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January 2, 2014

When Good Traders Go Bad


Matt Samelson

Also in this article

  • When Good Traders Go Bad
  • Today's bad decisions can become tomorrow's legal disasters. Here's how to recognize the pattern of a trader about to go rogue.
  • Page 3

These decisions appear low-risk to the transgressor at the time because the potential upside is far more tangible than the seemingly remote-but very real-likelihood of loss or punishment. Once a step over the line has been taken, and the rewards tasted, the prospect of continued success often propels further action. Gains act like an addiction, compelling the transgressor to accept the delusion that the questionable activity is risk-free. When the losses inevitably come, they instill a sense of desperation to "get flat" before the inappropriate actions are found out.

In the context of risk-based decision-making, the transgressor overweights the immediate and visible upside against the more remote and, to his or her thinking, "almost nonexistent" downside. In their frenzy to claim credit for the unexpected-and undeserved-success, transgressors may not even recognize the downside as a possibility.

A pair of such decision makers in different realms of finance illustrate the point: Madoff and the J.P. Morgan London Whale.

For many years, Bernie Madoff ran a securities business which by all accounts was legitimate and prosperous. Bernard L. Madoff Securities began as a market maker for pink sheet securities and later grew to become the largest market maker on the Nasdaq. His infamous investment advisory business began in the early 1970s using low-risk arbitrage strategies surrounding his market-making business. After the crash of 1987, unsettled clients pulled substantial investment capital, forcing Madoff to unwind hedges on unfavorable terms. Madoff then developed an index options strategy that required market volatility to work, but markets at the time were flat. According to Madoff, he "borrowed" client capital as a stopgap to perpetuate his consistently high previous returns and keep his business going. That unexpectedly resulted in a huge influx of new investor capital.

To keep up appearances, and because the high profiles of his new investors "fed his ego," Madoff continued the Ponzi scheme that resulted in his downfall. Once his scam was established, he deluded himself into seeing only the tangible aspects of wealth, materialism and inflated ego, all the while ignoring the downside of shame, punishment and prison that awaited.

In April and May 2012, J.P. Morgan's Chief Investment Office incurred large trading losses based on transactions booked through its London branch by Bruno Iksil, the "London Whale." A series of outsize derivative transactions involving CDSs were entered into, allegedly as part of the bank's hedging strategy. The bank announced a $2 billion loss with expectations the figure would significantly increase.

Iksil made huge bets on thinly traded indices that caused irregularities in value versus market expectations. The positions stood to benefit if the credit markets improved or stayed the same. Not only were the bets bad, but given the relative illiquidity of the indices, it soon became clear who was trading in what direction.

J.P. Morgan head Jamie Dimon attributed the loss to "egregious mistakes" in trading. He called the strategy "flawed, complex, poorly reviewed, poorly executed and poorly monitored."