JP Morgan: When basis trades blow up

By Felix Salmon
May 10, 2012
basis-trade disaster has happened at JP Morgan, where the famous London Whale seems to have contrived to lose $2 billion on what was meant to be a hedging operation.

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I’m not sure if it was the biggest quarterly loss of all time, but Merrill Lynch’s $16 billion loss in the fourth quarter of 2008 certainly ranks very high up there in the annals of investment-bank blowups. It happened after the bank had already been taken over by Bank of America, and it was in the middle of the financial crisis, so it didn’t get nearly the amount of attention it deserved. But it was not simply a case of assets plunging in value. Instead, it was, in very large part, a basis trade blowup.

The basis trade is an arbitrage, basically. There are two different ways the market measures credit risk: by looking at credit spreads — the yield on a certain issuer’s bonds, relative to the risk-free rate — or by looking at CDS spreads, which are basically the same thing but set in the derivatives market rather than the cash bond market. Most of the time, CDS spreads and cash spreads are tightly coupled. But sometimes they’re not. And at Merrill, a huge part of that $16 billion loss was reportedly due to a bad basis bet: the basis on many credits became very large and very negative during the financial crisis.

This time around, the basis-trade disaster has happened at JP Morgan, where the famous London Whale seems to have contrived to lose $2 billion on what was meant to be a hedging operation. And once again, although the details are still very murky, the culprit seems to be the CDS-cash basis.

I’ve been meaning to write a post about the CDS-cash basis for a few days now, which is why I happen to have this chart handy, showing the basis for various European banks as of Tuesday May 8.

basis.jpg

These are very big numbers, for very big banks: UBS is at 75bp, Deutsche is at 83bp, Natixis is at 116bp, and IKB is at a whopping 392bp. And this is just the banks — other corporates have seen similar price action. The cost of protection has gone up sharply, while the cash bonds are still trading at very low spreads.

Bruno Iksil, the London Whale, had a massive long position on corporate CDS in general, and the CDX.NA.IG.9 index in particular. He was selling protection, betting that credit spreads would go down, rather than up. The position was meant to be a hedge, although it’s a bit unclear how JP Morgan could have some massive short position in corporate debt that it was hedging against. In any case, CDS spreads went up — and credit spreads, in the cash market, didn’t.

Cue a $2 billion loss.

Rarely has a position been as widely publicized as Iksil’s, and I wouldn’t be at all surprised to learn that the credits with the highest basis were precisely the credits CDX.NA.IG.9 index. Whenever a trader has a large and known position, the market is almost certain to move violently against that trader — and that seems to be exactly what happened here. On the conference call, when asked what he should have been watching more closely, Dimon said “trading losses — and newspapers”. It wasn’t a joke. Once your positions become public knowledge, the market will smell blood.

Of course, this loss only goes to show how weak the Volcker Rule is: Dimon is adamant, and probably correct, in saying that Iksil’s bets were Volcker-compliant, despite the fact that they clearly violate the spirit of the rule. Now that we’ve entered election season, Congress isn’t going to step in to tighten things up — but maybe the SEC will pay more attention to Occupy’s letter, now. JP Morgan more or less invented risk management. If they can’t do it, no bank can. And no sensible regulator can ever trust the banks to self-regulate.

28 comments

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I fail to see how this proves anything. JP Morgan is losing $2 billion on this – so what? Is there anyone claiming this trade at all threatens the bank’s solvency? Basically, it should mean 1 quarter of disappointing earnings for a bank that has made over $17 billion in net income (after tax) over the past year. I’d really prefer that it hadn’t happened and hope that Dimon changes some procedures, fires some people, and fixes the problem. Banks are in the business of taking risks, though, and plenty of banks have blown themselves up in the traditional “boring” banking model of taking deposits and lending them out to companies, individuals, and governments. Take a look at everything from the S&L’s, to emerging market debt in the ’80s, to rig loans when energy prices crashed in the ’80s (which contributed to taking down Continental Illinois and forced Seafirst to sell itself to BofA), to bad commercial property loans that appear somewhere in the world every at least every 5 or 10 years. The idea that the Volcker rule will magically make banks safe is ridiculous.

Posted by realist50 | Report as abusive

“JP Morgan more or less invented risk management. If they can’t do it, no bank can.”

LESS. MUCH LESS.

And that’s even ignoring that J. P. Morgan went out of business–was acquired in a h/o/s/t/i/l/e/ t/a/k/e/o/v/e/r/ merger more than 11 years ago.

