No. of Recommendations: 29
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 skepticism these days. Sometimes the models miss key information, sometimes the people who use them miss what the models are telling them and sometimes traders manage to work around them.


The trade to short A/long B was derived by quantitative methods. In addition to that the Value At Risk was ALSO derived from a model. VAR is intended to show what the maximum loss for a trade can be in any given day. It is generally regarded as being the equivalent of simulating a 2 sigma (95%) or a 3 sigma (99.7%) event. Obviously this assumes that the range of results has a Gaussian distribution. But what happens if the distribution is NOT Gaussian?

4) Access to free ~0% funds makes investors willing to take more risks. This is exactly the result that Ben and the Fed want.


Iksil’s colleagues liked him, but he was not popular among some Wall Street dealers who brokered his trades. The London group had a reputation for using the weight of the bank to muscle the rest of the market and for being a little arrogant. “They thought they were geniuses,” said a hedge-fund manager on the other side of the trade that ultimately brought Iksil down. “They just had access to cheaper capital than everyone else, because they worked at JPMorgan,” that manager said. “It’s sort of like race cars — everyone else is in a Camry, and you’re in Porsche, and you think you’re the best driver.”





5) A lot of the story focuses on the challenges that Ina faced because of her sex over the years. It is NOT clear how or if the sexism has improved over the years. What is clear is that darn few women are in influential positions on Wall Street.


In the early 1980s, Chemical was making a push to hire women as traders, but that did not mean the workplace was particularly enlightened. Dina Dublon, who was one of Drew’s closest colleagues, joined the bank the same month that Drew did. “To say the environment was not welcoming to women is an understatement,” says Dublon, who rose through the ranks alongside Drew and retired in 2004. Dublon sat next to Drew in the early days, and the women went through packs of cigarettes every day, a cloud of smoke hovering around their desks like a barrier to the barrage of tasteless jokes.


BOTTOM LINE IMO is that firms will continue to see large trades that go bad by “surprise.” The odds of a regulatory answer seem low. The odds of a Federal Reserve bailout seem very high if the bank is TBTF. A whole flock of black swans went in for bleaching and are now white swans. We should not be surprised if a firm blows itself up again when a white swan lands close by.

You might come to entirely different conclusions after reading this story. If you are interested in swan detection techniques, you might want to read the story.

Thanks,

Yodaorange


[1] New York Times story on JP Morgan Chase- Ina Drew
http://www.nytimes.com/2012/10/07/magazine/ina-drew-jamie-di...
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I think all of your conclusions are valid.

5) A lot of the story focuses on the challenges that Ina faced because of her sex over the years. It is NOT clear how or if the sexism has improved over the years. What is clear is that darn few women are in influential positions on Wall Street.

A review of the past 20 years of buildup and implosion in the financial world (Born with CFTC, Bair with 2008, Drew with this JPMC trade, and others I'm sure we'll find out about eventually...) seems to make it perfectly clear that while there are women "on Wall Street", in reality, there are NO "powerful women on Wall Street." Some are in the right positions and drawing the big bucks, but when the real players get together in the room to make the really DUMB decisions, the women players involved mysteriously but consistently seem uninvited to the back room. This board has had numerous threads over the years citing studies about how males nearly ALWAYS over-estimate their ability to judge risk and over-weigh the plus side of a decision without properly weighting the downside.

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 skepticism these days. Sometimes the models miss key information, sometimes the people who use them miss what the models are telling them and sometimes traders manage to work around them.

JPMC was the original developer of these VAR models in the early 1990s and shared them with other players in the industry in the mid-1990s as a measure of good-will and a sense of "let's keep us all out of trouble." If I recall correctly from reading one of the books I've reviewed here or magazine coverage of some of the same events, for some large institutions, these VAR measures became their own perverse measure for traders to determine if they were risking ENOUGH rather than risking TOO MUCH. In other words, many firms became so convinced of their risk taking prowess and the accuracy of these models, that the numbers were used to ensure they weren't "sitting on their hands" letting "easy money" get made by competitors. In reality, the VAR numbers came to ENCOURAGE taking additional risks rather than ensure a firm stayed within limits defined by its management. Of course, no execs outside the trading divisions of these firms could explain how these VAR models worked with a gun pointed to their head, much less how the underlying trades were structured. In essence, the VAR calculations became an extremely complex, precise work of fiction that had virtually no basis in reality and had negligable impact in convincing management to apply the brakes.


