Category Archives: speculation

It takes 2 to tango, and 3 to intermediate.

The Wall Street Journal ran a story last week about Citigroup and Deutsche losing money on the oil hedge they sold to Mexico. The article talks of a loss totaling $5 million on a put sold for a premium of $450 million, so, in the grand scheme of things, this is not a big matter. However, it does raise an interesting puzzle in light of the Volcker Rule’s prohibition against proprietary trading.

Matt Levine over at Bloomberg does a nice job of dissecting what the banks are doing in the deals with Mexico. It’s part intermediation – taking a portion of the oil price risk from Mexico and reselling it through the oil futures market. But it’s also part acting as a principal – taking another portion of the oil price risk from Mexico and putting it onto their own balance sheets.

Are they allowed to do that – put the oil price risk onto their balance sheet? How is that different from proprietary trading? If Mexico weren’t involved, and the other side of the trade were a hedge fund, would that be any different, as far as safety and soundness is concerned?

Matt Levine thinks the story is a nice example of the banks doing their job. Sure enough, it’s a job that needs being done. But is it really the job of the banks to warehouse oil price risk? It may be socially useful, it may be a valuable financial activity, but it’s not an activity that belongs on a bank balance sheet. Levine’s column reflects how hard it is to get away from the old mentality in which banks think their job is to sell their balance sheet. The problem is, of course, that it isn’t their balance sheet that they are selling. It’s the taxpayers’.

Riddle or Ridicule? Reprise or Rehash?

One of my husband’s many incisive stories from his career as an educator reports on an incident in the teachers’ lounge at a high school after an exam. In comes one of the more senior teachers, griping about his students’ poor performances: “I’ve given the same exam now for 20 years, and they still get the same questions wrong.” My husband, of course, thinks the teacher’s complaint reflects more on the teacher’s weaknesses than on the students’.

I was reminded of this story by University of Houston Finance Professor Craig Pirrong’s blog post complaining that although he has been making the same argument since 2008, the critics of speculation still don’t get it. Speculation, he claims to prove, cannot cause price levels to trend up.

In his blog, Professor Pirrong’s favorite pose is ridicule, and this post is no exception. He proclaims his argument is just an application of basic finance theory, which the critics of speculation are too dim to appreciate. But, a number of well credentialed economists who are well versed in basic finance theory take exception to Pirrong’s argument. In particular, I’ve written elsewhere that speculation can cause the price of oil to trend up. We can have a reasoned argument about speculation and price levels, but it’s time to drop the ridicule.

Like the pompous high school teacher who wielded his authority against his students, Professor Pirrong brandishes his knowledge of finance against the untrained complaints of the public about speculation and proudly announces himself the victor. It is true that many of the untrained critiques of speculation imagine a simple, overly mechanical relationship between the volume of speculation and the level of prices. But where is the glory in taking an untrained critique and finding a flaw?

The volume of speculation matters. It may not be a regular direct cause of a price bubble or other problems in a commodity market. But it can be a symptom and it can be an indirect cause and it can also occasionally be a direct cause. Ignoring the volume of speculation is foolhardy.

Professor Pirrong is extreme in the weight he gives to ridicule in his argumentation. There are plenty of other economists who share his underlying critique, while maintaining a more respectful demeanor in the conversation. The annual convention of economists is taking place right now, and the issue of commodity speculation is on the agenda in a couple of sessions, including one on Saturday afternoon sponsored by the International Association of Energy Economists and the American Economics Association. There will be plenty of space given to the critique that speculation has not been responsible for moving prices. But there will also be presentations by other credentialed economists whose talks will reflect the same stubborn ignorance of the basic finance for which Professor Pirrong chides less credentialed critics. I will be among them. I’m looking forward to a substantive discussion free of invective.

CSI: prop trading investigation squad.

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.’

 

Piazzesi et al.

Let me explain.

Continue reading

Dynamic Hedging or Futile Speculation?

chesapeake

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.

Continue reading

Prop Trading at JP Morgan

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.

 

 

Prop-Flow stands convicted, too.

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.

SEC Staff examines copper ETFs with blinders on

The SEC is currently considering whether to allow JP Morgan and Blackrock to list new copper ETF’s on the NYSE Arca. Some copper industry players oppose the listing, as does U.S. Senator Carl Levin and the advocacy group Americans for Financial Reform. Comment letters can be found here. Earlier this month, SEC Staff in the Division of Risk, Strategy, and Financial Innovation filed a memo reporting its empirical analysis that downplays any potential problem. That memo is a testament to how America’s financial regulators too often fail in their duty to protect the sound functioning of US financial markets.

