The Wall Street Journal – J.P. Morgan’s $2 Billion Blunder
Bank Admits Losses on Massive Trading Bet Gone Wrong; Dimon’s Mea Culpa
A massive trading bet boomeranged on J.P. Morgan Chase & Co., leaving the bank with at least $2 billion in trading losses and its chief executive, James Dimon, with a rare black eye following a long run as what some called the “King of Wall Street.” The losses stemmed from wagers gone wrong in the bank’s Chief Investment Office, which manages risk for the New York company. The Wall Street Journal reported early last month that large positions taken in that office by a trader nicknamed “the London whale” had roiled a sector of the debt markets.

Comment

We have been dissatisfied with the explanations of what happened at J.P. Morgan.  Let us try to sum up the situation.

Who Is The London Whale?

J.P. Morgan’s London office has a credit default swap trading group called the Chief Investment Office or CIO.  The group is run by Bruno Michel Iksil. Officially the CIO group was supposed to be in charge of hedging J.P. Morgan’s credit exposure.

Mr. Iksil was not known outside the world of CDS trading until an April 6 Wall Street Journal and April 6 Bloomberg article dubbed him “the London whale.”  So secretive is Mr. Iksil that no picture has surfaced of him (yet).  The passage below comes from the WSJ article:

In recent weeks, hedge funds and other investors have been puzzled by unusual movements in some credit markets, and have been buzzing about the identity of a deep-pocketed trader dubbed “the London whale.” That trader, according to people familiar with the matter, is a low-profile, French-born J.P. Morgan Chase & Co. employee named Bruno Michel Iksil.  Mr. Iksil has taken large positions for the bank in insurance-like products called credit-default swaps. Lately, partly in reaction to market movements possibly resulting from Mr. Iksil’s trades, some hedge funds and others have made heavy opposing bets, according to people close to the matter… However, Mr. Iksil has turned more upbeat recently. He has been selling protection on an index of 125 companies in the form of credit-default swaps. That essentially means he is betting on the improving credit of those companies, which he does through the index—CDX IG 9—tracking these companies.

So Mr. Iksil’s CIO group had amassed a huge position in the CDX series 9.  And, as the charts from the Wall Street Journal above show, the positions in this derivative alone totaled over $150 billion dollars.  J.P. Morgan’s December 31, 2010 10-K filing revealed the CIO group held $350 billion in investment securities which made up 15% of J.P. Morgan’s assets.

Stories of Mr. Iksil and his large positions reminded us and others of another huge CDS trader based out of London, AIG’s Joe Cassano.  When Cassano’s position went bad in late 2008, it cost AIG $200 billion in losses.  The company needed to be bailed out the by Federal Reserve and nearly took down the entire financial system.

Did J.P. Morgan’s Management Learn Of The London Whale In The Paper?

After The Wall Street Journal and Bloomberg articles, the CIO group stopped trading CDS.  From an April 10 WSJ article:

A J.P. Morgan Chase trader whose massive derivatives sales in recent months earned him the nickname the “London whale” has stopped making those trades, for now. But investors that were squeezed in his earlier action remain engaged in high-stakes strategies against the trader.  Dozens of hedge funds are believed to have placed bets in the derivatives markets that pit them against positions taken by Bruno Iksil, the French-born trader who works for the bank’s Chief Investment Office in London, according to people familiar with the matter.

The five largest banks in the United States hold over 75% of all banking assets.  This is the highest concentration of banking assets among the top five firms in American history.  The concern of banks being too big to fail is worse now than before the financial crisis.

With these large financial intuitions comes the belief that they are also too big to manage.  The joke going around when these stories initially broke was that a lot of J.P. Morgan’s senior management first learned of the CIO’s activity by reading The Wall Street Journal.  That looked less like a joke after J.P. Morgan stopped CIO’s trading within four days of the stories.  If J.P. Morgan’s management knew all about these positions and approved of them, why stop CIO from trading because of media stories?

Is The Phrase “Tempest In A Teapot” Misleading And Fraudulent?

On April 13 J.P. Morgan reported its quarterly results and addressed media reports about the London whale.

J.P. Morgan Chief Financial Officer Doug Braunstein and Chief Executive Jamie Dimon scoffed at recent media reports and concerns about an outsized trader dubbed the “London Whale.”  “The CIO balances our risks,” Braunstein told media members on a conference call. “They hedge against downside risk, that’s the nature of protecting that balance sheet.” Braunstein added the bank is “very comfortable with the positions we have” and that all of the positions are “very long term in nature.”…Dimon chimed in that every bank has similar positions, though the size depends on the size of the bank, and added that regulators “see everything we do whenever they want.” He called the issue a “tempest in a teapot.”

