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Subject:  Countdown to the next financial bomb Date:  10/7/2012  12:01 AM
Author:  yodaorange Number:  405446 of 485018

As an investor, I spend a lot of time thinking about:

1) What I think I know (It’s a swan and it’s white)

2) What I am sure I do NOT know (It’s a swan, but I can NOT tell if it is white or black.)

3) What is so unknowable, that I cannot even postulate the problem (Do not see any swans on the horizon)

I am increasingly convinced that one or more firms will have meltdowns like MF Global and JP Morgan Chase. I know classify this is as “What I think I know.” It is NOT a mathematically provable point, so each investor will have to decide on their own.

The New York Times published a short story length article in this week’s Magazine that reinforces my belief. The article is about Ina Drew, who was the Chief Investment Officer of JP Morgan Chase when the “London Whale” trade went bad. [1] The story is entitled The Woman Who Took the Fall for JPMorgan Chase.

The London Whale trade was a single trade that the London office put on that is estimated to result in a $ 6 billion loss. The loss is manageable for JPMC and they will survive mostly with a damaged reputation. Obviously, the same is not true for MF Global where a single trade gone wrong killed the firm.

There are several themes in the article and it does NOT conclude that another large bad trade is inevitable. The article is more a matter of fact presentation about the history of Ina and the London Whale trade.

The central themes I picked out from the story are:

1) JPMC still maintains that trade was a HEDGE against other their loan portfolio. They steadfastly maintain it was NOT a speculative bet by their proprietary trading desk. Hence any regulation that allows banks to hedge their bets will still have the same risk. If you want to remove this risk from a TBTF and/or FDIC bank, you have to do a much stronger split of responsibilities. It is NOT clear to me if Glass-Steagall would have prevented this or not. As I understand Dodd-Frank, it would NOT have prevented this trade.

2) Banks absolutely, positively will NOT stop doing these type trades.

“was that by the time we were finished, we were making more than 50 percent of the bank’s profits.

No bank CEO is going to stand up to his board and say “I have a great plan for us to shut down our trading operation and cut earnings in half.”

3) Some of these financial Mensa members still 100% believe in models. Many of the “quants” have backgrounds in math and/or physics.

Drew’s team had all graduated from well-regarded schools, but unlike Edsparr’s group, they did not have Ph.D.’s in applied math; they weren’t M.I.T. graduates or physicists from Caltech

They approach finance like it is a hard science where a law of physics is sacred. Their belief is that they can develop a model that will include all possible outcomes. When a 10 sigma or black swan event arrives, they are shocked when the model fails.

To try to mitigate that very human dynamic, banks also rely on a variety of statistical models, including those known as “value at risk” models, which theoretically provide bankers with a certain degree of probability about how much they could stand to lose on any given day under adverse circumstances. Those V.A.R. models did little to help bankers when the unforeseeable happened in 2008, which is why they are generally viewed with some ske