Wednesday, May 23, 2012

The Only Man in the World Who Knows What Really Went Wrong at JPMorgan Chase

And he is too busy to bother!

But he saw it and said it almost 15 years ago in his ground breaking Speculative Capital.

- “So, what about that $2 billion – now $3 billion – loss at JPMorgan,” I ask Nasser. “Any comment on the torrent of comments from all sides?”

- “Do you know what was the most significant and critical word in the hoopla?,” he asks.

- “No, I can’t say I know.”

- “It was morph. Jamie Dimon used it.”

I found the quote:
But JPMorgan’s top executives have rallied around Mr Dimon, who told shareholders at the bank’s annual meeting in Tampa, Florida: “I can’t justify it. Unfortunately, these mistakes were self-inflicted.” Mr Dimon added: “What this hedge morphed into violates our own principles.”
-“So?”, I ask.

He shows me what he is reading from Hegel::
Language has compressed within it what man has made his own; and what he has fashioned and expressed in speech contains, either embeded or elaborated, a category: so natural does logic come to him, or rather it is his own very nature".
- “I take it this relates to morph”?

-“Yes, it does. How do you think a Sandy Weill protégé could think of using a complex word like morph? It is impossible, unless he actually saw it. And he did see it – only in hindsight.”

- “I am getting confused. Explain, please.”

- “A few weeks before the $2 billion loss was announced, Dimon dismissed the rumors of trouble as the ‘tempest in the tea pot’.”

- “Right.”

- “Now, ask yourself: Why would he say that if he knew the trouble was brewing. Why would the CEO of a multi-trillion institution make a fool of himself, knowing the news will inevitably come out?”

- “A good question. Are you implying he did not know?”

- “Of course he didn’t. And the reason he didn’t is that there was nothing there – or very little – out the ordinary.”

- “And then the whole thing blew up.”

- “Correct.”

- “But how?”

- “Thanks to hedging. That safe action to ‘insulate oneself against the market turbulance’.”

- “And hedging became arbitrage. I know that part.”

- “Yup. That is the secret of speculative capital. In a dialectical process, which is what drives economics and finance, the phenomena produce their opposite from within. Remember some time ago I quoted Sartre that: ‘In the most adequate and satisfactory tool, there is a hidden violence which is the reverse of its docility.’ Conservative hedging shows its violent side, becomes its violent side, by turning into aggressive, self-destructive arbitrage. That is the central point of Vol. 1. You must remember it. I actually used the example of J.P. Morgan to develop the concept.”

I found the quote.
The purpose of hedging is to insulate the owners’ equity against the adverse changes in the markets. The owners’ equity is the difference between a firm’s assets and liabilities. (The same difference in the case of individuals is called “net worth.”) We can express this fundamental accounting relation through the following equation:
Owners’ Equity = Assets – Liabilities
The requirement and condition of hedging that the owners’ equity remain constant is the same as saying that it should not change. Or, its change must be zero.
For that condition to hold, the change in the right hand side of the accounting relation, above, must also be zero. That is:
change (Assets) – change (Liabilities) = 0
The equation above shows the requirement for a hedge: the change in the value of assets must be equal to the change in the value of liabilities. That is called “matching” assets and liabilities.
The purpose of hedging is preserving the owners’ equity. The hedger begins with an existing asset (liability) and seeks to find a liability (asset) which will offset its adverse price changes.
The purpose of arbitrage, by contrast, is profit. The arbitrageur has neither an asset nor a liability. To that end, he uses the final relation of the hedge to search for any two positions which will enable him to “lock in” a spread. The two acts are mathematically indistinguishable.
What logically separates them is the purpose of each act which translates itself to the sequence of execution of trades. When done sequentially, the act is defensive hedging. When done simultaneously, it is aggressive arbitrage. Otherwise, the transformation of one to the other is seamless.
-“So you are saying that conservative hedging in front of Jamie Dimon’s eyes turned into self destructive arbitrage.”

-“Exactly. And in looking back trying to find out what had gone wrong, he saw that 'turning into'; hence his use of ‘morph.’ Hegel is right about language embedding logic which is innate to man; see how a Queens native not known for his eloquence comes up with the mot juste as if he were Elliot! I wish I had used the word in Vol. 1! Only he had not read my book and naturally could not see the essence of the loss. Just like that Times music critic you quote in your blog: he is looking at it, seeing it and even saying it, but does not understand it because he is on a ‘lower' plane’, as you explained.”