Posted by klhoughton | Report as abusive

“…the culprit seems to be the CDS-cash basis.”
You are jumping the gun here, there is NO way the basis has moved that much on the cdx.na.ig 9 to make for a $2 bln loss on a $100 bln portfolio.

Posted by alea | Report as abusive

The risk element lies in the ratio of Ratio of total credit exposure to risk based capital at JPM, which was 285% at 12/31/11 http://1.usa.gov/ITYIz8 p.17

The trade was proprietary. If they blew it, they are blowing something else.

Posted by masaccio | Report as abusive

Trust me – the SEC isn’t going to do squat.
The SEC has been gutted by congress.
The SEC has a board appointed by the president. Even John Stewart mocks Obama for being in the pocket of the big banks.

Nothing will happen until there is a great outcry and pitchforks in the streets from outraged citizenry.

Come Felix. Why do you think the Occupy Wall Street movement is being attacked so harshly by police in a nationwide crackdown? Yeah, lots of them are wackos of the nitwit fringe of the left. I have personally overheard Occupy leaders (yes, virginia, Occupy has leaders) in a cafe talking about how they don’t want the banking situation dealt with because they want “the revolution” to come to America. (Meaning Marxism. Yes, there are still addled eggheads who sincerely believe in Marx even now.)

Nothing will happen. The criminals running the big banks are doing fine. The DO NOT CARE.

Posted by BrPH | Report as abusive

Give him a bonus!

Posted by TFF | Report as abusive

It isn’t just JPM with profit reductions at this time, Switzerland’s UBS (profits down 54%) and France’s SocGen (profits down 20%) are suffering too. Why is it that during a quarter when stock markets went up, the profits of big banks went down? What are they unwinding? There’s a bigger story here than mere CDS spreads and you’re missing it Felix.

Posted by FifthDecade | Report as abusive

This trade makes no sense. JPM’s explination makes no sense. A college sophmore should be able to put on a credit hedge on a corporate bond portfolio. Furthermore with JPM’s clout and credit quality they should have been able to dictate the terms exactly how they wanted them to match their bond portfolio’s profile to 5 decimal places.

I thought this trade was a longterm “risk on” trade where JPM assumed the credit risks from other peoples bond portfolio and were paid to take that risk upfront… a virtual twin of Berkshires big play on equity indexes but with corporate bonds instead. That made sence. That trade would be like making loans which is a core competence.

Can someone smarter than me explain the benefits of a Basis trade? How was this suppose to work? What made it worth doing on a massive scale. This sounds like another attempt to eat a free lunch… I’ll hold lots of bonds I’ll buy insurance on all the risk and I’ll still be left with something at the end of the day. Everything you learn in business school about efficent markets dictates that it should be impossible to hedge all your risk and get a return above the risk free rate.

I think the Volker rule is a bad idea but this is pretty damming evidence that banks shouldn’t swim in this pool.

Posted by y2kurtus | Report as abusive

The bigger question is what do these types of trades do to benefit society. Certainly banks do perform some useful functions for society, such as lending money and helping people manage their money, but it seems like these days most of what they do (i.e. trading for their own account), benefits nobody but their employees and shareholders, while offloading huge amounts of risk onto society as a whole (should the bank collapse).

Posted by mfw13 | Report as abusive

Felix this is sloppy even for you. You’re talking about European bank basis when the index in question is NA (North America). You can see the credits here, found by Googling:

http://www.markit.com/assets/en/docs/pro ducts/data/indices/credit-index-annexes/ IG%209%20v4.pdf

This portfolio doesn’t even have Citi in it, although you do get some AIG and BofA (through Countrywide) exposure.

Posted by najdorf | Report as abusive

Just love it. I wish they would lose 20 b instead of 2b.
Now bank will look to increase fees on credit cards, debit cards, and some stupid fees.
All chase account holder look out more fees your way, Lucky me closed all accounts about 4 yrs back.

Hip Hip Hurray to Volcker Senator Levine.
Score
Volcker & Levine = 10/10.
JP = 0/10.

Posted by Indycar | Report as abusive

Kind of agree with NAJ, FS – you haven’t laid the facts out clearly enough for us.

The “Sober Look” piece makes it sound like this was a game being played to smooth-out/lock-down apparent gains in JPM’s balance sheet position arising from the accounting rule that firms mark their own debts down to FMV rather than list them at face value. Thus oddly, the firm’s balance sheet takes a hit when markets view it more positively and mark-up the FMV of its outstanding debts, and the reverse when the firm looks shaky – its debts appear to magically be reduced below face value.

