Moreover, the current battle over financial reform and the Volcker Rule gives bankers an incentive to escalate the confusion. They want to continue their speculative trading, and that can only be done by labeling it either hedging or market making. Clarity is not their ally. When regulators, legislators and pundits advocate bright line tests for hedging, these bankers ridicule them as simpletons, accusing them of applying a dangerously unsophisticated understanding of financial markets drawn from a bygone era. These simpletons, they complain, fail to grasp the complexity of the modern world that bankers are tasked with mastering in order to serve the needs of society.

So, in order to try to make some progress and gain some insight from the JP Morgan case, let us first step back from the details of the current trades and losses, and from the debate over the Volcker Rule, and instead gain some clarity on the concept of hedging. Then we can double back and analyze the JP Morgan case in light of a sensible notion of hedging.

Two points about hedging…

#1. Theory: What is a hedge? How is hedging related to speculation?

A hedge is a trade that reduces risk. Full stop.

In many instances, a hedge is a transaction made in a competitive financial market so that risk is transferred at a fair price. The party laying off the risk must surrender some return, too. But it’s a fair trade. Putting on a hedge is a zero NPV transaction. There are no direct gains from hedging, although there can be indirect gains such as reducing the costs of financial distress.

Hedging and speculating are opposites. A hedge is a trade that reduces risk. A speculation is a trade that involves taking on risk. Typically, the speculator hopes to make an outsized gain in exchange for taking on the risk, while typically the hedger expects to surrender the market’s required return premium as a requirement for being relieved of the risk.

#2. Practice: What defines a hedge? How is it differentiated from a speculation?

A lone trader can employ willy nilly any criteria he or she likes in evaluating whether this or that trade is a hedge. But when trading is conducted inside a larger organization—like a bank or a non-financial company—where there must be accountability within the organization on the implementation of the organization’s strategy and adherence to the organization’s controls, it is essential to develop a sound empirical definition of a hedge. It is not enough for a trader to proclaim that she or he “knows” a trade is a hedge.

For example, accounting standards impose a burden of proof on a corporation that seeks to use hedge accounting for a given transaction. These include things like a requirement that the underlying assets being hedged – whether one security or a portfolio, or some other item – be clearly identified up front, and a requirement that the efficacy of the hedge be statistically demonstrated, and so on.

What constitutes sufficient evidence may vary according to circumstances and according to who is exercising control over whom. But in all events some standard must be identified or the concept is meaningless, and accountability and control within the organization is impossible. It is the ability to impose accountability and control that enables the organization to delegate authority and responsibility down to staff. Without accountability and control, the organization’s capability shrinks. Because a majority of hedges can be demonstrated to be hedges, it is therefore possible to assign employees the task of implementing a hedging strategy. Insofar as it is difficult to evidence that certain trades are in fact hedges, it is impossible for authority to be granted for those trades to be run – at least unless there is an effective and reliable form of control.

The public interest in the safety and soundness of the banking system, and the taxpayers’ interest in avoiding bailouts of failed banks, imposes a need for public accountability and control on bank investments. This may be exercised through supervisory agencies, and it may be exercised through legislative mandate. The Volcker Rule is one such mandate. For the public interest to be protected, it is essential that there be a standard of empirical proof for any claim that some set of transactions are allowed as a hedge: “show me they are a hedge.” Without a burden to provide evidence the transactions are a hedge, it is impossible for the public interest to be exercised. “Trust me” is not accountability. Insofar as it is difficult to evidence to supervisory agencies that certain trades are in fact hedges, it is impossible for the public to extend license for bankers to make those trades.

…and now to double back to the issue of JP Morgan.

To date, there is very little public information on the details of JP Morgan’s trades. Therefore, it is impossible to prove that they were not hedges. Of course, it is also the case that JP Morgan’s own insistence that they were hedges ring hollow until JP Morgan provides the necessary proof. Hopefully, the regulators and supervisors are being given more than mere assurances. Hopefully, the regulators will require more than mere assurances.