WTH
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In essence, the VAR calculations became an extremely complex, precise work of fiction that had virtually no basis in reality and had negligable impact in convincing management to apply the brakes.

There's always the problem with what I like to call "systemic feedback" in economics. You develop a model on the basis of historical data. The conclusion that are drawn from the model influence your behavior (and eventually the behavior of a lot of other people) which changes reality, so your model no longer applies and your conclusions become invalid.

A good example is securitization. The models for developing securitization where originally created on the basis of mortgage data where no or only relatively few mortgages were originated to be securitized.
Of course once you get into mass securitization, mortgages are going to behave a lot differently, as:

1. the originator no longer holds the mortgage to maturity and thus has far less incentive to make sure it's repaid, and

2. securitization enabled a large increase in the volume of credit granted, which drove real estate prices into a bubble.

As a result, mortgages defaulted at a far higher rate and with far lower recovery rates than had historically been the case.
And so the application of conclusions drawn from the historical data altered reality in a way which rendered those same conclusions invalid.

There seems to be very little awareness of this phenomenon as a general problem in the financial markets (Soros is aware of it, he calls it "reflexivitiy".
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Yoda,

A friend of mine is a honest broker. Every time I sit down with him, which is not all that often, I ask is the bottom in the housing market in.....last night he said there could be another leg down.....we here on METAR know that......then he pointed to BAC's housing problems......

nuff said,

Dave.....ear to the ground....
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When you evaluate risks, you deal in odds. While traders might not think of themselves as gamblers, the distinction is minimal (like saying that Mexican cops are different from the criminals because they are wearing a uniform :-)

If someone whispered to a gambler that a roulette wheel landed on black 3/4 of the time, he would sell his wife into chatel slavery (or leverage with margin) to place huge bets. Frequently he would walk out of the casino with a big grin. On a few other occaisions ...

As Yoda pointed out, Corzime had a temporal error rather than a strategic one. Soros is a hero, but if he had been a month early, while still being famous - it would have been for a far different reason.

Jeff
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BOTTOM LINE IMO is that firms will continue to see large trades that go bad by “surprise.” The odds of a regulatory answer seem low. The odds of a Federal Reserve bailout seem very high if the bank is TBTF.

I agree. As long as there are banks there will be blowups. The future will follow the past where the trail of detritus leads back to the thirteenth century.

Too Big to fail is too big to manage and they should be broken up.

rc
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Glass Steagall was only 37 pages and it worked.......

those were more honest times.....

Dave
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No. of Recommendations: 41
1. First, that women on Wall Street have no power is irrelevant. I trust the studies which show that men (as a group) overestimate their ability to judge risk, and that women (as a group) swagger less, but so what? What gets you to the top in that field is making outsize bets and being right. If/when women get to a position of power, they are likely to be not reflective of the meme, and will be those who also take outsized risks and thereby have outsized success. For a while.

It's the culture of the street, not the predilection of one sex or another, that puts so much risk at risk.

2. There will be more failures, and they may be catastrophic. How catastrophic is the question. The disaster at JPM didn't bring down the entire global system, nor did the one at MF Global. It is only those that happen at a particular place and time, with such internal weakness and interconnectedness to others, and using such vast leverage that threatens me.

So some of JPM partners, managers, and stock owners got hammered? Too bad. So MF Global has 1,000 lawsuits? Oh well. I only care when the damage reaches other shores. (By the way, notice how all those screaming about "moral hazard" a while back don't seem to notice that firms are still going upside down and no one is jumping up to help them?

3. You are right; banks will not stop doing these things until prohibited by regulation. We learned that 80 years ago, but managed to unlearn it thanks to various "respected" think tanks.
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BOTTOM LINE IMO is that firms will continue to see large trades that go bad by “surprise.” The odds of a regulatory answer seem low.

