JPMorgan’s debacle, and its parallels to AIG
Barry Ritholtz
Washington Post May 19 2012





Last week, the once-future Treasury secretary and current JPMorgan Chase CEO Jamie Dimon revealed a $2 billion loss. This previously undisclosed derivative trade should be a wake-up call for those claiming that finance has been “reined in” and no longer presents a threat to the global economy.

As it turns out, nothing could be further from the truth.

Finance has become a low-margin, high-leverage business. This is not surprising in an environment in which trading volumes are exceedingly low and interest rates even lower. In any other industry, a slowdown in economic activity sends management scurrying to cut costs, develop new products, become more productive. In short, to innovate. Companies can throw money at new products, marketing campaigns or discounted pricing, but a slowing economy brings down demand. What we have today is a deleveraging economy, and that is even more challenging — limiting the options that CEOs can take to increase their company revenue.

The world of finance refuses to accept that reality. Whenever Wall Street is confronted with a decrease in profits, we see the same response: Increase leverage. We usually don’t hear about it until some market wobble causes the excessive leverage to blow up in someone’s face. This time, the novelty cigar was smoked by Dimon, and the damage was inflicted on his reputation. The losses, we learned, were a “mere” $2 billion, described as manageable.

Consider any major finance disaster of the past 30 years, and what you will invariably see is the result of trying to spin dross into gold. The magic of finance is that this can work for a while. The reality of finance is simple mathematics. Eventually, the probabilities play themselves out and the dice come up snake eyes.

One thing that makes the JPMorgan trade look especially foolish is that it’s nearly the same sort of recklessness that AIG exhibited: selling derivatives against zero reserves. As Doug Kass, who heads the hedge fund Seabreeze Partners Management, explained: “Under the knowledge of Dimon, the JPM investment office sold massive amounts of CDS [credit-default swap] premium on large U.S. corporations in 2011. Like AIG, they accumulated a large amount of reported profits in the three-year period ending 2011. In an equally familiar manner, the principals of the London investment office were handsomely rewarded. And so was Dimon.”

Gee, why does that sound so familiar?

So how long did it take after AIG blew itself up selling derivatives until some trader came up short making the same reckless bet? Less than four years.

The parallels to AIG continue to mount, including on the JPMorgan risk management committee. Astonishingly, Ellen Futter, who was a director at AIG, was also on the risk management committee at JPMorgan. It’s unclear what you need to do to get kicked off that committee, but the directorial equivalent of steering the Titanic into the iceberg apparently won’t do it.

Most financial debacles have a few things in common:

1 They vastly underestimate the risks involved;

2 They assume the future will look nearly identical to the past;

3 They use lots of leverage to generate profits without enough capital in reserve;

4 And everyone always pretends to be surprised when the trades eventually go bad.

As to Dimon’s statements, I am not sure which is worse: whether he knew about it and was not forthcoming, or whether he (as claimed) simply had no idea.

Regardless, the error at JPMorgan unwittingly reveals much about the present state of finance:

• Bankers remain imperfect, overreaching and bonus-driven participants;

• When using other people’s money, the promise of enormous bonuses is still weighed heavily toward excess risk-taking;

• No major U.S. money center bank has demonstrated an ability to manage proprietary trading risks. None.

• If traders have forgotten the lessons of the financial crisis less than four years later, what sort of reckless speculative risks will mis-incentivized persons be doing after 10 years?

• Trades that are so enormous as to be “credit index distorting” are not hedges but pure speculation.

• Within banks, apparently the word “hedging” loosely translates as “speculation.” Actual hedging of existing positions appears to be nonexistent.

• This trade was called “hedging for profits” — there is no such thing. That is speculation.

• Value at Risk (VaR) as applied by banks today is a mostly useless concept. This model is such that even minor deviations have devastating consequences.

• Dimon, formerly praised as the Capo di tutti capi of bank CEOs, apparently has been more lucky than brilliant. This past quarter, his luck ran out.

• Because of the enormous built-in leverage in derivatives, they are inherently dangerous. They remain financial weapons of mass destruction.

• “Too big to hedge” is a threat to the stability of the global economy.

• Wall Street in its current configuration is trying its hardest to be “unregulate-able.”

Although this was “only” a $2 billion loss, it easily could have been much greater. That banks such as JPMorgan are still putting on trades that distort indices is, quite bluntly, astonishing.