There has been a lot of discussion in the press about portfolio hedging, and whether portfolio hedging is a permissible activity under the Volcker Rule or a loophole allowing banks to evade the intent of the Volcker Rule. Properly defined, there is nothing wrong with portfolio hedging as opposed to hedging individual transactions. Indeed, the Dodd-Frank Act specifically allows hedging of aggregate positions. So why is portfolio hedging a hot topic? There are two reasons.

First, the term “portfolio hedging” is sometimes used as an excuse for poorly documented hedges. The real issue has nothing to do with whether the trade is hedging a single transaction or a portfolio. The real issue is complexity. But because it comes up more often and more sharply in larger combinations of securities and positions—i.e. in portfolios—the issue is mistakenly described as a problem of portfolio hedging.

Large portfolios inevitably are a bundle of many, many different risk factors. Layering on top of them any given transaction—the purported hedge—will alter the total risk and return of the portfolio in complicated ways. Therefore, evidencing that the given transaction is truly and certainly a hedge, to the satisfaction of a prescribed standard, becomes very, very difficult. Or, alternatively, in order to allow the purported hedge to pass muster, the standard is watered down so much that everything is a hedge. That is, there is no control.

So the real issue is not portfolio hedging. The real issue is whether or not there is any meaningful standard of accountability for what constitutes a portfolio hedge. If JP Morgan wants to call the CIO credit derivative trades a hedge in the sense of a portfolio hedge, that’s fine…, so long as JP Morgan’s claim is one that can be tested, i.e., so long as it is measured against a standard that meaningfully distinguishes true hedges and clear speculations. Otherwise, it’s just an excuse to neutralize public accountability and allow banks to do whatever they please.

Second, JP Morgan’s losing trades were a component of a dynamic portfolio strategy. The mandate of JP Morgan’s CIO involves running a complex, dynamic portfolio of investments in order to turn a profit. The positions in such a dynamic portfolio are constantly being adjusted. New investments are added, old positions are liquidated, weightings change and so on. Old positions can be liquidated by selling them, but the same result can be effected by layering on top of them a hedge. But the new trades layered on top may not actually be a hedge, but an essential element of the original dynamic strategy. Defining a hedge in the context of a larger, dynamic, speculative strategy is a more demanding task. The issue is not really one of portfolio hedging, although that’s the label it is given.

The bottom line is that in order for the public, via its regulatory agents, to sanction trades like those that lost $2 billion at JP Morgan, on the basis that these trades are a hedge, it is essential that the hedge claim be evidenced with data and against a meaningful standard that distinguishes hedges from speculations. Show me.

This is one of the key charts from Delta’s slideshow highlighting the rising crack spread Delta has paid over the last three years.

The possibility of further closures of East Coast refineries threatened to drive the local spread even higher, Delta claimed. Delta believes that by investing in the refinery, including $100 million in investments to shift even more of its production to jet fuel, it will be able to source its fuel cheaper and able to bargain better for the balance of its needs.

The title of Delta’s presentation reads “Addressing Rising Jet Fuel Risk”, and it does contain talk about how “jet fuel crack spreads cannot be cost-effectively hedged”, among other language evocative of risk management and hedging. But it would be a mistake to try and understand this as a hedge in the traditional sense. Delta isn’t trying to limit volatility: at least not volatility around a mean. It’s trying to put direct pressure on the mean level of the jet fuel spread. That’s a different thing entirely.

This is an attempt to gain a strategic advantage in the airline industry. Will it payoff? Apparently yes, according to Delta’s projections. Even if the Brent-WTI spread reverses and becomes negative and many East Coast refineries reopen for business, that will likely take longer than one year, as much time as Delta believes is needed to payback the investment. Time will tell.

