It’s probably a safe bet that JPMorgan Chase (JPM) CEO Jamie Dimon had been looking forward to today as an opportunity to stand before the bank’s shareholders at the company’s annual meeting, bask in the spotlight, poke fun at poorly paid journalists and easily handle questions about the economy, market liquidity and other obvious topics. But as we’ve all learned lately, maybe there are no real safe bets when talking about big investment banks.
Having announced a loss of at least $2 billion on a complex hedge using credit derivatives on a basket of corporate debt, Dimon is now likely to face calls for his resignation from some shareholders at the meeting. But what those shareholders should really be demanding – at the top of their lungs, and of every bank CEO and not just Dimon – is how risk management models missed the boat so completely. “People started justifying whatever we did,” Dimon told “Meet the Press”: a clear sign that the CEO of one of the country’s largest and most successful banks failed to understand some of the first principles of risk management.
JPMorgan Chase has already abandoned the new version of the Value at Risk (VaR) model that may have helped mask the trading problem at its London-based Chief Investment Office, or so Dimon informed listeners on that now-infamous conference call last Thursday afternoon. And it’s true that VaR models – of all kinds – are far from infallible. Their biggest advantage is that they give a risk manager or a CEO a quick and easy way to respond to a common question: “how much risk are we running?”
But the answer, in the form of a single figure – that an institution has a 97 percent or 99 percent chance of running a loss of no more than X on any given day – is based on history. As one of the architects of modern risk management put it to me nearly 20 years ago, long before derivatives-related losses had become a hot button issue, VaR “is like driving a car and using the rear-view mirror to steer.”
Models are just a starting point for a broader-based discussion about risk, and that’s what went wrong at JPMorgan. And that’s why we can’t afford even a smidgen of complacency about the London Whale and his losses – because the bankers themselves had become complacent about both their models and their ability to steer their way through a crisis.
Just ask Tanya Beder, chairman and CEO of SBCC Group, an independent advisory firm focused on risk management. Beder has had a ringside view on most of the big financial industry blowups since Orange County and Robert Citron in the mid-1990s. “What happens, far too often, is that if a firm is doing really well, or a trading area seems to manage risk consistently and makes money, people stop asking the questions of just how is it that we are making more money at this than anybody else,” she says. “With the passage of time and good performance, there is a high danger of complacency or high likelihood that no one bothers to ask the biggest, most important question – what assumptions and calculations underlie our models, and what happens if we are wrong?”
The problem with VaR and risk management as it’s practiced today, points out James Montier (a member of the asset allocation team at GMO LLC, a money management team with $105 billion in assets) in an eerily timely white paper published this month, is human nature. “Stop sacrificing reality on the altar of elegance,” he argues, adding a plea for “a little more common sense and a little less complex mathematics.”
Among Montier’s recommendations: Treat financial innovation with skepticism and don’t try to game the models. That, Beder says, may be impossible. Teaching a graduate-level course in financial engineering at Stanford, she introduces her students to VaR, telling them what the rules and what the incentives are. Within minutes, she says, they are gaming the model for all it’s worth. She suggests it’s like telling a driver that the speed limit is 55 miles per hour, but there’s a reward for arriving at a destination quickly. “Then tell them that they won’t be ticketed unless they are driving at more than 65 – really, what do you think is going to happen?”
Over the years, as VaR has become more accepted among regulators and within boardrooms of major financial institutions, Beder has seen it become more uncommon for senior managers to ask probing questions about what might go wrong – even after the events of 2008 demonstrated all too clearly that “Black Swan” events were the ones that had the power to devastate an entire financial system. When Beder presents a business plan to a student, a colleague or a client, “they’ll pick it to bits in seconds,” she says. In contrast, present a risk report to a board committee and the response likely is going to be limited to a polite “thank you.” “I’m astounded at the number of times I walk into a boardroom (at a company) where there has been a loss, and there is a misconception that it is too complicated for the directors to understand,” Beder laments.
Refining VaR, or using the best possible variant of VaR, is great. Limiting the discussion to the number and what it says? Not so much. Sometimes asking questions about what the number means can uncover a toxic problem, as the CEO of investment bank Sandler O’Neill discovered back in the spring of 2007. The investment bank was warehousing several hundred million dollars’ worth of trust-preferred securities, waiting for them to be repackaged and sold to investors. The risk appeared to be low: the volatility of these securities had been low in the recent past. But Dunne asked how much collateral the firm had on its balance sheet in connection with these holdings – and when he realized how much this was out of whack with the historical average, he told his traders to liquidate the positions. “I had to assume the worst case scenario,” he said later.
Because of that single question, Sandler O’Neill didn’t take a body blow when the market for trust preferreds turned sour not much later.
Things had been going very, very well for Dimon and JPMorgan Chase. While rival Lloyd Blankfein, the CEO of Goldman Sachs (GS), squirmed in the hot seat during Congressional hearings, Dimon got a smooth ride – and grabbed the number one spot in most “league tables,” to boot. But this risk management snafu isn’t just a question of a badly behaving model; it’s a question of corporate culture and human behavior. And while the bank’s shareholders aren’t likely to accept quietly any assertion that this doesn’t really matter because the losses barely put a dent in its balance sheet, they shouldn’t confine themselves to shrieking in general outrage. Rather, they should grill Dimon and his team about what went wrong with the firm’s culture surrounding risk management.
After all, JPMorgan was one of the banks that helped pioneer the intensive discipline of risk management as we know it today – if anyone should be aware of its limitations, it is this bank. All the more reason to ensure that it has a clear understanding of what went wrong – and a clear strategy for addressing the deeper flaws revealed by what could still become a far larger loss.