Back to 1998!


Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. You can follow him on Twitter: @Ritholtz

Category: Apprenticed Investor

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

23 Responses to “JPMorgan’s debacle, and its parallels to AIG”

  1. wally says:

    “Consider any major finance disaster of the past 30 years, and what you will invariably see is the result of trying to spin dross into gold.”

    Isn’t that the very definition of the financial “business”?

  2. wally says:

    “Actual hedging of existing positions appears to be nonexistent.”

    That’s a very interesting observation and is proven true by events that happened after Dimon made his announcement. He noted that the losses could ‘continue to grow’ and apparently (if reporting is correct) they did so as other traders took ‘the other side’.
    In a true hedge situation the ‘other side’ would have been as open to JPM traders as to any others. Dimon, in that case, would have been an absolute fool to make a public announcement without having neutralized the risk in that manner. His foolishness (again, as reported) is said to not be absolute, leaving the conclusion that the JPM positions were not a true hedge.

  3. Iamthe50percent says:

    “Capo di tutti capi” An apt title indeed!

  4. Sunny129 says:

    ‘Hedging for profits’ – A lot of truthiness and hence ‘ hedginess’


    The grip of power by the Financial Oligarchy over the regulators and the law makers is so deep and pervasive, only a repeat of 2008 x 10 will flush out the that affliction.

  5. ConscienceofaConservative says:

    Talking about parallels..
    Bloomberg reported that one of the directors sitting on JP Morgan’s risk committee formerly sat on AIG’s and who reportedly obtained a 36.5 million dollar donation from Hank Greenberg for a charity she ran.
    History may not repeat but it sure rhymes.

  6. obsvr-1 says:

    Spot on, time to break up the TBTF into manageable pieces.

    Come on, what other business CEO would say a $2B loss is no big deal …

  7. louis says:

    Has your house been egged by a limo yet?

  8. Excellent article, Barry! Thx!

  9. scottinnj says:

    Another key lesson of this is that you need to have a culture that can challenge the desks doing well. Everyone is all over a desk doing poorly, those don’t stay hidden for long. But once a desk becomes profitable it becomes TBTC “too big to challenge”. And that really comes from the culture set at the top of the organization. And that, really, is why I think Goldman has managed so well, since it still retains a lot of the partnership culture. In simple terms at Goldman the view was that you were playing with the partners money so the partner on the desk was keeping an eye on you and when audit or risk came into audit a highly profitable desk, the partner on the desk would without exception back the audit and risk. And if you passed, great – maybe some ideas for others and if you resisted then clearly you weren’t Goldman material. Now I’ve not been back to see Goldman for several years so this may be different, but at least in the partnership days it came through in their culture

  10. Asserting any kind of ‘professionalism’ at all in how the financial sector assesses risk is and has been a joke for a long time.

    And it doesn’t take a degree from Harvard Business School to see that.

    How about this one:

    House prices (and the lending for them) rising far faster and far farther than any related rise in income or rents?

    And the ridiculous (but conveniently self-serving) assumption that housing prices ‘would never meaningfully decline’…

    an assumption apparently made across the entire Western World!

    Didn’t any of those whiz-bangs look at that historical record?

    Can you guess why (if its not obvious) “Establishment” parties… whether Left or Right… across the globe backed the fantasy for decades until it took us all the way over the cliff? And then started blaming each other for the big ‘oopsie’?

    (Hint: it has noting to do with either Liberal or Conservative ideals)

  11. ToNYC says:

    Great nail in the right spot; keep driving ..on your own time. A hedge always cuts profits by its true nature requirement the payment of insurance to cover the losses on untoward outcome. Dimon is playing the leg-out of a bad trade via Martingale with Dudley and the Bernanke’s printing machine. It’s just another MF Corzine in the process of looting Dodge, nothing done since LTCM’s genius fail in 1998.
    Bill Clinton got a $100 million or so for the freeway construction as it turns out.

  12. carleric says:

    Cultural Engineer

    You are right…idiocy is distributed equally among the political and financial elite regardless of personal positioning.

  13. sureseam says:

    Correct me if I am wrong but these [JPM etc] are the key organisations running the ETFs, ETCs, etc where retail investors are keeping their pensions.

    How could things possibly avoid go horribly wrong?

