated much of what I was observing. The implications for the reigning ideology of the past 30 years of free, equilibrating, self-regulating markets were profound.

The aspiration of this blog is not cure the world of cognitive biases. Rather, by trying to put global macro issues and markets in a more behavioral context, the hope would be that we might be able to better recognize situations in which our biases are likely to surface so that we—whether as analyst or risk taker—can make that extra effort to try to avoid the systematic pitfalls inherent in the human condition. Not everything will have a behavioral angle to it either; I intend to splash down ideas wherever I think my background might lend itself to insight into current economics, finance, or politics.

In recent months I have become fairly active on Twitter (@mark_dow), and in recent years I have written articles and guest-blogged from time to time. But writing in my own blog is a new experience, one I am likely to take a step at a time. Not sure how it will go, or how often I’ll post. So, for those interested, please bear with me while I work things out.

Mark Dow