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Going From Bad to Worse

The BP oil spill was a mess that spread faster than it could be cleaned. And after the spill there were questions about what risks were taken, and how the industry was regulated.

The JPMorgan trading loss has been referred to as “a BP spill in derivative form”. There was no loss of life, and no environmental pollutants, but questions about risk and regulation are surfacing.

It took just four days for JPMorgan’s trading loss to increase 50%…from $2 billion to $3 billion. If it is not an oil spill, it is a fast moving train running off track.

Regulators are opening investigations. The media is all over the story. But asking all the questions after the fact and getting tied up in the details puts a veil over part of the real problem. It’s not just a matter of what risks were taken…the problem is how the firm estimated those risks.

JPMorgan relied on a calculation called “value at risk”…CEO Jamie Dimon admits the math is “inadequate”. The point of value at risk is to measure the firm’s maximum probable loss. The problem is that the metric is flawed. The other part of the problem is that the CIO, the unit of JPMorgan that was conducting the trades the caused the loss, used a looser value-at-risk measure than the rest of the bank used…ironic, considering that the CIO was supposed to hedge against risk.

On April 13, the value-at-risk calculation suggested that the unit’s risk was $67 million. But when a stricter measure was used just a couple of weeks later, the risk rose to $129 million…double, but still nowhere near $2 billion. Value-at-risk is by no means a fail-safe metric.

But by the time the increased risk was calculated, the bank’s positions on the soured trades were so big there was no way to unwind them quickly…or painlessly.

And underestimating risk is not unique to JPMorgan. Long-Term Capital Management said that its value-at-risk was $45 million…before it lost $4.7 billion. And before its bankruptcy, Enron’s value-at-risk was $66 million…while it was losing eight times that amount in a day (according to The Financial Times).

There is a lesson to be taken from Wall Street’s miscalculations: there is no room for broad assumptions and underestimations in real risk management.

And all of this is a reminder that the financial sector has issues. The activity over the past couple of weeks has taken its toll: a proxy for the sector, Financial Select Sector SPDR ETF (XLF), signaled an intermediate sell.

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