Stupid rule, IMO. Stupider still to play it like JPM did and apparently double-down rather than actually hedge the position.

OBTW: BrPH is spot on – this is all good news; things have to get a lot worse before they will inspire open rebellion, and until they do nothing will break the Street’s grip on DC. Let the disasters flow, the more the better – the bigger the better.

Posted by MrRFox | Report as abusive

SCHADENFREUDE…

Posted by Maruzik | Report as abusive

Some people will lose their jobs?,as boss let him lose his,after all when things go well he gets a huge bonus,perhaps when they dont,the head goes as well.
After all the buck stops there.

Posted by arfur11 | Report as abusive

No, arfur, if the last five years have taught us anything, it is the role of underlings. The boss always wins. When things go well, he gets a huge bonus. When things go bad, he gets a bigger bonus for his efforts in repairing the problems.

He’ll line up a few scapegoats and boot them off the bridge.

Posted by TFF | Report as abusive

I’ve not heard this theory put out, but accepting the stupidity of JP Morgan, and they were stupid, I wonder if there will be any introspection to look at the Fed’s role here. While the Fed didn’t tell JP Morgan to engage in this sort of trade, they are promoting a very interesting landscape via Fed policy. At zero interest rates, the spread is just not there for the bank’s to make certain types of loans or to take off the top of savings accounts and checking accounts, so the business model seems to be large proprietary bets and banking products that target fees instead of yield spread maintained by the bank(one big example here is prepaid debit cards which carry huge monthly fees).

Posted by Sechel | Report as abusive

Over at Alphaville, Lisa Pollack is also speculating that the money was lost on a credit basis trade: http://ftalphaville.ft.com/blog/2012/05/ 11/996131/too-big-to-hedge/.

However, she is guessing calendar basis, not bond/CDS. She doesn’t have any more facts to support her guess than you do, Felix, but she tells a better story. She also makes a good point at the end: if there is enough publicly available information to see that something big and unusual is going on in CDX.NA.IG.9, shouldn’t the regulators be trawling through the DTCC data to see what’s going on? Isn’t that supposed to be its purpose?

Posted by Greycap | Report as abusive

I would just point out that a basis trade is a very different strategy from a curve trade (and yes, Felix, you can’t really have such a loss from a basis trade). Let’s read up before we write.

Posted by Tseko | Report as abusive

Whether it is basis, calendar, CDS, curve or some other trade, the simple fact that $2billion was lost from a trade that had nothing to do as a “hedge”. It was a speculative bet.

No investor takes on such a huge position in a security/market where liquidity doesn’t exist. Liquidity is probably the most important consideration in owning any security since it determines spreads, ability to sell/buy, and ultimately profitability. Everyone knows the JPM is up to their eye teeth in derivatives – and they are still working down this position while we talk.

JPM supposedly hires the best and brightest, yet Dimon said himself it was ‘poorly executed and monitored’. What this says is that no one has enough knowledge and controls to handle these toxic trades. JPM reaped huge benefits from the 2008 crash (basically got Bear Stearns for pennies and handed off the risks to the tax payers). They have been the blue chip standard for all the financial gurus pushing deregulation.

Of course, the big question is who is next?

Posted by Acetracy | Report as abusive

I’m the CEO of The Bank of Screwya. The Fed has given me access to extremely cheap dollars (low rates). The intent is for The Bank of Screwya to lend to American home mortgage consumers.

As intended… I can make 30 year mortgage loans to American home buyers and earn a tiny protracted profit. I bundle these loans into “Collateralized Debt Obligations” and sell them to pension funds.

Or… The Bank of Screwya can purchase bonds with these “extremely cheap dollars”. Bonds from sovereign European countries like Anusgreece. The sovereign nation Anusgreece is receiving loans from the European Union (Germany) to remain solvent. So… The bonds issued by Anusgreece have a high rate of return… like 13%, because they are risky.

It’s all about risk management.

As CEO of The Bank of Screwya, my bonus is based on our profit. If The Bank of Screwya makes the virtually guaranteed 2.5% profit (low risk) by making mortgage loans, as intended, my bonus will be about 1 million dollars. If The Bank of Scerwya makes 13% in the Eurozone bond market, my bonus will be 100 million dollars. BUT THIS IS RISKY…………………….. or is it?

