Does JP Morgan’s derivative portfolio hedge its other lines of business? This picture says ‘no’.
Does JP Morgan’s use derivatives to make prop trade bets on interest rates. This picture suggests ‘yes.’
Let me explain.
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Lenos Trigeorgis has a piece in the Financial Times’ Economists’ Forum advocating the use of GDP-linked bonds for Cyprus.
Suppose that its steady-state GDP growth is 4 per cent and that fixed interest on EU rescue loans is 3% per cent Instead of the fixed rate loan, Cyprus could issue bonds paying interest at its GDP growth minus 1% (the difference between the average growth rate and the EU bailout rate). If GDP growth next year is 0 per cent, lenders would pay the Cypriot government 1%, providing Cyprus with some relief in hard times. But if after, say, 10 years GDP growth is 7 per cent, lenders would instead receive 6 per cent. In essence, during recession EU lenders will provide insurance and interest subsidy to troubled Eurozone members, helping them pull themselves up, in exchange for higher growth returns during good times. Increased interest bills in good times might also discourage governments from sliding back into bad habits.
As we’ve written in a couple of earlier posts, this is easier said than done. But it’s certainly thinking along the right lines.
Our paper on end-users and the cost of margins is now out in Morgan Stanley’s Journal of Applied Corporate Finance.
Chesapeake still thinks it can time the market.
On Tuesday management held its Conference Call to update to investors and stock analysts. Steve Dixon, the acting CEO, said “We’ve also taken advantage of the recent surge in natural gas prices to lock in additional price protection in 2013, and we have begun to hedge natural gas production in 2014 at prices well above $4, a level the market has not seen for some time.”
The company has had problems in the past from its foolish attempts to time natural gas prices. Last time prices were falling and the company took off its hedges. This time prices are rising and its putting on hedges. But the mindset is the same.
Behind this dynamic hedging strategy is a common misunderstanding about mean reversion in natural gas prices. The same misunderstanding applies to other commodities as well.
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January 25, 2013 – 9:19 am
Representative Dave Camp, Republican Chairman of the House Ways and Means Committee, has released a discussion draft on new rules for the taxation of derivatives. The press release is here. Detail material is found here.
In the draft, derivatives used for hedging are excluded. The criteria proposed here for determining whether a derivative is used for hedging in tax accounting are similar to the criteria already applied in financial accounting. However, a large fraction of derivatives held by non-financial companies are not accounted for using hedge accounting. So, it seems to me that this proposal would probably affect the tax treatment of those holdings.
It will be interesting to see how this discussion unfolds.
January 17, 2013 – 5:59 pm
Companies that hedge oil prices have been forced to reevaluate their strategies over the last couple of years. Many companies have used the NYMEX WTI contract, one of the oldest energy futures contracts and still one of the most liquid. The WTI contract is for oil delivered into Cushing, Oklahoma, but since crude oil is a global commodity and transportation links have historically been good, fluctuations in the WTI price have been a reasonable benchmark for global supply and demand.
However, in the last few years, the differential between WTI and Brent, the other leading global benchmark, have exploded and been very volatile. Suddenly, geography made a great deal of difference. Technology has opened up new production in North America, first from the Canadian oil sands and more recently from US tight oil fields. A bottleneck in the capacity of pipelines for shipping production out of Oklahoma down to the US Gulf Coast meant that the central US experienced a glut of supply, disconnecting the regional price from the global one.
This has meant that fluctuations in NYMEX’s WTI futures price reflected local variations in demand and supply that did not necessarily track variations in global supply and demand and global crude price. Hedgers not located in the central US faced increasing basis risk in using the WTI contract. Some switched to using the ICE Brent contract instead. Others adjusted their hedge ratios. These events have been a key feature of the recent marketing duels between NYMEX and ICE over which contract is best.
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January 16, 2013 – 5:54 pm
JPMorgan’s management released its Task Force Report (Report) on the trading losses at its Chief Investment Office (CIO). It’s very clearly written tick-tock and provides a good account of how various controls broke down. Taking for granted the task assigned to the traders running the CIO’s Synthetic Credit Portfolio, the report outlines where things went wrong.
As an accident of timing, the losses were first disclosed in the midst of a public debate about the Volcker Rule’s prohibition on proprietary trading at banks. So, for the public, the case became a test of whether the proposed regulations implementing the Volcker Rule had any teeth: would they prohibit the trades being done at JPMorgan’s CIO once they came into force? Management has always contended that the Synthetic Credit Portfolio was run to hedge the bank’s natural long position in credit risk, and that it was not proprietary trading and would not be prohibited under the Volcker Rule. That contention is repeated summarily in the Report when it gives an introductory overview of the Portfolio’s origin and operation. But, the contention is never actually substantiated: indeed, the Report does not purport to address the prop trading question directly.
There is much in the Report that would lead a reader to doubt management’s contention and to conclude instead that the Synthetic Credit Portfolio was a classic example of prop trading.
