How Bruno Iksil lost $2 billion

By Felix Salmon
May 16, 2012

In February 2009, Deutsche Bank announced that its Credit Trading desk had managed to lose €3.4 billion in the fourth quarter of 2008, with €1 billion of those losses directly attributable to the bank’s prop desk.

The losses in the Credit Proprietary Trading business were mainly driven by losses on long positions in the U.S. Automotive sector and by falling corporate and convertible bond prices and basis widening versus the Credit Default Swaps (CDS) established to hedge them.

In English, Deutsche Bank had put on a basis trade: it owned credit instruments, like bonds, and it also owned credit default swaps designed to hedge against those loans. And then the trade blew up.

The Deutsche trader responsible for the monster losses was Boaz Weinstein, who eventually left the bank to start his own hedge fund, Saba Capital. His first job, obviously, was to make sure he didn’t blow up a second time. But his second job, it seems, was to use his experience at Deutsche to be able to notice when someone else was about to blow up on a massive basis trade. In this case, JP Morgan.

Go back to early February, long before the articles about the “London Whale” came out in Bloomberg and the WSJ, and you’ll find Weinstein revealing his biggest trade at the Harbor Investment Conference:

The derivatives trader and legendary hedge fund manager said his trade idea is to buy Investment Grade Series 9 10-Year Index CDS (maturing on 12/20/2017).

“They are very attractive,” he explained adding that they can be bought at a “very good discount.”

At the time, Weinstein didn’t know — or necessarily even suspect — that his big trade would involve a zero-sum bet with one of the biggest hedge funds in the world, JP Morgan’s Chief Investment Office. But over time, as he bought more and more protection but the price stubbornly refused to rise, he began to learn just how big the other size of the trade was. Whale big.

Tracy Alloway and Sam Jones have pieced together the best account yet of what exactly JP Morgan was up to. Yet again, it was a basis trade, although this one was horribly complex even by basis-trade standards. Essentially, that CDX.NA.IG.9 position was a second-order hedge, designed to offset volatility in JP Morgan’s first-order hedge, which was designed to offset credit risk in the rest of the bank’s portfolio.

The first-order hedge itself doesn’t make a great deal of sense — Iksil seems to have bought “tranches” of CDS indices, which would pay off if some (but not all) credits suddenly got into trouble. For a bank which had broad economic exposure to European meltdown and/or a US double dip, that seems like a pretty narrow hedge.

But if the first-order hedge is weird, the second-order hedge is downright scary. Do you remember the notorious Howie Hubler trade at Morgan Stanley, where he made a smart bet against dangerous subprime securities, but then put on a much larger “hedge” which ended up costing him $9 billion? Iksil’s trade seems a bit like that:

Because of the mechanics of the trade, in order to achieve a “market neutral” position, whereby JPMorgan hedged the bet against volatility as best it could and offset the cost of its short positions, the bank had to sell far more units of cheap protection on the IG.9 as a whole than it bought on short, more expensive tranches.

Inevitably things started to go wrong. There are two things you can do when something starts to go wrong in the markets. You can unwind your position at a loss. Or you can try to fix it. Iksil, and Drew, chose the latter:

The two legs of JPMorgan’s trade did not move according to the relationship the bank had expected, meaning the position became imperfectly hedged. Like many credit models before it, JPMorgan appeared to misjudge correlation – one of the hardest market phenomena to accurately capture in mathematics.

In order to try and stay risk neutral, the dynamic hedge required even more long protection to be sold. The bank continued to write swaps on the IG.9, causing a pricing distortion that was spotted by more and more hedge funds seeking profit.

The rest, pretty much, is history.

Iksil, we’re told, is going to leave JP Morgan, while taking his own sweet time doing so: “although a spokeswoman for the bank said Mr. Iksil is still employed, he is no longer trading on behalf on the bank and is expected to be gone by the end of the year”. I’m sure he’ll use the intervening months to feel out his chances of being able to raise a few billion dollars for a hedge fund of his own, and weigh them up against simply joining a fund like Saba. Iksil’s now learned a $2 billion lesson — and as Boaz Weinstein can attest, once learned, those lessons can be surprisingly valuable.

More From Felix Salmon
Post Felix
The Piketty pessimist
The most expensive lottery ticket in the world
The problems of HFT, Joe Stiglitz edition
Private equity math, Nuveen edition
Five explanations for Greece’s bond yield
Comments
14 comments so far

The young and reckless. It would be a tragedy if it wasn’t such a farce.

Posted by Mitchn | Report as abusive

Ponder the possibilities for profiting that derive from JPM’s being one of only two banks presiding over the tri-party repo system, which enables JPM & BONY to determine what the haircut/margin will be on collateral presented to them in exchange for cash.

It’s conceivable that in Nov/Dec ’11, JPM may have been aiming to duplicate the ‘astute trading’ that Goldman achieved in Spring/Summer ’07:

Get flat your exposure to an asset class — in this instance, leveraged-loans to PE firms — and then buy downside protection that goes up in value if you can convince the world that leveraged-loans have declined in creditworthiness.

After you’ve established your index short, you then raise margin requirements on the leveraged-loans presented to you in the Tri-party repo system. At that point your long CDS position on junk bonds goes up.

After you put Amaranth, Bear, Lehman or WaMu out of business, you can then buy their assets for pennies on the dollar and ‘grow’ your balance sheet.

I mean . . . it’s possible that JPM’s CIO get’s the first call when margin requirements may change, isn’t it? And wouldn’t that be fantastic info to trade with?

How, indeed, do those Tri-party haircuts get determined?