___________________

Update: Liam Denning at the WSJ provides some useful statistics:

The Justice Department considers a market with a Herfindahl-Hirschman Index score above 2,500 to be “highly concentrated.” In 2010, the East Coast refining market’s score hit 3,255, against a nationwide one of 680, according to the Federal Trade Commission. If Pennsylvania’s Trainer facility had stayed idle rather than be bought by Delta, the score would likely have surpassed 4,000, according to the American Antitrust Institute.

You like tomato and I like tomahto,

Potato, potahto, tomato, tomahto!

Let’s call the whole thing off!

            from Let’s Call the Whole Thing Off by George & Ira Gershwin

This past Tuesday was the closing date for Comment Letters to the CFTC on its proposed Volcker Rule, and this gives us a second batch of responses to consider. The letter submitted by Morgan Stanley (back in February) is interesting because in Attachment 2, the company focuses specifically on commodities and provides three Example Customer Transactions that Morgan Stanley alleges would be impaired by the proposed Rule. These examples help to make concrete the actual activities that the banks allege are uniquely provided by banks and that are endangered by the Volcker Rule.

For today, let’s focus on just one of Morgan Stanley’s three examples:

Example B, Helping a Major U.S. Airline Reduce Jet Fuel Related Costs.

As part of a Chapter 11 restructuring, a leading U.S. airline sought Morgan Stanley’s help to reduce its operating costs, working capital requirements, and balance sheet usage associated with its jet fuel supply. Prior to bankruptcy, the airline managed a large jet fuel supply operation in which it maintained up to a month’s inventory, creating significant operational overhead and a need for costly financing. To reduce these expenses, Morgan Stanley provided the airline a long-term contract for delivery of jet fuel, typically one day prior to the airline’s daily need to service its fleet. Morgan Stanley provided all logistical support and sold the airline jet fuel at a lower price than it was paying previously. This enabled the airline to reduce its operating expenses, reduce the size of its balance sheet and lower its overall interest expense.

I’m missing the part where Morgan Stanley explains how this is market making. They may call this market making, but I call it the jet fuel logistics business. The airline is subcontracting out a specialized function, one step in the air travel value chain. Lots of companies subcontract certain functions. This allows them to focus their managerial talent on the elements of the value chain on which they have a comparative advantage. My university has a contract with an electricity company to market the power our generator produces and to provide the balance of its fluctuating need for electric power on stable price terms. Hopefully we save money that way: the university has actively explored going into the wholesale electricity market on its own behalf, but rejected that option. The real estate company that owned and managed the downtown office building in which I worked subcontracted for janitorial services and for cafeteria services. Each of these subcontracted functions involves providing a real service quite distinct from making a market in financial securities. And Morgan Stanley’s jet fuel business provides a real service, too. It’s just not market making in financial securities. One can imagine that Morgan Stanley’s ability to offer jet fuel logistics services on favorable terms benefits from the banks expert analysis of volatile petroleum product prices, and also on its ability to trade in both the physical and financial petroleum and petroleum product markets. But none of that transforms the business into market making. There are plenty of non-banks that provide exactly this kind of logistics services in all kinds of commodities. Think Glencore, Cargill, etc. And all of these non-banks have had to master the markets in order to price their services competitively. Trading in financial securities may be useful to providing the logistics services, but it doesn’t turn it into market making.

Morgan Stanley, like several other banks, does some business in real commodities and related physical business. As we’ve pointed out elsewhere on this blog, many so-called end-users also conduct finance business underneath the same holding company–see here and here. Similarly, many banks provide non-financial services underneath the same holding company–see this post about Goldman Sachs. Just because a service is offered by a company best known as a non-financial company does not mean that service is a non-financial service, and just because a service is offered by a company best known as a financial company does not mean that service is a financial service. A lot of what commodity trading desks at the big banks do has nothing to do with market making

In an earlier post, I criticized a study by the consulting company IHS which was commissioned by Morgan Stanley. One of the key and faulty assumptions in that study is the claim that if the market making services can no longer be housed inside a bank, then the same service cannot be provided as readily or efficiently outside of a bank. Morgan Stanley’s jet fuel example helps to highlight what is so wrong about this assumption. Morgan Stanley currently faces direct competition from many non-banks on this front. And Morgan Stanley never provides any evidence or explanation to motivate understanding their jet fuel business as uniquely benefiting from being housed within a bank. If implementation of the Volcker Rule were to push Morgan Stanley out of the jet fuel business, that very same business unit could operate equally well without the Morgan Stanley name.

