The $2 billion trading loss that JPMorgan Chase (JPM) announced in a hastily scheduled conference call on May 10 has its roots in credit-default swaps, the same derivatives that helped trigger the financial crisis—only this time there were no mortgages involved.
The bank has launched an internal investigation, regulators are swarming, and the Department of Justice has said it is pursuing a criminal probe. The bank has not yet released details of the money-losing trades. But based on publicly available information plus interviews with traders, former JPMorgan employees, and fund managers, it’s possible to draw the basic outlines of what may have gone wrong.
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The mistakes were made in the bank’s Chief Investment Office, run by Ina Drew, who left the company on May 14. The office is in charge of managing excess cash and some of its investments. In the past five years, Chief Executive Officer Jamie Dimon has transformed the operation, increasing the size and risk of its speculative bets, according to five former executives with direct knowledge of the changes, Bloomberg News reported in April. The mandate was to generate profits, a shift from the office’s mission of protecting JPMorgan from risks inherent in its banking business, such as interest-rate and currency fluctuations. A spokesman for the bank declined to comment.
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Credit-default swaps are insurance-like contracts between two parties. The buyer makes regular payments to the seller, who must make the buyer whole if an insured bond defaults. In addition to buying credit-default swaps on a particular bond, investors can buy swaps on indexes of bonds, such as the ones created by Markit Group, a deriviatives firm. The indexes rise when economic conditions worsen and the likelihood of corporate bond defaults increases. Traders use them to speculate on changing credit conditions. Buying the index can be a way for someone who owns a lot of corporate bonds to hedge against a decline in their value.
In 2011, JPMorgan profited by betting that credit conditions would worsen. In December, though, the European Central Bank provided long-term loans to euro zone banks, igniting a bond rally. Suddenly, JPMorgan’s bearish bets were vulnerable. Early this year, London-based traders in JPMorgan’s Chief Investment Office made offsetting bullish bets, according to market participants. It sold credit insurance using a Markit CDX North America Investment Grade Index that reflects the price of credit-default swaps on 121 companies that had investment-grade ratings when the index was created in 2007. The bank is thought to have sold insurance on the index using contracts that expire in 2017.
To protect against short-term losses, it also bought insurance on the index using contracts that expire at the end of 2012. That could have been a profitable strategy, because the 2017 insurance was more expensive than the 2012. And as long as the spread between the prices of the two contracts remained relatively stable, any decline in the value of one would be offset by an increase in the other, reducing the bank’s risk of an overall loss on the position.
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JPMorgan bought and sold so many contracts on the Markit CDX that it may have driven price moves in the $10 trillion market for credit swaps indexes tied to corporate health, according to market participants. At one point the cost of insurance via the index fell 20 percent below the average cost of insuring the individual bonds that composed the index. “The strategy overall got too big,” says Peter Tchir, a former credit derivatives trader who now heads TF Market Advisors, a New York trading firm. “Once their activity was moving the market, they should have stopped and got out.”
Sensing an opportunity, some hedge funds bought the 2017 contracts and sold credit insurance on the underlying bonds, hoping to profit when the relationship between the prices returned to normal. But because JPMorgan continued to be a big seller of insurance, the prices got even more out of whack, giving the hedge funds a paper loss. That led some traders to complain about the situation to the press. On April 5, Bloomberg News published a story saying that Bruno Iksil, a London-based trader for JPMorgan, had amassed a position so large that he may have been driving price moves in the credit derivatives market. The information was attributed to five traders at hedge funds and rival banks who requested anonymity because they were not authorized to discuss the transactions. Iksil’s influence on the market spurred some counterparts to dub him the London Whale.
Once the news got out, things quickly went south for JPMorgan. Hedge funds increased their bets that prices would come back in line. Thanks to their trades plus deteriorating credit conditions, the prices of the 2017 index contracts rose more than the prices of the 2012 contracts. JPMorgan’s paper losses mounted.
Compounding the losses were the sheer size of the bets, which made it difficult for the bank to unwind its trades. “These had to be massive positions” to inflict the loss JPMorgan suffered, says Michael Livian, CEO of Manhattan asset manager Livian & Co. and a former credit derivatives specialist at Bear Stearns. “And when you build that kind of size in the credit derivative market, you have to know you can’t just exit the position overnight.”
On the May 10 conference call, Dimon confessed: “The portfolio has proven to be riskier, more volatile, and less effective as an economic hedge than we thought.” For JPMorgan, the nation’s largest bank, the stakes are far bigger than a $2 billion paper loss. Since the bank announced its loss, investors have driven the stock down 13 percent, knocking $20 billion off the company’s market value as of May 16.
The episode has reignited the debate over how much freedom banks should have to make bets. Dimon had been a vociferous opponent of the Volcker Rule, a section of the Dodd-Frank financial reform law that would greatly limit the kinds of risks banks can take. Now, as Dimon himself pointed out, the proponents of the rule can point to JPMorgan to buttress their case. “This is a very unfortunate and inopportune time to have had this kind of mistake, yeah,” he said in an appearance on NBC’s Meet the Press.
The loss also raises the question of why the bank was putting shareholders at risk to gamble in a market of arcane indexes, where specialized hedge funds seek to profit from pricing anomalies. “JPMorgan was definitely in the very dark gray area between insurance and speculation,” says Robert Lamb, a finance professor at New York University who has studied risk on Wall Street. “To be the one side of the market and to think you were immune from the crowd on the other side is not safe, sane, or reasonable.”
The bottom line: Big bets on arcane credit derivatives left JPMorgan vulnerable to moves by hedge funds and rival traders.
With Mary Childs and Shannon Harrington