J.P. Morgan’s $2 billion and rising mistake in what was supposedly a hedging strategy is a perfect example of what can happen when an otherwise extremely capable and effective chief executive gets stretched too thin. Dimon did, mostly, the right thing. He faults himself for not having micro-managed the Chief Investment Office as much as he micro-managed everything else, but (a) he trusted its head, who had proven herself again and again, and (b) the positive results coming from it had justified his trust. In retrospect, all those positive results should have flashed a red light, because hedging operations are not supposed to generate profits, at least not consistently. But this is the same mistake that was made by almost every other business, financial or otherwise, which suffered a blow-up over the past twelve years. Even the best manager can’t be everywhere, and it is difficult and usually inadvisable to attempt to fix that which doesn’t appear to be broken.
What this incident demonstrates, yet again, is that these highly complex derivative strategies, when multiplied by a legion of traders, of quant analysts, each pursuing a different concept, and the competing executives who each acquire a stake in the success of their particular group, become too complex for any human being, or small group of human beings, even aided by the best information technology in the world, to manage. Models only work until the assumptions underlying them break down, and relying upon diversification to bail you out can become a curse when the strategies become correlated, as they do particularly when something has gone wrong, and you have to sell. These trading groups have become too big in comparison to the organizations they supposedly serve, and the advantage of being able to play with an almost infinite pool of shareholders’ money becomes a disadvantage, because it is too easy to become oversized compared to the market in a particular security; being oversized in a basket of correlated ones (since they are all part of the same strategy) multiplies the correlation.
Dimon’s real mistake was in believing—or allowing others to convince him—that trading, or indeed any business activity, is infinitely scaleable, and that it is possible to hedge $340 billion in credit exposure and other banking activities the same way you can hedge $34 billion, or $3.4 billion. Just as with the cartoon images of a human-shaped being 60 feet tall, it doesn’t work in reality; other things have to change, and drastically, if you are going to be that big. It’s elementary physics.
Not only do risk managers have to become more knowledgeable and powerful, risk limits have to be respected. Psychologically, traders are the worst people in the world to have to manage this risk, because, by definition, they are risk-seeking, rather than risk-averse. And since the strategies are so complex, it is impossible for anyone, no matter how financially sophisticated, to understand more than a few of them, let alone every circumstance in which they might begin to correlate in unfavorable ways. The general manager of a bank, who has to have many other duties and skills, only one of which is supervising trading departments, cannot possibly review all this work and stay on top of it. The chief risk officer, who has many other areas to watch, cannot possibly monitor all the risks involved. The trading departments of the modern mega-banks have simply become too big for anyone to understand sufficiently to control them. And then there are the human variables: the supervisor who was able to hold the line on risk exposure gets sick or has a family crisis and has to resign. There is a hiatus. Her or his replacement does not know the situation as well, cannot command the same initial respect from subordinates, and does not have the same clout in the organization. A key person is having emotional problems, or personal distractions. No system is immune to breakdown. And the bigger the system, the greater the effect of that breakdown, not in a linear fashion, but exponentially.
The only answers seem to be, either to drastically limit the size of any one bank, or to somehow regulate and limit the complexity of trading strategies. The former may limit the ability of banks to fulfill the financial needs of their corporate customers. (Although there are those who say that banks haven’t been really serious about corporate finance since the traders took over.) The latter may be impractical, likely to discourage innovation or to drive it offshore. But both have to be considered, studied, seriously, honestly, and with as little bias as possible, and probably implemented to a greater or a lesser degree.
On thing seems certain: one risky strategy cannot simply be offset by surrounding it with a plethora of competing strategies which in theory offset one another: under extreme conditions, any two strategies can correlate, and then the only defense becomes the ability of the parent organization to withstand the loss. As long as trading desks are able to finance their operations with a deep pool of someone else’s money, exaggerated risks will continue to be taken by some, and fail to be adequately controlled by others. The only answer is that those who propose to undertake these risks must have their own personal wealth (and not just next year’s bonus) tied up in these strategies.
Years ago, Jamie Dimon himself very cleverly began a policy of putting everything his managers asked for into their budgets; not just the usual items, but also established perks and even incidentals. If you wanted to have the Wall Street Journal or the Financial Times delivered to your desk every day, it had to come out of your budget or out of your salary. This made everyone stop and think about how badly they really needed some of these perks and services. Perhaps this was going a bit too far: some who might be instinctively cheap possibly deprived themselves of information that could have made them more useful and productive. But it certainly took a lot of fat out of the cost structure! For most, the intellectual exercise of the trade-offs entailed by having to adhere to a budget is useful. Those for whom it is counter-productive and who deprive themselves of necessary expenditures for the sheer virtue of saving money at any cost, will see their productivity fall, and if the situation is serious, will soon be out the door.
Those senior traders and their chiefs charged with implementing novel and cash-consumptive trading strategies should have to make the same trade-offs. If this means that many trading operations have to revert to being partnerships of one form or another, so be it. There is presently too much risk in the system: too much for shareholders, too much for the stability of markets, too much for the safety of the whole economy. If J.P. Morgan can screw up, everyone can; but not everyone can afford to take the hit, especially at times when there is other turbulence in the markets.
Why is this a governance issue? Because it is up to boards to say, “No more.” And it is up to boards to appoint CEOs who are unlikely to bet the farm, again and again, until one day it is gone. And if their ambition is to make it the only “farm” on Earth, it will go: the sheer scale of it simply won’t work. We’re seeing that already.