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 17^th century Japanese farmer. 

How speculative capital transforms derivatives and even makes their valuation possible becomes apparent if we transport them to a hypothetical 17^th 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.

‘No Country For Old Men’ - 3: When Virtuoso Are a Dime a Dozen

Last August (14, 2011, p. AR1), The New York Times ran an article about the profusion of piano virtuosos. Under the apt title Virtuosos Becoming a Dime a Dozen, it said:

The overall level of technical perfection in instrumental playing, especially on the piano, has increased steadily over time … And in the last decade of so the growth of technical proficiency has seemed exponential. Yes, [the 24-year old Chinese] Ms. Wang, who will make her New York recital debut at Carnegie Hall … can play anything. But in China alone, in recent years, there have been Lang Lang and Yundi Li…

After reciting these examples, the writer, one Anthony Tommasini, turned analytical:

What long-term effect this trend will have on the field is not clear. Classical music is facing its share of challenges, including declining appreciations of the art form among the general public, and not all segments of the audience are noticing the breakthrough in technical accomplishment that is apparent to insiders.

Almost 15 years ago, Nasser said that the rise of speculative capital is a rational phenomenon. Because of that rationality, every stage of speculative capital’s development on its march towards the inevitable crisis appears logical; the stages follow one another the way conclusions follow from antecedents. That is why none of the luminaries of business and academia could answer Queen Elizabeth’s famous question about the onset of the crisis: “Why did no one see it coming?” To see the crisis coming, one had to situate himself on a higher plane of consciousness, where alone the contradictions at the preceding, lower stage could be discerned and resolved. Read Nasser’s Speculative Capital, Vol. 1. written a full decade before the onset of the ongoing crisis to see what I mean.

Dialectic is at work everywhere, not only in finance. Hence, the prevalence the “inability to see”. Witness the Times’ music critic’s comments. Not in a million years would he suspect – let alone realize – that the long-term effect of virtuosos being a dime a dozen is already crystal clear. It is the declining “appreciation” of classical music among the general public. In fact, like a good virtuoso of the history of music, the man even provides the answer when he writes that: “The first several decades of the 20th century are considered a golden era by many piano buffs, a time when artistic imagination and musical richness were valued more than the technical perfection … But audiences and critics then tolerated a lot of playing that would be considered sloppy today.”

He writes that but does not understand what he is saying.

Let me begin by commenting first that per se, there is nothing wrong with virtuosity, playing all the notes correctly, in the same way that there is nothing per se wrong with knowing how to spell difficult words. But musical virtuosos and spelling bee virtuosos achieve their technical wizardry at the expense of the content of their discipline; virtuosos are folks who have gone astray. The sequence of their “development” is that first, they lose sight of what is important in their field – spelling bee champions lose sight of what the literacy is all about; piano virtuosos what music is all about – and then they become virtuosos. Both deviations are rooted in vanity. Both arise – seemingly ironically, but in fact quite logically – because the alternative is more difficult.

I explain.

If the technical skills in piano playing have continuously improved as per the Times article, one must assume that the trend will continue. It is implausible to take the position that the current players have reached the absolute level of technical perfection.

Yet, what form would the technical improvement in the future take? How could players who could play anything improve further?

Imagine a virtuoso who can play the Chopin etudes standing on his head. That could certainly be an accomplishment, as it is tremendously difficult to play an even short and simple piece standing on one’s head.

But we can top that. Imagine a virtuoso who can play Chopin etudes flawlessly while standing on his head and juggling two oranges with his feet.

How’s that for virtuosity?

We can go still further. Imagine a virtuoso who can play Appassionata and make piano obsolete by playing it on a single key. How, you ask?

Our virtuoso would be so devilishly fast that she could reach for the string attached to the key and increase or decrease its length by the exact amount that is needed for it to sound A, B, D, etc. She could do that in one millionth of a second, without compromising the sound or the interval between the notes.

Try topping that.

In the case you are wondering, this absurdity is already de rigueur in the stock market in the form of high-frequency trading, a subject which Nasser critiqued in a 9-part series.

Returning to the music and setting aside the implausibility of “high frequency playing”, ask yourself: in which way would such a superhuman performance enhance the joy of hearing Appassionata and understanding and appreciating it?

The answer is: in no way. In fact such an incredible performance will serve to overshadow and finally bury the purpose behind the Appassionata. As we approach performance that is closer to circus, we necessarily get further away from music.

The modern-day virtuosos stand midway between those two poles, their path having been blazed by the likes of Liberace.

The cause and effect relation is never one directional. Rise in virtuosity is also a response to declining interest by the public in classical music. So the technical wizardry, like the suggestive poses or clownish conduct, is used as a bait to lure audiences to the concert halls.

