by J John Swanko
5/25/12 (People Port) -Banks manage their asset portfolio risk so their portfolio goes up faster than their competitors. Your assets value need managing also. Your house, boat, car, 401k, savings, and checking are some of your assets in your portfolio. Your lottery ticket for next week's lotto is part of your portfolio of assets. Most of your assets can go up or down, exactly like a big bank.
There is only so much Real Estate, so it always has to go up -was a common mis-conception. Your boat will almost always go down in value. Again, not always true: The BP disaster proved that. Nothing is certain. You can buy assets that tend to go up, no matter what is happening. That is what the big banks try to do.
They do even more. They build into their portfolio a hedge. A hedge generally will go up in value when the asset you are hedging goes down. You do not buy a hedge covering all the asset value, it costs too much.
Banks are not Hedge Funds. Hedge Funds may not be covered by our Security and Exchange Commission rules. They may value next weeks lotto ticket at any price and when you find that out, They may not let you sell. All legal and you may make money -lots of money.
Problems occur when hedging your portfolio. Often the math the banks or you depend on will not work when there is a sudden and total change in people's perception. A house will always go up. When that changed, fear replaced reason. Big banks ate one another. Think Black Friday in reverse. We call it a run on the banks. The product that banks relied on as a hedge should have skyrocketed.
As we have seen in the latest market shock, JP Morgan hedged their portfolio, As commentators reported, their hedge became a bet. JP Morgan has very good rules in place. Their pamphlet for Microfinance Institutions warns in simple terms what can go wrong and how to prevent, limit the damage.
JP Morgan has a proprietary Monte Carlo model (They did not tell me if theirs did not work on their portfolio) and they show how a Microfinance firm can use a simple one.
Most likely, the JP Morgan disaster that kept you awake a few nights was simply a bad hedge. The expected loss should be minor. That loss could be a giant number for your State or mine. When you are a trillion dollar firm, it most likely will be minor. Their CEO and the retired CIO are known to make money no matter what. I would not be surprised if their hedge made them money. Your lottery ticket may win you some money next week.
Background:
I looked into the JP Morgan mess because I have touted Monte Carlo simulation for years as a way to specifically avoid sudden shocks wiping a firm out. It is a great way to find new innovative avenues.
People did not understand how this JP Morgan disaster happened so fast and -for a while- many thought we were about to see another collapse. The investigators will eventually tell us what happened.
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People Port
Image: Crestock
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