Analysts who overlook the power of privileges may mistake dominance for efficiency, getting backwards the true state of affairs.  They also miss that the distortion reduces the welfare of society and redistributes wealth and power in favor of the inefficient.

That’s true in any industry and especially relevant in the case of the dominance of OTC derivatives markets over exchange trading during the last three decades.

One of our colleagues, presenting his work in a recent seminar, made the offhand comment that the dominance of OTC markets must reflect some efficiency on the part of banks in providing derivatives to end-users. Undoubtedly, other economists without a detailed knowledge of how the game is played draw the same conclusion.  The deeply ingrained idea that markets are free makes them oblivious to the simple fact that markets are institutions, and institutions operate with rules and regulations designed by people.

The logic that OTC markets are superior only works on the premise that banks are competing with exchanges on a level playing field. But prior to the financial crisis of 2007-2008 (and until the effort to reform finance is successfully completed), the playing field has been not level: banks have enjoyed some significant privileges. Key among them was the failure of some banks and regulators to properly price the credit risk embedded in derivatives.

The term-of-art in the banking industry is Credit Valuation Adjustment (CVA), or the money needed to account for the credit risk in a portfolio of derivatives with a counterparty. Over the last three days, the Financial Times’ blog Alphaville has been running a series of posts on CVA by David Murphy, a former head of risk at the trade association International Swaps and Derivatives Association (ISDA) and current blogger at Deus Ex Machiatto. In the first post in his series, he writes that

Whenever you are promised cash in the future by someone who might not pay you back, you have credit risk. In derivatives trading, situations often arise where someone might owe you money in the future, perhaps because you have purchased an option from them, or because a coupon on a swap goes your way rather than theirs. This means that derivatives trading often includes taking some credit risk, along with the more obvious market risks.

In the very early days of over-the-counter derivatives, some banks did not take this lesson to heart, and thus derivatives traders could (effectively) lend money without the banks’ loan officers noticing.

Murphy goes on to note how bankers started recognizing this risk. Regulators, however, remained behind the curve, and did not apply adequate capital charges for the credit risk embedded in many derivatives.

A report of the BIS, the international organization of central bankers, explained that

…one of the key lessons of the crisis has been the need to strengthen the risk coverage of the capital framework. Failure to capture major on-and off-balance sheet risks, as well as derivative related exposures, was a key destabilizing factor during the crisis.  … While the Basel II standard covers the risk of counterparty default, it does not address CVA risk, which during the financial crisis was a greater source of losses than those arising from outright defaults.

Getting the rules right is a tough task, as the blog posts by Murphy help to explain. There are many complications and difficult interactions to take into account.

What is alarming is that certain legislators in the US want to return to the former practice of ignoring the credit risk embedded in a swap. In late March, the U.S. House of Representatives passed a bill (HR2682) directing banking supervisors to overlook the credit risk embedded in non-margined swaps sold to end-users and others. They hope to thereby lower the cost paid by end-users. We explained the problems with this bill in an earlier post. It is an ill informed attempt to preserve a back door subsidy. It risks leaving the financial system unstable, at potentially great cost to taxpayers, households and firms that rely on safe banks.

Our understanding of embedded credit risk has been hard won. It would be a mistake to renounce it.

How much of the price drop has been due to which factors?

Of course, the answer to that question is anybody’s guess, and no one’s guess can be hazarded with too much certainty. But the term structure of futures prices is a good distillation of the opinions of many market participants. Anyone trying to comment on market movements would be well advised to be informed on how the whole term structure has shifted, and not just on how the spot price has moved.