My bonus is “contractually guaranteed”. If we go bust, we are “too big to fail”. The federal gov’t of The USA (actually, it’s the US taxpayer) will have to bailout The Bank of Screwya. I will be fired and my career will be over… but I get 100 million in contractually guaranteed bonuses.

If sovereign nations like Anusgreece remain solvent for a couple of years, I can collect my $100 bonus for a couple of years before the house of cards comes down.

As CEO of The Bank of Screwya, what would you do?

Posted by Effed | Report as abusive

Catfish, what are you talking about? What’s two billion dollars to a beheamoth like JP Morgan Chase – a week of profit or loss?

Posted by ptiffany | Report as abusive

Everyone is smarter after the fact occurence, even though things that happen in the future are uncertain. Heding some illiquid positions is a very tricky business… What if JPM didn’t do any macro-hedge, their short position (whatever that is) went sour, causing a 1 bn loss, and CDX spreads actually tightened? then JPM bankers would have been lynched for not managing their risks properly. so whatever you do, you might be right or wrong in the retrospect – banking is a risky business, means future outcomes are uncertain, and some trades or hedges might not work as envisioned. as long as this stays within amounts manageable for an institution without causing systemic effects, that should be fine, even though the media and public are keen for hot stories… 2bn loss sounds pretty substantial to fire some people and rethink the limits for JPM… the regulators are meanwhile familiar with the financial markets business complexities and limitations, so hopefully will make a good decision on whether such risk taking needs tighter regulation or it is rather a propriatary problem of the bank and its owners .

Posted by maxi_milian | Report as abusive

On the subject of CDS and the unclear raison d’etre for JP Morgan’s humongous bet: JP has indeed had a more favourable CDS than the other US big banks. Could the bets have been made to influence the bank’s own CDS? It wouldn’t be the first time it’s been attempted: http://uti.is/2012/04/bruno-iksil-the-10 0bn-bet-and-jp-morgans-cds/

Posted by Pohadka | Report as abusive

realist50 you ask so what? How interesting that you dont mind a bank using taxpayer insured money to gamble for their own profit. This happened in the late 80′s as well and gave us the savings and loan crisis with the resulting Resolution trust bank to clean the mess up. Additionally we are are allowing these banks to borrow money essentially at 0% interest at the expense of those who have saved and so are getting nothing for their thriftiness and then using this money not to make loans and grow the economy but to place bets …..how sad that even knowing this you and others dont care….

Posted by thebeorn | Report as abusive

At a minimum, CEO Dimon should resign from the NY Fed if not from JP Morgan Chase, as well.

One would think after the fiasco of the 2007-2008 financial crisis, the too-big-to-fail (“TBTF”) banks would have learned a lesson about risk management — but, no, here we are again with JP Morgan Chase losing $2+ billion of their “own” money — and under the leadership of CEO Dimon who is one of those most vocal against limiting the banks’ proprietary trading under proposed legislation.

The shareholders, bondholders and managements of these TBTF banks should pay the price for “mistakes” such as JP Morgan Chase’s recent fiasco. However, the US taxpayer remains on the hook just as in the 2007-2008 financial crisis.

Banks have been granted their “franchises” and given preferential treatment to serve the needs of the general economy and to facilitate the movement of funds between individuals/entities wanting to have a relatively safe haven for their excess liquidity (aka, depositors) and those needing to borrow those resources. Proprietary trading of the TBTF banks’ “own” funds has little place in this economic environment — those funds should be distributed to the shareholders who can then invest in riskier asset classes under their own decision regimen. If a hedge fund investment is what they want, then let them make a conscious decision to invest in a hedge fund, without any Federal guarantee of the investment.

This approach would take much of the burden off US taxpayers to correct the ” sloppy” and “stupid” decisions (CEO Dimon’s own adjectives) that have been made by the TBTF banks in the post-Glass-Steagall era.

For more on the interaction of financial and political decision-making, see http://theviewfromthemiddleoftheroad.blo gspot.com/.

Posted by rg.williams | Report as abusive

Just for good order I have never seen a more clearer admission of fault and guilt by a governing officer of a bank and yet he is still retained by the shareholders.
Unless he runs his business like the Murdochs he was obviously aware that this was a straight out punt which went wrong. So why does he still have a job ?
The answer is that the democrats are one of the best republican parties (in disguise) that have ever occupied the white house.

Posted by ColonelAngus | Report as abusive

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