Wednesday, May 30, 2012

What will it be: Feelings killing reason, or reason killing feelings? JP Morgran versus Bridgewater Associates

Today’s New York Times article ( confirms our earlier interpretation of JP Morgan’s trading loss some two weeks ago. ( There were hedge funds, most notably one called Saba, founded by Boaz Weinstein, who were on the other side of JP Morgan’s trade. JP Morgan was selling credit default insurance at prices the other hedge funds believed were too cheap. “Smelling blood,” they bought, anticipating correctly that the cost of insurance would have to rise. When Jamie Dimon learned how mispriced his firm’s position was, he shut down the unit selling the insurance. As we noted, it is as if an insurance company unwittingly sold cheap homeowner’s insurance to households on a floodplain. Its potential liability would be far higher than it had anticipated

What is most interesting is how the New York Times, in several reports, has emphasized the emotionality surrounding this trade. While Jamie Dimon might have been surprised by his firm’s losing position, there was considerable conflict between the London office, which oversaw the trade, and its New York City counterpart. As the New York Times reporter writes, “The head of the London office, Achilles Macris, gained more latitude to build and expand trades from his desk in London — including the wagers that ultimately went so wrong for the bank. But, “Althea Duersten, who was Mr. Macris’s counterpart in New York and oversaw North American trading, raised objections to Mr. Macris’s outsized bet, but was routinely shouted down by Mr. Macris during conference calls between London and New York, former traders said. What’s more, the brewing tension between Mr. Macris and Ms. Duersten left traders feeling whipsawed, said one trader in New York…. At one point, Ms. Duersten called one trader into her office at the New York headquarters and told him that he would report to her, instead of to Mr. Macris, the trader said. “Achilles hit the roof” upon hearing of the meeting, the trader said, adding that he “didn’t know who to listen to.”

Interestingly, in describing Boaz Weinstein they paint a picture of a “conquistador” eager for the big fight and the bit bet. “Those who have traded against Mr. Weinstein describe him as an aggressive trader who bets big and moves fast. He values a deal more than old-fashioned etiquette. Traders tell tales of losing money to him because of split-second price differences he picked up faster than they did. While that kind of behavior doesn’t win a lot of friends on Wall Street, these traders concede that Mr. Weinstein is too big and powerful to ignore.” The article notes that Weinstein is an avid poker and blackjack player. But the article also reports that he lost $1.8 billion for Deutsche Bank in 2008, trading in, of all things, credit default swaps!

It was not supposed to be this way. One presumptive benefit of quantitative finance is that reason and caution should rule, and where necessary, rule out, emotion. There should be no place for impulses and no recourse to unexamined intuition. Indeed, JP Morgan had “value at risk” economic models, which in 2011 pegged the London unit's exposure at only $1 million less than for the firm’s much larger investment banking business. The unit’s loss of what might now be as much as $3 billion suggests that this quantitative model failed to constrain Macris’ trading impulses. But then again, Deutsche Bank failed to constrain Weinstein’s.

I have recently completed a study, based on limited but publicly available information, of another hedge fund star, Ray Dalio, and his trading style. He is the head of Bridgewater Associates one of the largest hedge funds in the word, which had assets under management of $38 billion in 2011. He has written a remarkable manifesto about his principals for living and managing. The manifesto’s central theme is, “Drive out all emotions.” The financial results are undoubtedly superb. Dalio does not try to hit home runs, he is obsessive in his search for correlations among a wide array of financial instruments, he is cautious and disciplined, and he meditates every day as a way to gain control over his feelings. He believes that markets are unforgiving and that the world is a machine.

But the culture he has created appears to be unnatural. As he reports, and as employees and ex employees report anonymously on a job board, everyone is vulnerable to being “probed” (his word) in order to ferret out their emotional responses. When a reporter from the New Yorker magazine visited Bridgewater to do a profile, Dalio readily berated an employee, called Peter, in front of colleagues for letting emotions get the better of him the day before the reporter’s visit. When, as the reporter writes, Peter protested that he felt that his integrity had been attacked that day, Dalio walked up to a white board and wrote down the word, “Felt”. The anonymous employees writing on the job board confirm that everyone is potentially vulnerable to an inquisition through which probes extract and eliminate feelings. Moreover, one employee writes that everyone is being watched with video cameras, even in areas where there are supposed to be none!

I think we can safely say that this culture stimulates paranoia. Humans are feeling creatures. The prospect of being probed to identify unwanted emotions must lead to mistrust and wariness. Paranoia may be a useful adjunct to trading; after all other traders are trying to increase their wealth at your expense. But should paranoia be all consuming, and should feelings be the identified enemy?

This split between excessive emotionality on the one side, and its ruthless suppression on the other, raises important questions about the psychological climate that trading and investing stimulates. What will it be: Feelings killing reason, or reason killing feelings?

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