Satyajit Das on JPMorgan's Loss, the Volcker Rule's Efficacy, and the Deeper Problems in the Banking Sector
How many other problems in other firms remain undiscovered?
A $2 Billion Banana Skin
The losses indicated are US$2 billion and may be higher. JPMorgan's share price fell around 9% (a loss of US$14 billion in market value) when the new was announced via a hastily arranged news conference. The bank also lost immeasurably more in reputation and franchise value.
The episode has all the usual trappings of a salacious trading disaster. Competitors had christened Bruno Iksil, one of the traders responsible, Lord Voldemort (after the Harry Potter villain). The position, which has been common knowledge in the market since early 2012 at least, was dubbed the "London Whale." After the losses were announced, the usual journalistic liberties were taken – the Whale has “beached” or “been harpooned." A sub-editor gleefully coined the headline "Dimon Is a Whale of a Hedge Fund Manager."
But the losses raise serious issues. As they do not relate to the usual “rogue trading” incident which is typically dismissed as impossible to detect or control, the episode provides insights into the problems of modern high finance, bank strategies and regulation of markets.
Details are sketchy. The losses relate to a position taken to “hedge” a US$300+ billion investment portfolio managed by JPMorgan’s Central Investment Office (CIO) overseen by staff including experienced hedge fund investment managers. The portfolio has increased in size from $76 billion in 2007 to $356 billion in 2011.
The objective of the CIO is hedging JPMorgan’s loan portfolio and investing excess funds. During an April 13, 2012 conference call, Jamie Dimon, the CEO of JPMorgan referred to the unit as a “sophisticated” guardian of the bank’s funds.
At the same time, however, the bank advised investors in a statement that: “Since March 31, 2012, CIO has had significant mark-to-market losses in its synthetic credit portfolio, and this portfolio has proven to be riskier, more volatile and less effective as an economic hedge than the Firm previously believed.”
The large investment portfolio is the result of banks needing to maintain high levels of liquidity, dictated by both volatile market conditions and also regulatory pressures to maintain larger cash buffers against contingencies. Broader monetary policies, such as quantitative easing, have also increased cash held by banks, which must be deployed profitably. Regulatory moves to prevent banks from trading on their own account -- the Volcker Rule -- have encouraged the migration of trading to other areas of the bank, such as liquidity management and portfolio risk management hedging.
Faced with weak revenues in its core operations and low interest rates on cash or secure short term investment, JPMorgan may have been under pressure to increase returns on this portfolio. The bank appears to have invested in a variety of securities, including mortgage backed securities and corporate debt, to generate returns above the firm’s cost of capital.
In 2011, the CIO portfolio contributed $411 million to JPMorgan’s earnings, below its contributions of $1.5 billion in 2008 and $3.7 billion in 2009. JPM’s disclosures show that the unit took significant risk. Based on a common measure known as VaR (Value at Risk), the potential statistical loss for a single day was $57 million in 2011, similar to the $58 million of average risk in the bank’s larger investment bank and trading business.
The Art of Topiary
The losses relate to an attempt to hedge the exposure on this portfolio.
As hedging would reduce returns, the strategy adopted appears to have been to buy insurance against default in the short term (to end 2012) and finance the hedge by selling insurance against default in the medium term (to end 2017). The structure took advantage of the difference in pricing of insurance between the two maturities of around 0.60-0.70% per annum. The strategic view was that risk would increase in the near term but abate in the longer term.
The choice of hedge instrument was an older “off-the-run” credit index: the CDX NA.IG (“North American Investment Grade”) Series 9. In all probability, the choice was driven by economic considerations. The constitution of the index may have provided a better match to the exact risk in JPMorgan’s books. The pricing of the index may have been more favorable than the more recent “on-the-run” index. The relative liquidity of alternative hedging instruments would have been a factor.
The choice may also have been motivated by the desire to mask the bank’s trading activities from other market participants to allow the position to be established without moving market prices. The particular contract, originally issued in 2007, was extensively used in a variety of structured products. This meant that trades could be disguised as hedging existing products or client positions rather than on JPMorgan’s own account.
It is possible that the hedge could have been “juiced up,” that is, leveraged, by trading in different instruments such as the tranched version of the index to increase sensitivity to changes in market credit spreads.
With the benefit of hindsight, the trades seem to be no more than what Lord Voldemort might view as “school-boy spells you have up your sleeve!”
In the conference call announcing the loss, Mr. Dimon explained that the CIO portfolio was a hedge for the bank’s balance-sheet risk. He stated: “It actually did quite well. It was there to deliver a positive result in a credit-stressed environment. And we feel we can do that and make some net income.”
It is questionable whether the CIO portfolio or the problematic positions could be regarded as a true hedge. It is complex and relies on the correlation between the bank’s underlying positions and trades. The effectiveness of the hedge also relies on the changes in credit pricing for different maturities. The simplest way to reduce risk would have been to sell off existing positions or offset the positions exactly.
The bank’s assertion that the entire set of transactions was both a hedge and a source of earnings is confusing. The bank should have heeded the warning of the seventeenth-century French author François de La Rochefoucauld: “We are so accustomed to disguise ourselves to others that in the end we become disguised to ourselves.”
Given JPMorgan vaunted risk management credentials and boasts of a “fortress like” balance sheet, it is surprising that the problems of the hedge were not identified earlier. In general, most banks stress test hedges to ensure their efficacy prior to implementation and monitor them closely.
While the $2 billion loss is grievous, the bank’s restatement of its VaR risk from $67 million to $129 million (an increase of 93%) and reinstatement of an older risk model is also significant, suggesting a failure of risk modeling.
During the conference call, Mr. Dimon conceded that the trades were “flawed, complex, volatile, poorly reviewed and poorly monitored ... there are many errors, sloppiness and bad judgment.”
The episode also points to failures on the part of parties other than JPMorgan.
Banks are now obliged to report positions and trades, especially certain credit derivatives. This information is available to regulators in considerable detail. Given that the hedge appears to have been large in size (estimates range from ten to hundreds of billions), regulators should have been aware of the positions. It is not clear whether they knew and what discussions if any ensued with the bank.
External auditors and equity analysts who cover the bank also did not pick up the potential problems. Like regulators, they perhaps relied on assurances from the bank’s management, without performing the required independent analysis.
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