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.
To take one example, after describing how Drew’s unit at Chemical Bank was tasked with hedging the bank’s interest rate exposure on its loan portfolio, Dominus then quotes Drew’s colleague as saying “…by the time we were finished, we were making more than 50 percent of the bank’s profits.”
No one who is truly hedging is responsible for making more than 50 percent of the bank’s profits. A hedging removes the bank’s exposure, meaning her trades REDUCE the bank’s potential for net profit and loss. Of course, it is in the nature of a hedge to make a profit when the underlying business makes a loss. But a true hedger doesn’t claim responsibility for the profit on the hedge leg. Or, at least a true hedger’s supervisor doesn’t give the hedger responsibility for that. The profits earned on a hedge are not the profits from hedging. The other side of the coin for the hedger is that when the underlying business makes a profit, the hedge must be looking pretty bad. But that, too, is not the hedger’s fault. The hedger did her job when she successfully shaved both the net upside and the net downside. Only by looking at the total position on net, and across all possible outcomes can the hedger be evaluated for success or failure at hedging.
Dominus later advertises Drew’s clairvoyance: “Drew’s deals essentially turned on one key question she seemed to answer correctly more often than most (or at least when it mattered most): Would interest rates go up or down?”
No hedger needs this clairvoyance. It is wasted on an office responsible for hedging. Clairvoyance is what qualifies a person for proprietary trading. If Drew’s skill was in forecasting the direction of interest rates better than others, and if she was putting her skills to work in JP Morgan’s CIO, then she was doing proprietary trading, not hedging. Hedgers can do their job successfully without pretending to clairvoyance. Hedgers take market prices as given as trade at them to reduce risk and exposure.
Unfortunately, this fundamental confusion about hedging is rife, not just among journalists, but among businesses that hire traders to hedge risks for them. Knowing the difference is an important skill for top management. Speculative trading is the antithesis of hedging. The source of value in speculative trading is entirely different from the source of value in hedging. Only when the distinction is clear can the company craft a wise hedging strategy.