Counterparties: Your massive guide to JPMorgan’s failed hedge

By Ben Walsh
May 11, 2012

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It turns out we probably should fear Voldemort. Yesterday Jamie Dimon hastily scheduled a 5 p.m. conference call in which he was forced to explain a sudden $2 billion loss in his Chief Investment Office, a division that was supposed to safely hedge the bank’s risk.

JPMorgan’s stock fell more than 9% on the news. Dimon, who last month called the issue a “tempest in a teapot”, said the hedges implemented by the “London Whale” (aka Bruno Iksil) were a “bad strategy, executed poorly”; he also conceded “many errors”, “sloppiness” and “bad judgement”.

The responsibility for mistakes ultimately rests on Dimon’s shoulders. Jonathan Weil noted that yesterday’s disclosures meant that “either Dimon misled the public about the gravity of the festering trades during his company’s first-quarter earnings call last month. Or he didn’t know what was happening inside the bowels of his own company.” Barney Frank didn’t let this opportunity pass him by, either, saying that “JPMorgan Chase, entirely without any help from the government, has lost, in this one set of transactions, five times the amount they claim financial regulation is costing them.”

Adding to Dimon’s chagrin was his acknowledgement in yesterday’s conference call that he gave proponents of increased financial regulation, including Barney Frank, yet another proof point. As Felix notes, the strong likelihood that the trades were Volcker-compliant “only goes to show how weak the Volcker Rule” is and affirms the need for “dumb rules” that traders can’t easily game.

So just what specifically went wrong? For a deep and wonky explanation, Lisa Pollack details what might have been going on and concludes that both regulators and Dimon should have seen the buildup of risk, if not the losses, long before yesterday. Heidi Moore also has a handy guide that spells out exactly what happened in non-financial English. Zero Hedge outlines how analysts need to change how they examine the profitability of big banks, and their hedging business model.

There’s still some dispute over whether Iksil’s positions were actually a hedge or just a disguised bet. Matt Levine has an extended take on this, and before the latest revelations the Epicurean Dealmaker pointed out that the difference between a hedge and speculation is subtle because “the same trade or financial instrument can be used in either way at different times and under different circumstances.”

Chief among Iksil’s errors, it seems, was a model that didn’t accurately capture the risk of the strategy. The CDS index Iksil was selling protection on has moved away from him recently, but why JPMorgan’s losses were so large relative to the index’s more modest change remains unclear. Derivatives are a zero-sum game, of course, and at least two hedge funds run by mostly ex-JPMers have made some $30 million each.

For his part, Dimon is far from finished explaining what went wrong, and we won’t have to wait long for his next attempt. On Wednesday, he taped an interview with NBC’s David Gregory to air on Sunday’s Meet the Press. After yesterday’s announcement, Dimon has decided to retape the appearance. – Ben Walsh

Before we move on to today’s links, we’re announcing the second Counterparties book giveaway. Exhausted by cetacean puns, we believe Jamie, Bruno et al. at JPMorgan deserve their own lolcats. Here’s an image to get you started. Send us your best work, and you could win a copy of Tadas Viskanta’s book Winning Strategies from the Frontlines of the Investment Blogosphere. We have two to give away!

What it’s like to have your boss ask you to execute a $1 billion hedge – Kid Dynamite
Simon Johnson: It’s “stunning” that JPMorgan lost so much at a mild time in the credit cycle – Huffington Post
Levin: “The latest evidence that what banks call ‘hedges’ are often risky bets … banks have no business making.” –
The controversial measure of JPMorgan’s risk that tripled over the last year – BI
In their own words: JPMorgan’s risk management standards – JPMorgan
The 10-Q in which JPMorgan discloses CIO’s losses – SEC
Fitch downgrades JPMorgan – Bloomberg

New Normal
A map of economic mobility in America – South Carolina, Oklahoma and Louisiana rank worst – Pew
Jobless claims fall again – AP
More than 230,000 unemployed Americans are going to lose their unemployment benefits this weekend – WashPo

Be Afraid
What short-sellers mean when they say Chinese banks are “built on sand” – Bloomberg

Pork Products
Basically every important manufacturer in America gets some sort of government subsidy – NYT
Obama’s stupid idea for a manufacturing subsidy – Yglesias

Occupational licensure as rent-seeking – Conversable Economist
The case for global accounting – Floyd Norris

The troubling financialization of the Washington Post – CJR

Domestic oil production is irrelevant to oil prices – Yglesias

NYC is now the fastest-growing tech hub in America – Mashable

Bond titan Jeff Gundlach was once in an extremely hilarious-looking ’80s rock band – Businessweek

Co-founder Eduardo Saverin gives up his U.S. citizenship ahead of IPO, presumably to save on taxes – Bloomberg


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Just as a matter of curiosity, if London Whale’s bet are in the money, then the counter parties which are the hedge Funds are out of the money, right? Hedge Funds do not punt with 100% of own money, they have lines from the banks, right? Now, if they are on the wrong side of the bet, the aggregate impact would mirror London Whale’s position – i.e the banks that lend them money will also be in trouble more or less, right? Then we are all in trouble too? Some smart people out there, do we need these hedging tools?

Posted by rissey | Report as abusive

MrRFox, you would be interested in this one: gy/eduardo-saverin-facebook-citizenship/ index.htm

One fewer plutocrat paying US taxes…

Posted by TFF | Report as abusive

@MrRFox, that is a far more generous take on it than mine.

Posted by TFF | Report as abusive

@TFF – Thanks, I guess. It does highlight your concern about run-away rich and the estate tax. I think enforcement is a problem that has a solution, if that’s one’s only objection to confiscatory estate taxes – but that’s not something we’ll ever actually know without trying it.

At this point IMO the discussion ought be about the merits of the tax, not enforcement.

OBTW: About Saverin – he’s demonstrated both confidence in the stock and disdain of a sort for life in the US. Being an ex-pat myself, can’t really object to that last part, can I?

Posted by MrRFox | Report as abusive

Heidi Moore: “The corporate bonds were probably already owned by JP Morgan as part of its trade with corporate clients. JP Morgan also owns a lot of “high-yield,” or junk bonds. Those are low-rated bonds from companies that are close to default. If JP Morgan owns a lot of high-yield bonds, the best way to balance that risk is to bet on investment-grade corporate bonds.”

Uh, no. I don’t know what the opposite of junk bonds is, but everyone ought to know by now it’s NOT AAA corporate bonds.


Posted by Eericsonjr | Report as abusive