Braunstein and Dimon have responsibilities to make accurate and truthful statements.  If a month later they hold a hastily arranged conference call to announce everything they thought about the CIO group was wrong and they lost tons of money, did they suspect this might be a problem on April 13?  If so, did they then make fraudulent statements?  If not, why did they stop this group from trading on April 10?

Dimon Learns A Lot About His Firm From Reading The Paper

In the conference call yesterday, J.P. Morgan’s CEO Jamie Dimon said:

Jamie Dimon: Regarding what happened, the synthetic credit portfolio was a strategy to hedge the firm’s overall credit exposure, which is our largest risk overall in this stressed credit environment. We’re reducing that hedge. But in hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed, and poorly monitored. The portfolio has proven to be riskier, more volatile, and less effective as an economic hedge than we thought.

And this …

Q – Brennan Hawken: And the implication I guess might have been that there
was all this press speculation about certain trading individuals out of
London. Were some staff fairly new that came into execute this new or this -
some of this new angle, and are those folks no longer in that? That’s been
re-jiggered, I think you said, right?

A – Jamie Dimon: No. No, no, it was nothing to do with new folks; a little
bit to do with the articles in the press. So it was somewhat related to that.
And it was obviously more than that, but somewhere related to that. And I
also think we acted a little too defensively to that.

Q – Mike L. Mayo: And lastly, just one last follow-up. You said you had
some smaller losses in the first quarter. Were there – even in retrospect
were there any signs that perhaps you should have paid more attention to,
looking back?

A – Jamie Dimon: Yes, in retrospect, yes.

Q – Mike L. Mayo: And what would those be?

A – Jamie Dimon: Trading losses.

Q – Mike L. Mayo: Okay, so actually trade…

A – Jamie Dimon: There was some stuff in the newspaper and a bunch of other
stuff.

Translated, the CIO group were out of control and not supervised.  J.P. Morgan might have had no clue what was happening at CIO until they read it in the newspaper.

Where Did The Losses Come From?

We know these positions were in derivatives on U.S. corporate bonds (CDX).  These were not positions on European bonds, commodities, mortgages or equities.

Dimon said these trading losses were due to the volatile environment.  But the environment was not that volatile, certainly not as volatile as 2011.  Frankly, nothing special has happened in the corporate bond market in the last month.

So what happened?

Zero Hedge – Is JPM Staring At Another $3 Billion Loss?
This is the 10Y IG9 credit index (dark blue) and its fair-value (light blue) and the difference or skew (orange). What is clear is that the index remained massively rich to its fair-value through this period (red oval) and it was not until the last two months or so that the skew (red arrow) began to compress as perhaps Iksil got the nod and more and more people realized the arb…(or understood from where the technical pressure was coming in the index rallying)…

 

In early April, as news of this broke across the market, the credit and equity markets were beginning to quiver again at European contagion and US macro data and as a proxy for the volatility JPM must have been feeling we can see very significant (2-3 sigma) swings in the credit index they held. This would more than likely have triggered a risk manager to come along and look over the trader’s shoulder – suggesting humbly that he exit/hedge/don’t panic.

This is IG9 10Y spreads (upper pane) and their rate of change (lower pane) – (h/t @swaptions for idea) and as is clear the 3-sigma multiple day move likely scared a few risk managers (and Iksil) into fessing up…

To translate, the CIO group became so big that they were the market.  When J.P. Morgan’s management read about their position sizes and saw potential trouble brewing in credit because of Europe, they shut Iksil down around April 10.

However, shutting down such a large player came with consequences.  See the two charts above and notice what happened before and after April 10.  The only significant change was J.P. Morgan stopped trading this instrument.  In other words, J.P. Morgan’s actions may have caused their own downfall.  Furthermore, J.P. Morgan’s continued (in)actions could make the situation worse.

For these types of relatively small market moves to cause a $3 billion loss, J.P. Morgan must have had tremendous exposure.

Dimon also said on the conference call:

We are also amending a disclosure in the first quarter press release about CIO’s VaR, value at risk. We’d shown average VaR at 67. It will now be 129 [chart].

The numbers Dimon cited were averages.  The March 30, quarter end VaR was 186.  And since much of the loss has occurred since March 30, this VaR could be significantly higher.  So yes, their exposure was much higher than they thought.

What Next?

Dimon said on the conference call:

The portfolio still has a lot of risk and volatility going forward. So how are we going to manage that? So, number one, we’re going to manage it to maximize economic value for shareholders. What does that mean? It means that we’re not going to do something stupid. We’re willing to hold as long as necessary inventory, and we’re willing to bear volatility. Therefore, the volatility for the rest of this quarter and next quarter or so will be high. It could cost us as much as $1 billion or more. Obviously, we’re going to work hard to have that not be a negative at all. But it is risky, and it will be for a couple of quarters.