-“Good connection! It is very ironic that the likes of Jamie Dimon and JPMorgan who owe their rise to the rise of speculative capital are in the last take also its victims.

-“What do you suppose I mean when I repeatedly emphasize that speculative capital is self-destructive?”

-“Got it! But Nasser, hedging was around for the better part of the 20th century. All farmers hedge their positions in Chicago exchanges. Where was speculative capital then. How come no one noticed it?”

-“Some trace hedging even longer, to the 17th century Japan or the ancient Greece. But then, hedging was harmless. Hedging is merely a form. I explained this point in Vol. 2. You should be able to find it. But you are on your own if your readers start asking questions about options!”

I found the quote.
Derivative products, as many finance books are quick to remind us, have been around for many years. They can hardly be called innovative. There is certainly nothing new about the form of derivatives. What is new is the driving force of speculative capital behind them which makes them appear as resisting regulation. This force is infinitely more potent than what Japanese or Dutch peasants could  muster centuries ago. The use of options by the manager of a multi-billion dollar hedge fund has quite a different implications than the use of the same instrument by a 17th century Japanese farmer. 
How speculative capital transforms derivatives and even makes their valuation possible becomes apparent if we transport them to a hypothetical 17th century Japanese village and look at their use to a certain farmer Hiroki. 
Hiroki could certainly use the derivatives as an instrument of bet. He could, for example, sell wheat forward for 10 yens, even though he does not own any wheat. He is a rice farmer. Then, at contract delivery time, if wheat is above 10 yen, he will make money. Otherwise, he will lose. There is nothing new there. The time lag between inception of contract and delivery time in derivatives lends itself to betting. 
But derivatives also have a hedging function. Let us assume that Hiroki is concerned about the falling price of his rice, currently at 10 yen per unit. He could sell rice forwards, but we cannot speak of a “cost-of-carry.” Even if a village usurer is around to lend at 30 percent, farmer Hiroki must accept the forward price as set by the landlord. That is because speculative capital that could, through arbitrage, bring about the “equilibrium” price of 13 yen is as yet unknown. 
Options valuation is even more ludicrous. Just imagine farmer Hiroki constantly adjusting the composition of his rice and interest bearing “portfolio” to replicate the value of rice options! Without speculative capital, the option valuation, as suggested by Black, Scholes and Merton is not logical. That is, despite the model’s mathematical nature, its is not, like a mathematical operation, unconditionally true across space and time. It presupposes the existence of speculative capital and thus, cannot be derived in the environment of farmer Hiroki. 
That explains why the original paper by Black and Scholes was not accepted for publication for more than a year. Fischer Black mistakenly attributed the difficulty of publishing the paper to his “non-academic return address.” But more than a bias against non-academic authors or a high standard in publication was at work there. The fact is that in 1970, speculative capital had not been sufficiently developed to impress itself upon the conscious of academic scholars. That is why an option valuation formula had to await the emergence of a modern financial market in the first place.


  1. This seems like a lot of weight to place upon Dimon's choice of the not-especially-esoteric word "morph." After all, back in 2008, Nokia created a mobile phone it called the Morph, just as a "concept phone" to show where mobile devices might be headed. It was unveiled with a good deal of hoopla, involving Cambridge University and the Museum of Modern Art. I suspect that in Dimon's circles, "morph" isn't all that rare a word.

  2. Chris,

    Totally correct that morph is not a particularly esoteric word per se but who used it was what attracted Nasser's attention. Morph is an abstract term. It is not a part of the daily business jargon. Listen to, or better yet, read, captains of industry and you will see how they talk. As Nasser pointed out in a commentary on Stanford U. , the business card of Mark Zuckerberg who is held up ad nauseum as the role model for the entire world said: "I the CEO, bitch." That's how business leaders talk. Google Dimon's even official and prepared speeches, and you will see.

    And then suddenly, this man says that "the position morphed." What Nasser was saying was that the word perfectly described what had taken place, which was transformation (morphing) of harmless hedging to self-destructive arbitrage. That is the genesis of Speculative Capital and Nasser's great discovery.

    But Dimon did not know that. Yet, he used the perfectly precise word-- like getting a code word right. That could only mean that in looking back he saw the actual morphing of the bank's positions. Hence, perhaps, his humility and bafflement about "not understanding".