There will be one but the chances that it will be an effective one don't seem to be brilliant. Between US, UK, and Europe, there are now three different proposals on the table. The first sentence says it all:


AT LEAST the lawyers will be happy. Banks are already straining to come to terms with two reforms designed to reduce the risks that investment banks pose to other bits of the banking industry: America’s Volcker rule, which aims to ban proprietary trading (trading for their own profit) by banks; and the Vickers “ring-fence”, which proposes to force British banks to isolate their retail activities from trouble in their wholesale arms. Now European banks must gen up on a third proposal.

This one was presented on October 2nd to the European Commission by a group of experts led by Erkki Liikanen, the governor of the Bank of Finland. The group had been asked to report on whether Europe ought to split up its banks to reduce the risks to taxpayers of having to bail them out. Mr Liikanen’s experts concluded that there should be a strict separation between investment banking and retail banking. They also proposed forcing banks to hold more capital against some of their risky businesses, and to have debt that could be “bailed-in”, or turned into equity, to recapitalise an ailing bank. ...


http://www.economist.com/node/21564233
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" internal weakness and interconnectedness to others, and using such vast leverage that threatens me." Over leverage seems to be the key ingredient that could be regulated in some reasonable way.

I don't think regulators have any corner on wisdom, they will make their own mistakes. Over regulation (the inclination of agencies) and under regulation (the proclivity of bankers) both can produce bad results. Both have to be limited, not an easy task. History shows that banks blow up every few decades , they will undertake something where neither they or the regulators see the risk at the time. Prohibit X and banks will do Y. Prohibit too many things and you retard commerce. Banks lend money, a hazardous undertaking in itself. You can't make it too attractive or too unattractive.

But the hazard to the system can be limited by limiting leverage and inter-connectivity even if the risks of specific activities are not seen by most at the time. Excessive risk taking by management can perhaps be reduced by some sort of clawback provision to their income, activated if they go bust and need public help.

But no matter what is done 2008 will not be the last banking crisis.
Ultimately regulators are the creatures of the legislature, and what big money interests want will eventually become the rules.


An article on recent regulatory failures by the left leaning Washington Post
http://www.washingtonpost.com/wp-dyn/content/article/2009/12...
Bernake 2007 " we see no serious broad spillover to banks or thrift institutions from the problems in the subprime market,"

Putting more regulators at work can be like loading more people in a sinking boat. It will just sink faster unless some of the new people can identify and fix the leaks.
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Putting more regulators at work can be like loading more people in a sinking boat. It will just sink faster unless some of the new people can identify and fix the leaks.

From the time we signed the Banking Act in the New Deal, until we repealed it in the Clinton term, we never had a major banking failure in the US. (S&L had been deregulated under Reagan and they tanked within a couple of years)

Is there any evidence at all that from 1934 to 1999 the American economy had been throttled by the banking regulations?
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we never had a major banking failure in the US.

Individual bank failures have always been part of the landscape.

Continental Illinois

The Continental Illinois National Bank and Trust Company was at one time the seventh-largest bank in the United States as measured by deposits with approximately $40 billion in assets. In 1984, Continental Illinois became the largest ever bank failure in U.S. history, when a run on the bank led to its seizure by the Federal Deposit Insurance Corporation (FDIC). Continental Illinois retained this dubious distinction until the failure of Washington Mutual in 2008 during the financial crisis of 2008, which ended up being over seven times larger than the failure of Continental Illinois.
------
In May 1984, Continental Illinois became insolvent due, in part, to bad loans purchased from the failed Penn Square Bank N.A. of Oklahoma—loans for oil & gas producers and service companies and investors in the Oklahoma and Texas oil & gas boom of the late 1970s and early 1980s. Due diligence was not properly conducted by John Lytle, an executive in charge of oil lending...Lytle was sentenced to three and a half years in a federal prison.


http://en.wikipedia.org/wiki/Continental_Illinois

The difference between then and now is that, then, irresponsible and corrupt bank honchos went to the slammer, now they get taxpayer funded handouts.

Steve
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Seems to me Yoda and Jeff are both wrong about Corzine. The market was his judge. His gamble included TIME. That flunked him. Bet on time wrong and you are Wrong. Flunked. Requiring far out explanations or very powerful figures influencing legal decisions to redeem.
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