In other words, they still hold these positions and these losses are not finished.  Should the market continue to move against them, the losses could grow substantially.  In fact, since CIO stopped trading on April 10, normal market relationships have been diverging from historical norms.

More from Zero Hedge:

Of course, the situation is far worse because 1) any efforts to unwind such a huge position will lead to the market yawning wide and swallowing him in illiquid bid-ask spreads; and 2) the rest of the world knows their position – so why would the hedge funds not push their position. Perhaps this explains why JP Morgan’s CDS has remained relatively wide while its exuberant stock price shot up on stress-test ebullience – only to plummet back to CDS reality this evening. Critically, JPM will need to use whatever method they can to hedge this now over-hedged and over-long position – which likely means credit instruments such as JNK, HYG, HY18, and IG18 will all get their share of strange attraction as the trader mispriced not just the basis risk (the volatility between the hedge and its underlying) but the attraction of running with a trend when you have a bottomless pit of money to cover it – until now.

It is already evident in the on-the-run liquid indices – HY18 for instance has exploded wider twice now – in line with the net notional reduction and hedging moves from JPM’s IG9 position…

Translated, CIO had been trying to hedge using the “on-the-run” series 18 CDX (CDX are issued every six months with the latest being series 18).  This alone has caused a divergence in normal historical market relationships.  Now that the world knows J.P. Morgan’s CIO group is bleeding, hedge funds and other speculators will push these positions to the brink, hoping to force J.P. Morgan out of these positions at a profit to themselves and a bigger loss to CIO.

As the hedge funds push the market against CIO, they will be sitting on an unrealized profit.  The problem is they cannot all get out with that profit unless J.P. Morgan is forced out and has to buy the hedge funds’ positions.  Since the potential profit involved in this strategy will be huge, the hedge funds will certainly try.

A Final Word About Mr. Bernanke

How was J.P. Morgan able to amass such a large position?  If a mere mortal tried this, he or she would have been required to put up ever-larger amounts of collateral with counter-parties that would have effectively stopped the position from getting this big.  Since the Federal Reserve proved in 2008 that they would bail out any bank considered too big to fail, no one worries about details like collateral from one of the big banks.

Counter-parties were only too happy to take the other side of J.P. Morgan with little-to-no collateral.  They figure that either Mr. Dimon or Mr. Bernanke will honor their contract.  The Federal Reserve already set the precedent for such a bailout when it let Goldman Sachs out of its AIG contracts at par.  If the markets become too chaotic for J.P. Morgan to handle, the counter-parties are banking on such a bailout once again.

In the days and weeks ahead, the Federal Reserve will no doubt support legislation to stop this scenario from ever happening again.  It will not work.  The real fix is the same one that has been around for a 1,000 years.  It is called capitalism.  Let these institutions fail.  Tell their creditors they are on their own and push for transparency so everyone can see what banks like J.P. Morgan do.  Finally, get out to the way and let the markets fix this problem.  This would undoubtedly wreak havoc in the short term, but it will serve as a lesson to everyone in the future that taking such large risks has consequences.

Instead Bernanke will give assurances, hint at more money printing and encourage J.P. Morgan to bury these positions in the hold-to-maturity account where they do not have to be marked to market and we can all pretend they do not exist.

Source: Bianco Research

Category: Think Tank

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.

19 Responses to “Understanding J.P. Morgan’s Loss, And Why More Might Be Coming”

  1. Greg0658 says:

    I gotta be careful ie: the overposting boot .. but thanks for that .. and am I right am I wrong that there is an MFGlobal mix in the last 6 months of trading .. getting aorund to:
    is it possible someone ordered a make MFG whole .. just get it done ?

  2. Centurion 9.41 says:

    “The Federal Reserve already set the precedent for such a bailout when it let Goldman Sachs out of its AIG contracts at par.”

    After Warren Buffett’s “investment” in GS, he publicly lent support to the political movement to bailout the banks. Think about that for a minute, and when you do remember the following:

    * WB already had a large amount of exposure to the banking sector, does this jibe with a man whose self-proclaimed philosophy includes as a fundamental tenant to control risk and exposure?

    * WB later claimed his risk to the banking sector were protected by the very same type of derivatives as he in the past called “financial weapons of mass destruction”.

    The fact is this. WB would have been wiped out IF the US tax payer DEBT had not been used to bailout the banking sector.