Why the public loses interest in classic music is a subject best left for Nasser in the upcoming volume of Speculative Capital. By way of anticipation, he shows that society’s condition of life makes its members atomized and divided, with the result that they are incapable of decoding the language of music which is about social spirit. For an excellent introduction, read his What Lies Behind the Descent of Man.

Conductors arise from amongst this confused and divided mass. So, they cannot understand and interpret the music either. Even if they could, the audience would not “get” them. In this way, the condition is set for the rise of virtuosos, technical wizardry to overcompensate for the lack of understanding.

In the concluding sentence of Part 2, I asked: How does a Chinese female virtuoso play Beethoven?

I answered: masterfully and uncomprehendingly. That answer must now be clear. She plays the notes with perfection, in the same way that she might read the words of The Phenomenology of Mind with perfection. But she does not understand what she is playing – or reading.

To understand Beethoven, one must know Beethoven, Hegel, Kant, German, Germany, The French Revolution, the rise and fall of Napoleon, Kant, Christianity, with hundreds of related topics – big and small – thrown in for good measure.

Do not read too much in to “know”. I am using it in the same vein that I would speak of a Shiite peasant in Afghanistan knowing the quality of a passion play about Ali’s martyrdom. He need not be a scholar to judge the quality of what he is seeing and hearing. But a 24-year Chinese girl, precisely because she is not German and would not know the culture innately, must strive to know him through education, with all the related areas which are listed above.

That’s a tall order, bordering on the impossible. Better to focus on the notes and get them right.

That is the stuff the virtuosos are made of.

If one truly knows music, it would not be of paramount importance to get all the notes right. What difference does it make if you understand T.S. Elliot poetry but mispronounce a few words?

The focus on the big theme or the grand narrative of the music, without paying much attention to the individual notes to the point of actually changing the notes according to the mood of the moment, is the idea behind the improvisation which has a long and honorable place in Eastern music.

In the West, too, improvisation is what makes jazz and blues what they are. Watch this scene from the 1950 Hollywood movie Young Man with a Horn starting Kirk Douglas.

(Youtube removed the video because of a copyright dispute, but it still has the entire movie here. Watch from 21:13 to 22: 55. Douglas's performance from 22:46 to 22:48, when he is playing the notes “correctly” as per the band leader’s direction, is memorable. You can stop after 22:55)

In classical music, you could not change the notes. But you could “skip” them. “Skipping” notes was a common practice by the master pianist of the early 20th century, the “golden era” of piano according to the Times critic. The incomparable contemporary pianist, the anti-circus performer par excellence, Krystian Zimmerman, explains the point. You must listen to the entire 2008 BBC interview with him. It offers an invaluable insight to music and what it is all about. In the beginning, below, Zimmerman notes that “music is not an audio experience”. He then goes on to refute “virtuosity” and explains, through an example of Alfred Cortot, the logic behind what the ignorant Times critic calls “sloppy playing”, a style than only an intelligent player who “dives under the distortion” could execute. Listen:

Here are the links to the rest of the interview: Part 2, Part 3, Part 4 and Part 5. “Music is not sound,” he says. “Music is organizing people’s emotions in time”. And leading them, I must add – organizing for composer, leading for the conductor, who can add his own way of “reading” to the piece. A Julliard graduate might conceivably know of these concepts but he or she can never put them into practice because the prerequisite which is the connection with the audience is not there. Let us once again return to the New York Philharmonic. Play the video and watch the body language of the performers.

The sound they produce is perfect, notewise. But it is empty. Look at their faces and body language, say, from 0:31-0:38 or 4:59-5:08. They play music with the same passion that prostitutes have sex. It is a job and pays the bills, so they go through the motions – and they are good at it. The only reason that they do not take a peek at their watches is because they know exactly how much time is elapsed and how much more is left to finish the piece, take a bow to the uncomprehending men and women in the audience who habitually give them a standing ovation – with the occasional shout of ‘bravo!’ from a few particularly egregious fools – and go home until next time. Any assembly-line worker would readily understand their sentiments! (The indifference bordering on disdain when they stop playing comes through at 0:36-0:38). Such musicians do not lend themselves to being conducted, being told, being led. They already know how to play. And what is that nonsense about being led? In this way, orchestras self-destruct. Who needs mechanical players when you’ve got synthesizers? And who needs conductors when you've got mechanical players? So, the conductor becomes a prop, a human metronome whose only function is to “keep the beat”. You can read some gems arguing that point here, here and here.

To conduct is to lead. The conditions have conspired to conceal that role from the public. But the evidence is out there.

I will return with the evidence.