The J.P. Morgan Chase derivatives fiasco, which reportedly has cost the bank in excess of $2 billion, is confirmation once again of the truth of Warren Buffett's observation, “Derivatives are financial weapons of mass destruction.”
They can seriously damage even a financial institution considered to be among the best managed in the U.S., if not the world, and which was reputed to have possibly the best risk management expertise.
The fiasco is also another timely warning to pension executives, who must pay close attention to the use of derivatives by their funds' investment managers.
It reiterates the message about derivatives that should have been sent by the 2008 financial crisis that was worsened, if not caused, by the collapse in value of mortgage-backed securities and the credit default swaps that were written against them: “Handle with care.”
The costly error also shows once again that risk models are not flawless. This is another lesson that should have been learned in the 2008 crisis.
According to reports, J.P. Morgan's top management might have been lulled by a value-at-risk model that understated the possible cost of a failure of the strategy being used.
Many Wall Street executives were likewise misled by the VaR calculations on their exposures in 2008.
Pension funds have been using derivatives, initially in the form of call and put options, since the mid-1970s, without significant problems.
But since the development of the futures markets, the Black-Scholes Options Pricing Model, and the influx of mathematical wizards on Wall Street, derivatives have become ever more complex.
The use of derivatives is tempting. Call options provide a way for pension funds to earn extra income when the stock market is moving sideways. Put options provide a way to buy insurance against a sudden drop in a stock's price. Stock index futures provide a way for pension fund managers to move significant amounts of assets into the market or out of the market quickly without causing significant changes in stock market prices.
Derivatives provide a way to hedge risks by entering into a contract, the value of which moves in the opposite direction to that of the underlying asset. They also provide leverage at a low cost so that a small movement in the value of an underlying position can yield a large gain.
But leverage swings both ways, and derivatives can magnify losses when an investment moves the wrong way, as J.P. Morgan discovered to its cost.
According to Jamie Dimon, chairman and CEO of J.P. Morgan Chase & Co., the initial transaction that ultimately led to the $2 billion loss was supposed to hedge a position. But that hedging position apparently went awry, and efforts to rescue it apparently made the situation worse.
Warren Buffett also said: “Beware of geeks bearing formulas.” Yes, and fund executives should hire geeks to understand the formulas brought forth by Wall Street's geeks.
If an institution as financially sophisticated as J.P. Morgan, with reputedly the best risk-management team on Wall Street, can mess up a hedging operation, pension fund executives should be wary of the hedging efforts of their money managers, who most probably will not have the depth of talent of a J.P. Morgan.
In fact, they should examine the whole range of derivatives use by their fund managers. The obvious places to look are hedge funds, enhanced managers and overlay managers. According to the data in this issue's special report, managers in these strategies oversee more than $500 billion.
Fund executives should be questioning their managers more closely about their use of derivatives. They should call in expert help to understand the strategies of the managers and the risks the strategies bring with them to the funds.
They should also subject the risk-control strategies used by their managers to greater scrutiny and skepticism. It is apparent that risk-control models and strategies often are flawed and should not be relied upon too heavily.
Derivatives are useful tools. Used properly, they can enhance investment returns or reduce risk. Used without sufficient caution, or sufficient knowledge, they can create huge losses.
What the 2008 crisis and the J.P. Morgan fiasco show is that derivative strategies might have become so complex that even the best, most experienced derivatives managers cannot always predict what will happen.
They are at times like the sorcerer's apprentice: The magic wands (derivatives) are in control, not the apprentices.