    I can accept taxpayer debt being used to save the banking sector. HOWEVER, those who held positions of either authority [e.g. C-Suite and MD types] as well as those “sophisticated investors”, who get the benefit of being designated “Accredited Investors”, that hold positions significant enough in size to require filing of a Form 4. Doing those things, along with breaking up the banks such that they could no longer be TBTF, would have maintained the integrity of “moral hazard” while saving the sector.

    Btw, the argument that reducing the size of the banks to below TBTF would result in tremendous damage to US’ investment/banking sector is a staw-man built to prey upon the FEAR and ignorance of the American people; classic political scum MO.

    For those that think JPM’s trade is the only roach, history reminds that Wall Street has traditionally behaved like a herd. And the reason this position became known about in the first place was due to the fact that ALL the “whales” were playing in this part of the ocean.

  3. texasdiver says:

    What’s not said in this explanation is who exactly managed to take $2 billion off of J.P. Morgan?

    Some unidentified hedge funds apparently. Surely there are champagne corks popping somewhere as hedge fund managers are celebrating scalping Dimon for a cool $2 billion. I’d love to hear who those folks are and what their story is.

    This is typical of these stories. We get endless detail about the losers but never hear about the winners.

    ~~~

    BR: It was most likely 100s or even 1000s of counter-parties. Lots of little winners on the other side.

    Once the sharks smelled blood in the water, they started betting against the whale, making his losses much bigger. The huge size that traders were complaining about when it was pushing the market around became a liability.

  4. albnyc says:

    Do we need more evidence that we live in a corporatist, not capitalist economy? Bastards. One and all.

  5. blackjaquekerouac says:

    I was shocked by Jamie Dimon’s response more so than the loss actually. First he didn’t blame himself. Then he admitted he didn’t see it coming. Finally he summed it all up by saying “the position is still active.” My first thought was “why are you still active” then? Isn’t the right response to take blame and “get to the bottom of this”? i had to laugh out loud when the Morganistas all said “this is no big deal”…interestingly “the equity market agreed” as JPMorgan’s stock price plunged but the rest of the market let out a collective yawn. Perhaps “zero” is better after all…http://www.youtube.com/watch?feature=player_detailpage&v=bj45hsYraNc

  6. Mike in Nola says:

    “Mistakes were made.”

  7. Mike in Nola says:

    I thought this was a pretty good explanation of what has been going on. Haven’t heard “martingale” since college 40 years ago. I don’t agree about the reserve currency bit as those who want to export to a debtor nation have no choice but to take it’s money in exchange, esp. now that we are about the only currency in town.

    http://www.zerohedge.com/news/double-or-nothing-how-wall-street-destroying-itself

  8. Sunny129 says:

    But for the juicy details (OMG!)nothing said above is a new or secret but continuation of this corrupt practice, highlights the reality of grip of power by the Global Financial Oligarchy over the Economy, market, regulators and the lawmakers!

    Back to ‘ Privatize the profit and socialize the debt’ ?

    The charade of ‘business as usual’ will continue after a short break of cognitive pause!

    Time to REPENT and repeat ’2008′ in grand style to remind every one, once again that ‘those who don’t or seemingly afford NOT to remember the past, are condemned to repeat it’ much sooner than one thinks!

  9. victor says:

    Where are you Bill Seidman with your Resolution Trust Company when we need you? Bill was an honest, modest man who knew how to persuade the people in power. But that was then when Joe six pack could count on protection from corporate malfeasance; now it’s all different with the rich protecting the rich and Joe sixpack alone left holding the bag.

  10. Blissex says:

    «insurance-like products called credit-default swaps.»

    That is the usual propaganda: CDSes are gambling-like products because in nearly all CDS transactions there is no underlying insurable interest.

    Indeed a crucial point, probably the most important, of the Gramm-Leach-Liley act about derivatives was to explicitly exempt derivative trading and traders from gambling laws, which otherwise would have been applied to them, as the head of the CFTC at the time had mentioned.

  11. many good Comments, above, no question..

    though, read this..

    “…But that was then when Joe six pack could count on protection from corporate malfeasance…”

    and, thought..~wtf? When? was that?
    ~~

    http://www.amazon.com/Death-Supermarket-Fattening-Dumbing-Poisoning/dp/1569803323

    http://www.amazon.com/The-Hundred-Year-Lie-Chemicals-Destroying/dp/0452288398/ref=pd_sim_b_2

    http://www.amazon.com/Slow-Death-Rubber-Duck-Everyday/dp/1582437025/ref=pd_sim_b_3

    http://www.amazon.com/Excitotoxins-The-Taste-That-Kills/dp/0929173252/ref=pd_sim_b_2

    H*ly Cow~ and, that’s, merely, “from the ‘Shopping Cart’…”

  12. [...] à celle de LTCM. La bataille continue aussi longtemps que JPM n’avoue pas sa défaite. Plus d’informations en anglais sur ce lien J'aimeJ'aime  article   Leave a [...]

