An assortment of United States coins, including quarters, dimes, nickels and pennies. (Photo credit: Wikipedia)

When JP Morgan lost 9 billion dollars on a derivatives trade, many people saw it as the market functioning properly.  What made the story interesting is the scale of the losses, 9 billion dollars at last estimate.  Yet, the story contains a deeper concern for two reasons.  On the surface, there is the issue, not widely known, that another part of JPMorgan was on the other side of the trade.

That one hand of the bank was selling while another was buying is not uncommon in the dog-eat-dog world of Wall Street. Yet that trading is typically done on behalf of clients, not in a way that, inadvertently or not, undermines what the bank is doing for itself.

The point is noteworthy because even as one side of the bank was losing money, the other gained. The trade shows, to an extent, that the bank is operating separately in its dealings with its money and its investors’ money.  However, it does make one wonder of the point of the market, at all, with such transactions.  Even though the surface question is interesting, the deeper question is more troubling.

The deeper part of the story, though, is the mechanics of the trade itself. Therein we see the darker, more dangerous, side of Wall Street. What we have to consider is whether the market is really working in derivatives trading or whether something more sinister is at work.  Here is where the parable of the Good Samaritan becomes important because it shows us Wall Street in a different light.  Instead of finding out who our neighbour is, so that we may help them, the question at the heart of the parable, the goal of derivative trading seems to be to beggar our neighbour. More to the point, the goal appears to inflict a loss on our neighbour without any regard for the consequences. As long as we gain, it does not matter what happens to anyone else.

The trade in question was that JP Morgan was based on buying “insurance” to hedge against potential losses on another deal.  JP Morgan was using a hedge index, based on a portfolio of financial instruments (IG Series 9 10 Year Index CDS) (that does not mature until 2017) to deal with the risk of losses. If the fund increases in price, that is if the companies behind the index (of the default risk of 125 major North American companies, including Aetna, Walt Disney and Lockheed Martin (across 14 different industries) become greater, then JP Morgan, losses money. If the index goes down, the risk of default goes lower, those companies from the 14 different industries become stronger, and then JP Morgan makes money, which protects its other investment.  In that deal, JPMorgan’s trader was assuming that the economy, overall, would improve so the index would go down.  However, as the economy did not improve the index increased.  At the same time, the index increased because others were buying it on the belief that it would increase and JPMorgan would have to cover it.

What the hedge funds noticed was that the price appeared artificially low because JP Morgan was selling so much of it.

 With JPMorgan selling so much of this insurance, the price was artificially cheap. In buying it, the funds were betting that the cost would increase when the bank eventually stopped selling. Such a move would notch them a tidy profit while causing steep losses on paper for JPMorgan.

You will note that the hedge funds were not interested in what the 14 industries were doing, nor were they interested in what the 125 companies were doing. Nor, were they interested in the overall health of the economy.  Moreover, the index was not maturing until 2017.  Instead, they saw the JP Morgan was short on the deal.  In a word, they saw that JPMorgan was vulnerable, and they took advantage of JP Morgan’s need to insure against risk.

The deal itself was not to create a better product.  The deal was not to provide cheaper funding for other projects.  The deal was not to grow a company or an industry.  The hedge was against risk against other investments, the investments themselves were not necessarily in industries or services creating jobs or economic growth.

The issue, though, is not about derivatives or how they work. They are like any financial tool; they are neither good nor bad in themselves. They become a problem because of the intent for which they are used.  In this case, the goal appeared to be to reduce risk for capital invested in other more productive areas.

What the deal comes down to is that one party understood a way to take advantage of the other.  There was no mutually beneficial outcome.  The goal was not to find a productive use for the money aside from being in a position to take advantage of someone else.  The hedge fund profits by finding someone, anyone, else in a vulnerable situation and makes a profit from their vulnerability. The hedge fund is not interested in growth, productivity, or market share.  The only goal is to find the vulnerability that can be exploited no matter the consequence or cost to others.

The deal is not about finding a mutually beneficial result. Instead, it is to find those results that are not only zero sum, but upon which the other party is so vulnerable that no matter what they do, they will suffer a loss. The goal, it would seem, is not so much to make a profit as to inflict a loss on the other party.  However, if a trade is supposed to be mutually beneficial, what is the purpose of a zero-sum trade?  We return to the question that is at the heart of the Good Samaritan: Who is my neighbour?   In the market, we have to ask whether we have a duty of care to the market to consider the result for the market on any trade.

The hedge fund has succeeded. They have their profit. Yet, JPMorgan could default and collapse. Some might say, “Well that is how the market operates, the weak companies need to be destroyed.”  Yet, are they being pushed out of business because they cannot compete nor are they being pushed out of business because someone saw their vulnerability and exploited it.  Does the hedge fund even consider what it is doing to the other company or the market?  If it has considered that effect, does it even care? If JP Morgan defaults entirely, and goes the way of Lehman Brothers, then the financial market cannot recover.

Here is the interesting thing about the behaviour in the market.  The hedge fund would not tolerate such behaviour within its company.  Could you imagine if the CEO had to be worried that his (or her) employees were trying to undermine the company at every opportunity without concern for the consequences?  The only defence against that fate is to take out more and more “risk” insurance.  Yet, what does that do?  What we see is that we are not dealing with risk. Instead, we are dealing with the absence of trust. The deals and decisions, which other celebrate, have dramatic and drastic consequences for the world.  Imagine if every industry in the world were run this way.  Why do we accept it in derivatives but no other industry?  Moreover, what is the larger social good from such a deal?  What does it benefit anyone, but the hedge fund and its investors, when a loss of that size is inflicted on a company?

The hedge fund has made its profit, but at what cost?  The next time we get on the other side of a “trade”, we may need to ask, “who is my neighbour?”  Perhaps, the deeper problem from this is not risk, but the lack of trust within the market that requires companies to seek someway to insulate or insure themselves against the inability to trust anyone else in the market (even their own company.)

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