17 March 2013

How Many Shoes Does a Centipede Have? [update]

Well, yes, the centipede drops another shoe. Today's Times has an evaluation of the Levin committee's report on JP Morgan's whale watch. Here's the report. One wonders whether Google is in league with The Banksters, since the report doesn't appear in the results. I had to follow many links to get to it. (The Times piece does have a direct link, though.) For future reference, this is the URL for that subcommittee.

The report runs over 300 pages, so I'll (for now; there may be updates to the missive as I work through) drop some cute quotes from Morgenson's piece.
BE afraid.
That's the takeaway for both investors and taxpayers in the 307-page Senate report detailing last year's $6.2 billion trading fiasco at JPMorgan Chase. The financial system, thanks to dissembling traders and bumbling regulators, is at greater risk than you know.

What we care about here is to what extent the quants were either co-opted or active participants in the shenanigans. Defenders will assert, as expected, that the quants were either just following orders or were kept in the dark.
... risk limits created by the bank to protect itself were exceeded routinely ...

Morgenson goes on to re-state the obvious
Remember that this is a report examining JPMorgan Chase, the bank that enjoys the best reputation among its peers. One can only wonder: if JPMorgan Chase traders think nothing of misrepresenting the value of their trades to minimize losses, what are the financial world's lesser players up to?

Dimon was particularly trenchant in defending himself and his bank during The Great Crash. From some years ago:
Instead of simply trusting his traders, Dimon put himself through a tutorial, so that he would understand the complex trades the bank was exposed to. And rather than run its mortgage machine at full throttle for as long as possible, Dimon reined in lending earlier than did others and warned his shareholders of looming trouble.

May be he didn't really? Could be. He certainly didn't do an Ahab imitation this time.

So, we have this later from the report:
Hoping to understand JPMorgan's practice of relaxing its valuation method on the troubled investment portfolio, Mr. Levin asked of Mr. Braunstein: "Is it common for JPMorgan to change its pricing practices when losses start to pile up in order to minimize the losses?"

After a bit of back and forth, Mr. Braunstein said: "No, that is not acceptable practice."

Here's where it gets a bit mathy. Risk assessment in the bankster crowd relies on gauging tomorrow's chance of collapse based on historic fluctuations in whatever sector/industry/company/etc. under review. Which is a perfectly acceptable stat methodology when the object of investigation is some natural process. With natural processes, barring events such as asteroids taking out most of the Yucatan, there's so much going on in the environment around the process we're interested in, that the causes of fluctuations in the process under review have all been blended into the historic data. Think: Brownian motion (financial quants have been known to invoke BM in their work; if only they had a brain). Human driven processes, where events are the result of specific human decisions, just don't work that way.

Since they say they're doing quant, rather than policy, they look for a number to quantify risk. Turns out, they use a measure of variability in the historic data. It's an attempt.
Normal practice at the bank and across the industry is to value these kinds of derivatives at the midpoint between the bid and offer prices available in the market. But in early 2012, as it became apparent that JPMorgan's big trades at the chief investment office were going bad, the bank began valuing the portfolio well outside the midpoint. This reduced its losses.

In other words, just as a butcher who doesn't know you (or does, and still hates you) puts his thumb on his side of the scale, Morgan leaned full force on the scale. The losses weren't really reduced, only the reporting said so.
In March, however, all 18 deviated, and 16 were at the outer bounds of price ranges. In every case, the prices used by the bank understated its losses.
Then, in April 2012 alone, risk limits were exceeded 160 times.

That's one angry butcher. Sweeney Todd on meth.

Levin goes in for the kill. Morgan had done its own investigation:
"You just told us that shifting pricing practices to minimize losses is not acceptable," Mr. Levin said. "Did you say that in your report? Did you say that's what happened?"

"I don't believe we called that out in the report," Mr. Cavanagh answered.

Here's why all this matters.
JPMorgan, don't forget, is the largest derivatives dealer in the world. Trillions of dollars in such instruments sit on its and other big banks' balance sheets. The ease with which the bank hid losses and fiddled with valuations should be a major concern to investors.

Mama, don't let your boys grow up to be quants.

From page 94 of the report:
Step by step, the bank's high paid credit derivative experts built a derivatives portfolio that encompassed hundreds of billions of dollars in notional holdings and generated billions of dollars in losses that no one predicted or could stop. Far from reducing or hedging the bank's risk, the CIO's Synthetic Credit Portfolio functioned instead as a high risk proprietary trading operation that had no place at a federally insured bank.

From page 155 of the report:
The CIO's lead quantitative analyst also pressed the bank's quantitative analysts to help the CIO set up a system to categorize the SCP's trades for risk measurement purposes in a way designed to produce the "optimal" -- meaning lowest -- Risk Weighted Asset total. The CIO analyst who pressed for that system was cautioned against writing about it in emails, but received sustained analytical support in his attempt to construct the system and artificially lower the SCP's risk profile.

From page 168 of the report (quoting Morgan documentation):
"The Firm calculates VaR to estimate possible economic outcomes for its current positions using historical simulation, which measures risk across instruments and portfolios in a consistent, comparable way. The simulation is based on data for the previous 12 months. This approach assumes that historical changes in market values are representative of the distribution of potential outcomes in the immediate future. VaR is calculated using a one day time horizon and an expected tail-loss methodology, and approximates a 95% confidence level. .. "

In other words: "we expect today to be just like yesterday".

Here's where it gets interesting (and sounds familiar?). The Whale Pod decided that the risk model used by Morgan was too pessimistic, so they'd do their own, but
Although Mr. Stephan [an experienced quant having built VaR models for Morgan] remained employed by the CIO in a risk management capacity, he was not the primary developer of the new VaR model; instead, that task was assigned to Patrick Hagan, the CIO's senior quantitative analyst who worked with the CIO traders. Mr. Hagan had never previously designed a VaR model.

So, sing the bridge again:
Mama, don't let your boys grow up to be quants.

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