  13. [...] with genuine, lasting value like GE and US Steel. These modern bankers create nothing of value.JPMorgan executives may have learned of the impending disaster with their London Whale trade from articles in the WSJ [...]

  14. Charlie Smith says:

    A great, informative article. As I understand it, since the big 5 banks control 75% of the banking assets, the markets are a charade. A real market must be made up of many diverse interests on both sides of a trade. This will be interesting, to say the least.

  15. Sandy the Swede says:

    Talk about timing! Just watched the movie “Margin Call” last night.

    Why shouldn’t the 5 or so TBTF banks continue their stay at the roulette table? Uncle has their backs.
    Rule of Law for the shlubs is gone (auto company bondholders screwed, e.g.) and Moral Hazard for the crony capitalists is gone (current article, e.g.).

    The battle of the Titans (Inflation vs Deflation) continues. I don’t know when it all comes to an end, but I do know that it will continue until it doesn’t. My money is on inflation despite ZIRP. Our level of debt is unsustainable. Although we will not formally default, we will repay it through stealth default: Inflation. If you see another way out, I would like to hear your view.

    Sandy the Swede
    Retired and recovering banker

    P.S. Great article, James!

  16. Chuck says:

    Sandy — Has no one ever considered the possible “joint venture” between the FED, ECB, Obama, and China, where the private banks get gobbled up by the “joint venture” group, Western Europe and the U.S. fall under martial law paving the way for Obama to complete his “hope and change” of instituting a socialist government on both hemispheres? If you really sit back and look at the bigger picture, you can see that there is more going on than most people realize. There is a race between China and the “Globalists” to see who’s currency becomes the world’s next reserve currency, and my money is on the “Globalists”. That last I heard, they want to create the “Bancor” as the next reserve currency for global trade. The key to understanding the TBTF banks is this: All Central Banks (those owned and controlled by the wealthy European families) were brought into existence for the purpose of controlling the profitability of the large private banks and other multi-national corporations that are either privately owned by, or which have large equity holdings by, those wealthy European families. Your comments indicate a mindset that believes the U.S. is going to get out of this mess. I’m sad to say, it won’t be able to. Take a look at the debt clock, which I am assuming you have seen. There is one very large number on that clock that is larger than all the rest of the numbers added together. When you find that number, look at the description of what that number represents. You will find that the leveraging in the banking derivatives are large enough to collapse the economies of the entire world many times over. Take some time and put all these events in perspective — you will begin to see the forest from the trees. What is going on with J.P. Morgan plays right into the hands of those wealthy European families I mentioned earlier. Obama’s role of taking the U.S. into a socialist state requires the takeover of corporations, and the Central Banks will play a huge role in that process. I expect the “joint venture” group to begin ramping up this process in July, 2012 and complete their goals in less than five years. If you’re a Christian, you can also phase in some other cataclysmic events that, I believe, will foil some of their plans.

  17. whatnow says:

    I heard the problem started when Jamie Dimon took his eye off the ball because the CIO Group had been doing so well with their trading the recent past. The CIO Group made the same mistake most human traders make. If they do well for a while they begin to believe they can not make a mistake in the market. They use the old Trust Me I know what I am doing look at my past winning trades. The problem is the market has changed directions and there is a new bubble in some other area just starting to build. In other words the old winning ways are like fashion the cool markets are no longer fun to play in.

    Jamie Dimon took the reassuring words of those in charge under him that every thing was fine and under control. He ask more questions and got more reassuring summaries just like when you suspect your kid of doing something wrong but have no caught them in the act. They may not outright lie but will not be completely open with you hoping with time the problem will go away. Mr Dimon finally asked for the actual trading paper work and realized how bad the problem was and stopped the trades. He also had the brains to fire those he had trusted and promoted the coverup.

    I thought Jamie Dimon should have been fired but now that he got burned he may be the best person to clean the mess up and keep at least one TBTF bank from doing trades of such size and risk they could bring the bank down. My problem is the CEO at the other banks that are weaker are they making trades like this that could bring the bank down if the taxpayer does not bail them out.

    Like someone else said if you are an accredited investor like Goldman Sachs then you will not be made whole if a whale trader blows it.

  18. [...] Morgan reports its VAR in its regular financial filings.   It is a highly volatile number.  In a press release this quarter, JP Morgan said the VAR it calculated for the investment group [...]