The chart above shows the natural gas futures prices for delivery in three different months. The blue line is the price for delivery in April 2012. The red line is the price for delivery one year later, in April 2013. The green line is the price for delivery one more year later, in April 2014.

Back in late 2008,  the three prices lay on top of one another. All three were markedly below the spot price at the time. The three futures prices stayed close to one another for some time. In the 18 months from July 2008 through December 2009, the price of all three contracts fell nearly 40%. The drop was virtually identical across the three. That tells us that the factors driving down the price at the earliest of these three dates were not unique to any one of these three delivery dates, but were expected to impact all three years. In all likelihood, the price fall shown in those 18 months was due to lasting factors like the ongoing technological developments that are increasing the resource base that is available across all years.

However, in the 7 months from September 2011 through March 2012, the price for the April 2012 contract fell by 47%, but the price for the April 2014 contract fell less than half as much, only 24%. About ½ of the price drop in 2011-2012 is likely to have been due to short-term, transitory factors like the unseasonably warm weather. But not all of the price drop can be attributed to these transitory factors. The other ½ of the price drop in 2011-2012 appears to be due to more permanent factors, such as the ongoing technological developments making supply cheaper.

There are more formal modeling techniques for extracting this kind of information from the term structure, but this is the basic content regardless of the particular mathematical model employed.

Thank you for your interest in our report.  We wanted to take an opportunity to clarify a few points about our work.

The first point in your Blog refers to “bans banks from proprietary trading” but should instead speak to “restrictions on market makers.”  We have no issue with bans on bank proprietary trading, and the banks have already exited, or are currently exiting this activity, due to the heightened capital adequacy requirements of Basel 2b and Basel 3, which make the ROE of proprietary trading quite poor.  Our study does not address “proprietary trading”, but just the opposite – “market making” is the role that the Volcker Rule Legislation had intended to preserve for the banks (but the Regulation appears less able to do so), due to its importance in serving the energy industry specifically, and for the safety and soundness of our financial markets, more broadly.  Marketing making is the function that creates, in aggregate, a willing counterparty for commercial companies (e.g. airlines, natural gas producers) to lock in commodity prices and hedge their financial risk.  Hedging is the opposite of speculation and is more akin to buying insurance.

Now, regarding non-bank institutions, such as hedge funds, providing market making for commodities risk management and intermediation services, let’s first keep in mind that the intent of the Legislation (“the very purpose of the Rule”) is to avoid creating any “void” in the provision of hedging and market making services in the first place – this is why there are exemptions for these services.  Unfortunately, in commodities markets, these are difficult activities to strictly define since principal trading is required for both proprietary trading and market making.  That we are even talking about a potential void to be filled is a warning sign that the proposed Regulation does not meet the intent of the original Legislation.  And why would our regulators want to push this activity, so vital to our economy and to our energy security, into distant and unregulated reaches of the world?

It was certainly was not obvious to us who the natural players, with the requisite capabilities, could be to adequately fill any void, at least for some period (our modeling period was five years).  This role requires an “A” credit rating or better, in order to be a viable counterparty that most corporations could even consider doing business with, and especially for long-dated contracts.  It also requires a client-facing business model with account executives out calling on American companies to identify their needs and develop client solutions.  It requires a willingness to provide financing, which is often an important component of many structured solutions.  And on occasion, this activity demands someone capable of straddling both the physical and financial markets, in order to efficiently provide an effective client solution.  Again, it was not obvious to us who was a good fit with the requisite positional assets and organizational capabilities for this role.