The SEC staff asks two narrow questions.

First, is there a simple and enduring mechanical link between the flow of money into a commodity ETF and the price of copper. They answer, ‘no.’

Second, is there a simple linear relationship between copper inventories and copper prices. Again, they answer, ‘no.’

The Staff’s analysis is faulty in many ways. Both industry players and the advocacy group Americans for Financial Reform filed careful, detailed critiques of the econometrics and reasoning. These are well worth reading, and thoroughly impugn the soundness of the Staff’s conclusions.

What alarms me most is the narrow scope of the questions that the Staff posed, even had they bothered to do a thorough analysis of those questions. A proper regulator needs to assure that the market functions well. There are any number of ways in which its operation can be disrupted. We have a long, long history of commodity markets in the US, and that means we have a long history with market manipulation and other price distortions. We have a long, long history with financial markets in the US, and that means we have many experiences with asset bubbles, especially in the recent past with the dotcom and housing bubbles, as well as the oil price bubble. Neither of the two empirical tests the SEC Staff examined touches in any way on the issues one would want to examine in order to assure the sound functioning of the copper market and the healthy contribution that financial trading could make to the market. The mechanical link the Staff searched for would not show up in a market rife with manipulation. Nor is that mechanical link necessarily symptomatic of an asset price bubble. So failing to find such a link provides no assurances that this market will function properly. And it is alarming that the SEC Staff does not explore any of these other important issues that must be settled. Just as the SEC Staff did in the Madoff case, it carefully asks the wrong questions and thereby comes to easy answers.

Personally, I’m confident that financial markets have a valuable contribution to make in extending the efficiency and productivity of the real economy. I believe that’s true for all commodity markets as well, copper included. But making that happen requires active engagement by US regulators, and not a ‘see no evil’, hands off, laissez faire approach. That way lies market disruption and an undermining of the productivity of the economy.

The SEC can do better. It must. American industry depends on it.

Was Ina Drew a Hedger or a Speculator?

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.

Continue reading

Chesapeake’s Two Natures

In yesterday’s post I said that Chesapeake’s management was speculating on natural gas and oil prices. But Chesapeake claims that it is a hedger. Speculating and hedging are different things, so is Chesapeake a hedger or a speculator?

In representations to regulators, Chesapeake’s Vice President for Finance and Assistant Treasurer, Elliot Chambers, has stated categorically that “we never speculate.” Is that true? Is his definition of a speculator the same as mine?

Chesapeake is a hedger. It uses exchange traded futures and options, OTC swaps, and a specialized financing vehicle called Volumetric Production Payments, among other things, to mitigate the price risk on its production and “predict with greater certainty the effective prices we will receive for our hedged production.” (10K for FY2011 p. 72)

But Chesapeake is also a speculator. The company is straightforward in its SEC filings that it tries to profit off of price swings: “We intend to use this volatility to our benefit by taking advantage of prices when they reach levels that management believes are either unsustainable for the long term or provide unusually high rates of return on our invested capital.” (10K for FY2011 p. 6) “Depending on changes in natural gas and oil futures markets and management’s view of underlying natural gas and oil supply and demand trends, we may increase or decrease our current derivative positions.” (10K for FY2011 p. 59) “Our general strategy for attempting to mitigate exposure to adverse natural gas and oil price changes is to hedge into strengthening natural gas and oil futures markets when prices allow us to generate higher cash margins and when we view prices to be in the upper range of our predicted future price range. Information we consider in forming an opinion about future prices includes general economic conditions, industrial output levels and expectations, producer breakeven cost structures, liquefied natural gas trends, natural gas and oil storage inventory levels, industry decline rates for base production and weather trends.” (10K for FY2011 p. 87) As I related in yesterday’s post, Chesapeake’s decision last fall to remove its natural gas hedge was based on its prediction that prices were temporarily low and would recover, allowing it to replace the hedges and capturing a profit on the short-run volatility. This is all speculation.

A company can be both a hedger and a speculator.

Continue reading

Chesapeake takes its eye off the ball

Chesapeake Energy has been going through a shake-up of late, most recently at Friday’s shareholder meeting. The low, low price of natural gas is contributing to a cash squeeze. This has made all the more vital the many debates about corporate governance and the company’s investment strategy. To the list of items needing review, I would add the management’s short-term speculations on natural gas and oil prices.

Here’s a slide from a deck distributed in advance of last week’s meeting:

Continue reading

Follow

Get every new post delivered to your Inbox.

Join 30 other followers