Posted by dedalus | Report as abusive

“Iksil’s now learned a $2 billion lesson”

This is not a lesson it is a horrific and sociopathic crime. How much suffering can $2,000,000,000 alleviate? How many lives could $2,000,000,000 save.

Investment banking and high finance is a societal cancer. We need to eradicate it.

Posted by robertowen | Report as abusive

“Investment banking and high finance is a societal cancer. We need to eradicate it.” (RobertO)

Not to mention those who practice it and those in DC who protect and enable them. “Off with their heads” – said Madame Thérèse Defarge, and me too.

Posted by MrRFox | Report as abusive

The $2 billion did not disappear. It was just transferred to someone else. Probably a lot of small funds and a couple large ones that may give a lot more to charity than JPM. Nevertheless, no real capital — meaning, like a building, or a process or whatever asset you want to imagine, was destroyed.

Posted by Nicostrata | Report as abusive

Felix:
If Weinstein’s trade idea was “to buy Investment Grade Series 9 10-Year Index CDS (maturing on 12/20/2017).” it means he was selling protection, same as what the “whale” was reputed to do.

Posted by alea | Report as abusive

Correction: $3 Billion and counting.

Posted by LadyGodiva | Report as abusive

“The $2 billion did not disappear. It was just transferred to someone else.”

Yes, but under Wall Street rules, every time $2B is transferred from one pocket to another, the gambler directing the winning side of the trade pockets 20% to 50% of the proceeds as a bonus.

Posted by TFF | Report as abusive

@alea

Maybe confusing wording in Felix’s piece but clear from the context in the FT article that he meant buy (cheap) protection, i.e. take the other side of the whale.

Also, Felix, pet peeve of mine but I’m not sure I’d call this a “basis trade” loss, at least based on what we know to date. Seems like he wasn’t trading the basis correlation on the IG.9 3-7% tranche to the index (with a possible curve element thrown in if the tranche was on the 5y with the offsetting index leg on the 10y, as seems likely).

At least as far as we know, he wasn’t trading the (synthetic) index against the (cash) underlying, which would be a true “basis trade”.

Posted by CasualSophist | Report as abusive

Crap, @Felix above… should read “wasn’t trading the basis but rather trading the correlation”.

Posted by CasualSophist | Report as abusive

It does make one wonder how much better off JPM would be if they hadn’t indulged in all this financial engineering in the first place. Sometimes it sounds like people who think they are cleverer than they are (or at least, have persuaded someone who pays big salaries to think they are) are doing the equivalent of applying the Pythagoras theorem to determine the location of an unobserved quark.

Imagine a world in which this financial engineering and hedging was not done. Everybody would be long on positions, and would have to measure the real risks of lending to places like Greece, and the rates on Greek debt would have risen long ago so as to offset the known risk rather than having been artificially kept lower than it should have been.

The effect of the current position is there are a lot more Porsche Cayenne’s in Greece than their would have been if Greek debt had been rated more expensively – and more honestly. It’s all very well costing 20% after the event, but that’s like putting a second bolt on the stable door long after the horse has gone. If those rates had applied earlier, they could have gone a long way to mitigating the losses that now have to be paid for – and Greek debt is the only EZ debt that has had a haircut so a balanced approach to investing in debt of EZ countries would have put just 2% in Greece, and lost just 1% of total European exposure, although it would have earned 80% of that from the higher rates that should have been charged, meaning a 20 basis point exposure, less grief in Greece, and a much smaller banking crisis perhaps.

Posted by FifthDecade | Report as abusive

Fifth Decade – I’d argue that the low rates on Greek debt had very little to do with hedging and a lot to do with banking regulation that treated all Euro-zone debt as a risk-free asset, which provided banks with a bad incentive to load up on the worse credits to find a little more yield and thereby also compressed yields more than should have occurred.

That said, I agree with your broader point that JPM would almost certainly be better off with less financial engineering. I can understand the desire on their part to hedge interest rate risk or currency exchange rate risk, for example. I expect a bank to be long corporate credit, though, so as an investor I’d prefer to make an investment decision with that fact in mind rather than have management try to undertake a complicated set of trades that hedge some of that broad credit risk, then try to fund the cost of those hedges, etc.

Posted by realist50 | Report as abusive

@R50 – That first paragraph of yours is spot on. About the second one -

IDK – this loss at JPM looks terrible, but weighed against all the homeruns the JPM prop traders have racked-up in the past, it doesn’t compare at all. Expecting perfection or a record that never has a monumental screw-up on it is pretty unrealistic it seems.

Still, insured deposit-taking institutions shouldn’t be doing this kind of thing IMO.

Posted by MrRFox | Report as abusive

@Realist50 Are you trying to say the banks ignored common sense just because the regulators said it was OK? Were they really so unworried about repayment of debt? I don’t think so, and any bank that did had fools in charge. Just because debt is expressed in a single currency doesn’t mean you treat each borrower the same way; the risk of repayment varies. Even at the time of the Euro launch it was widely reported on TV and in the media that Greece had fiddled the figures to get into the currency in the first place. Greece shouldn’t have been let in, but that was a political decision by Germany’s right wing Chancellor, Helmut Kohl and France’s Socialist President, Francois Mitterand who drove the sudden Eurozone expansion.

By hedging risk down (or thinking risk has been reduced), the perceived need for higher interest rates declines, which increases borrowing for overspending countries – but one day comes the reckoning… if the risk had not been hedged, the real risk would not have been disguised, and the degree of danger would have been harder to ignore.

Posted by FifthDecade | Report as abusive
Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/