  14. Bob A says:


  15. Tioga says:

    Be kind to Mr. Dimon. We can assume on the basis of his record that he grew up in the administration of a credit card company (the one that plays those terrible advertisements of viking terrorists), not on the basis of merit, but on the basis of his appearance and manners more than dominating his rivals over the years. Then, after the merger, his square-jawed, steely gaze, never in doubt, commanding presence bullies his rivals to the top. There is nothing to indicate he has anything more than a double digit IQ. Did he graduate in Applied Math? Did he secure a PhD in Financial Math? Does he, Did he understand truly what the risks he authorized were all about? Give him a break. Those Quants could take days, weeks, all the time they want to explain their perception of risks to the vast majority of us, and we would probably never truly understand. A lawyer, like yourself, might quickly understand the difference between owning tangible property, and owning someone’s promise to perform (which in turn is only as good as his intention and his ability to perform, which may be dependent on someone else’s intentions and abilities etc. etc. etc.) [That is why owning a Rembrandt is better than owning a Lehman Bond etc. ] But Mr. Dimon never became a lawyer. He proves the law that states that we are all promoted to the level at which we are incompetent.

  16. mark says:

    If traders have forgotten the lessons of the financial crisis less than four years later, what sort of reckless speculative risks will mis-incentivized persons be doing after 10 years?

    Forgotten? Actually, THE lesson of the financial crisis was learned all to well. Banks that were once too big to fail are now even bigger. THE lesson was that really big profits will remain private and really big losses will be socialized.

    For what it’s worth: Simon Johnson predicted this back in 2009 and his now classic article “The Quiet Coup” is worth re-reading:

  17. Futuredome says:

    lol. I don’t agree with this post at all.

    AIG was part of systematic risk going in chain reaction. It would have eventually lead toward a complete federal takeover of industry to battle the super contraction.

    I think free market intellectuals never get this and what would have happened as deposit after deposit would have been lost, job after job, house after house.

    JPM’s was just what always goes on. Like ,what is the big deal? Didn’t you know?

  18. Tioga,

    Banc One, not Capital One..



    with..”…Those Quants could take days, weeks, all the time they want to explain their perception of risks to the vast majority of us, and we would probably never truly understand…”

    doesn’t that, Simply, mean that They Fail (?)

    ” An intelligent fool can make things bigger, more complex, and more violent. It takes a touch of genius — and a lot of courage — to move in the opposite direction ” — A. Einstein

  19. Pantmaker says:

    JPM is gonna blow…not a doubt in my mind…still short.

  20. AHodge says:

    This is completely accurate and thorough. Glad you waited
    I only add from friends
    Big Girl notes you cavt apply VAR( if they did) to CDS they don’t pay out on a Baysian normal curve
    Big Guy is convinced they dealt part with their own probably un consolidated hedge fund
    AND at two different internal prices
    I note that CDS accounting is potentially the most in the toilet of all derivatives. At worst BOTH sides os the deal have claimed an asset or asset enhancement against the other side
    There is talk of the item traded as ITraxx. But big guy insists JPM dealt as over the counter so potentially huge leeway for cheating

  21. PeterR says:

    JP Morgan’s loss was whose gain? You KNEW someone had to have made a killing on this debacle.

    Bring in hedge fund the sharks!

    Have a good weekend. You can make a safe bet that Boaz Weinstein is.

  22. victor says:

    Excellent article, they will hate you for it.

    Banking: started by Phoenicians and perfected by European Jews in the Middle Ages as they were banned from most other activities in those societies. Borrow at say 3% and lend out at say 6% to credit worthy customers. Use the spread to cover costs (including bad debt) and make a living. Beyond that, speculation. Now we have Too big to Fail because they are Too Big to Manage. Today, if their assets were properly marked to market they would be declared insolvent. No skin in the game, no claw back provisions. How sweet it is.

    In this case JPM’s loss was several hedgies’ gain including one of JPM’s funds, ironically it made $ for its clients! But if JPM became another LEH, who could predict the consequences?

    BR: “the once-future Treasury secretary and current JPMorgan Chase CEO Jamie Dimon” well put . He was proceeded in this by Jon Corzine who even had the GS emblem in his resume besides his stints in the US Senate and in the NJ Governor’s mansion…

  23. victor says:

    Corzine of LM Capital preceded (not proceeded, sorry) Jamie as future Treasury Secretary after Tim goes “outside” to cash in on his stint.