A key forensic test for distinguishing prop trading from hedging is the compensation criteria. A hedger’s success is not measured by his or her own profit and loss on the hedge trades. Instead, a hedger’s success is measured by how well his or her own profits and losses track and set off the losses and profits on the assets being hedged. The metrics for performance on hedging should incentivize minimizing net risk. The metrics should measure net risk reduction. When the desk reports big profits — after netting out the matched positions — that’s a bad sign, not a good one. The JPMorgan Report strongly suggests that the traders on the Synthetic Credit Portfolio expected to be rewarded on their own profit and loss, not on how successfully they hedged the bank’s natural long position. That compensation system fits prop trading, not hedging.
The Report does briefly consider the wisdom of the compensation scheme, but not from the perspective of the Volcker Rule and identifying prohibited activities. Instead, the Task Force was just concerned with the question of whether the profit and loss criterion was overvalued to the exclusion of other criteria management imposed on the unit.
So, it looks as if JPMorgan’s CIO, and its Synthetic Credit Portfolio provide a useful test case for the Volcker Rule going forward. The original regulations proposed for implementing the Rule did include an assessment of compensation criteria. Whether that will continue in a final rule is yet to be seen. And then comes the question of enforcement.
January 7, 2013 – 2:25 pm
Liam Denning’s Heard on the Street column in this morning’s Wall Street Journal is reliably hard-nosed about budget trade-offs:
Investors want it all—but they should be careful about companies that promise it.
ConocoPhillips is a case in point. … E&P stocks tend to compete on growth, whereas the integrated majors are prized for how much cash they return to shareholders. Conoco offers both. It targets annual production growth of between 3% and 5% a year out to 2016. And it offers a dividend yield of 4.6%, around double the average for its peers.
What’s not to like about that?
…Conoco’s near-term strategy implicitly relies on high oil prices, not merely to provide operating cash flows but also to attract high prices for disposals. The danger is not that Conoco suddenly can’t pay its dividend; indeed, it has prioritized it. Rather, it is that weaker prices or unexpected costs would upset the cash-flow math and force investors to dial back their enhanced expectations–and Conoco’s valuation with them.
Conoco’s exposure to oil prices is a matter of choice, not circumstances. The company does practically no hedging. The company’s stated “policy is to remain exposed to the market price of commodities.” In fact, the company takes this curious commitment so far that “we use swap contracts to convert fixed-price sales contracts which are often requested by natural gas and refined product customers, to floating market prices.”[1]
Conoco has good company as a non-hedger. We’ve written before about the notable fact that ExxonMobil refuses to hedge. But even among smaller E&P firms, roughly 50% of the firms report no hedges at all in any given year.[2]
Perhaps Conoco can afford to remain exposed. Its balance sheet is in very good shape so that it has unused debt capacity which could cover some shortfall. Nevertheless, if exposure to commodity prices were truly a threat to Conoco’s twin goals of investing for growth and paying a reliable dividend, the company could do something about that. But to do so would require giving up its third goal of being fully exposed to oil prices.
Two out of three ain’t bad.
[1] ConocoPhillips Form 10-K for FY2011, p. 74.
[2] Haushalter, G. David, 2000, Financing Policy, Basis Risk and Corporate Hedging: Evidence from Oil and Gas Producers, Journal of Finance 55, 107-152.
November 21, 2012 – 10:30 am
The trial of UBS trader Kweku Adoboli ended yesterday with his conviction on two counts of fraud and the dismissal of the accounting allegations. Some news accounts have noted that testimony at the trial also exposed embarrassingly shoddy risk management at UBS. Prop-flow also stands convicted.
Prop-flow is one of those wonderful neologisms of the investment banking world. UBS’s Delta One desk, where Kweku Adoboli was employed, is a classic example of the prop-flow trading model. Ostensibly, a Delta One desk is serving customers, manufacturing risk exposures that the clients want, and earning revenue for providing that service. But the testimony at Adoboli’s trial leaves no doubt that his assignment was proprietary trading, pure and simple. He wasn’t convicted because he did prop trading, but because of how he did his prop trading. The testimony leaves no doubt that his UBS managers always expected him to be placing proprietary trading bets. The only dispute was about how those bets were managed and recorded, and the scale of the bets along the way.
How much tolerance bank Boards of Directors and bank regulators have for neologisms like prop-flow will be an important question in the coming years as the Volcker Rule and similar prohibitions come into force.
October 9, 2012 – 4:45 pm
This Sunday’s New York Times Magazine included a piece by Susan Dominus about Ina Drew, the former Chief Investment Officer (CIO) at JP Morgan who resigned following the outsized trading loss in her unit. The focus of the piece is on the rough and tumble of a woman trying “to succeed as an interloper in the Wall Street boys’ club. But buried within the piece is a repeated confusion of hedging with proprietary trading. Dominus repeatedly describes Drew as responsible for hedging this or that risk facing the bank, but immediately afterwards Dominus lauds Drew’s uncanny ability to predict where the market was heading and so to be a profit center. Since the question of whether JP Morgan’s CIO was or was not hedging is at the heart of the public policy dispute surrounding JP Morgan and the Volcker Rule (see here and here), it is worthwhile addressing the confusion in Dominus’ piece.
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