IHS did not ignore taxpayer subsidies to banks.  FDIC insured customer demand deposits (DDA) is indeed a relatively inexpensive form of funding, but this is not bank capital.  You can think of DDA as a COGS item on your Income Statement, but not something that goes on your Balance Sheet.  Bank capital is largely shareholder equity, though admittedly, banks are also allowed to hold a portion of capital in Tier 2 form, such as long-dated junior subordinated debentures or trust preferreds, which also command some credit from the ratings agencies.  Nor is the presence of DDA an important or even prevalent part of the business model for the principal market makers in commodities risk management and intermediation services (they secure their funding through the wholesale markets).  DDA is more the domain of money center banks, like the large regional and national retail franchises.  But credit risk is very much a part of the business model of market makers, and it is one that garners close scrutiny by the credit committee in extending financing and executing trades with all counterparties.  Now, our study does not address financial institution capital adequacy – this is well outside the scope of the report – but indeed, regardless of how the accounting falls, enhanced capital adequacy guidelines (i.e. Basel 3) goes a long way to improving the safety and soundness of our financial markets.

The price of natural gas in the US has been falling almost continuously since mid-2008 when it peaked at over $13/mmBtu. It now lies just above $2/mmBtu.

Despite the falling price, natural gas production in the US has continued to climb. According to data from the EIA, between July 2008 and January 2012 US production increased 17%. Companies have been slow to adjust their expansion plans to the falling price. Finally, in late 2011 and early 2012, companies have begun to adjust their capital expenditures to the current low natural gas price reality. Gregory Myers has reported on this in the Financial Times, citing decisions at Chesapeake Energy and ConocoPhillips. In 2011, Encana Corp finally confronted reality and abandoned its 2008 pledge to double production.

Even as capital budgets are cutback, companies still face a need to raise new cash. The new technologies can also be applied to production of unconventional oil resources, like the tight oil in North Dakota’s Bakken Shale or Texas’ Eagle Ford Shale, as well as to development of liquid rich gas fields. Since the price of oil remains high, it can pay to develop these resources. But many natural gas companies with experience in the new technologies find themselves cash poor due to the low operating profits on their gas properties. Cash poor, and prospect rich.

These companies are selling their traditional gas assets to buy higher value shale deposits. Equity issuance is also at historically high levels. Dealogic estimates that share issuance by the sector represents one-fifth of all the US equity raised this year.

A more interesting development is to get cash from accrued gains with pre-existing hedges as reported by Ajay Makan in the FT. An example would be of a company which had entered in 2009 into short positions in forward/futures natural gas contracts for the next six years, until 2015. Right now, in March 2012, the company has on its books gas contracts with maturities varying from June 2012 to 2015. Since the gas yield curve back in 2009 when the company initiated the positions was significantly higher than the current gas yield curve, the company is sitting on significant unrealized gains. Consider just one of its many futures positions: 1000 contracts sold in 2009 with maturity March 2014. The price in 2009 of a March 2014 contract was around $4. Now the same 2014 futures price is around $3.4. Since each contract is for 10,000 mmBTU, the company can close the position and make a profit of 10,000 mmBTU x ($4-$3.4) = $6,000 per contract, for a total of $6 million.

The companies can close out these contracts in order to cash in on the gains.

A couple of questions are in order:

1. Why would the companies want to do that?

2. If the companies sold the hedges wouldn’t they become unhedged and exposed to greater risks?

The answer to the first question lies in the fact that with low gas prices, companies are not able to generate enough cash from operations to fund investment in land, drilling and exploration of shale gas fields, when the industry faces a lot of competition to own such assets.  Faced with an operating cash squeeze, the companies are tapping their reservoir of gains generated by pre-existing hedges.

But, going forward, won’t the companies be much more vulnerable to price gyrations if they liquidate their hedges?

No.

The companies can immediately lock into new forward contracts at the prevailing forward price. The companies are simply realizing past gains on their outstanding contracts in order to plough the money back into their businesses. Unrealized gains are a wasted resource. The companies are free to establish new hedges. Analysts who claim that companies are taking on more risk to avoid cutting back on investment are just wrong.  There is not a conflict between cashing in on unrealized gains from past hedges and being hedged going forward.