How Dumb Rules Can Mitigate Model Risk

Editor’s Note: Mark Roe is the David Berg Professor of Law at Harvard Law School, where he teaches bankruptcy and corporate law.

For those curious about the timeline of the world's biggest prop-desk blow up, here it is day by day and, pardon the pun, blow by blow. Nov. 2006    Bank authorizes Chief Investment Office (CIO) to trade credit derivatives. 2008    Synthetic Credit Portfolio (SCP) acquires its name. 2009    As financial crisis eases, SCP earns $1 billion. 2010   

Editor’s Note: Ben W. Heineman, Jr. is a former GE senior vice president for law and public affairs and a senior fellow at Harvard University’s schools of law and government. This post is based on an article that appeared in the Harvard Business Review online. The apparition of 2008 returns once more.

There is so much grist in the just-released Senate Permanent Subcommittee report on the JP Morgan London Whale trades that the initial reports are merely high level summaries, which is understandable. Even with the admirable job done by the committee in documenting its findings and recommendations, it will take some doing to pull out the critical observations and convey them to the public. Plus the hearings tomorrow should provide good theater and further hooks for commentary.

While JPMorgan's arrogance and complete ignorance (intentional or not) of both risk limits and regulatory expectations is now grossly obvious, the fact remains that a lie is a lie and given the following, how can anyone ever trust anything that anyone from this 'fortress-like' balance sheet ever says again? To wit, again and again and again, the public and the regulators were told this was a long-term 'hedge' for a bank that is a natural net 'lender' and therefore exposed to deterioration in credit markets over the long-term.

This is something people are starting to talk about in the blogosphere that should give all of Wall Street pause. Over at The Baseline Scenario, law professor James Kwak, says that what has been generally under reported about the London Whale debacle — how badly Excel failed as a financial modeling program.