Why JP Morgan’s CIO found it so easy to make money

By Felix Salmon
May 16, 2012
proof that JP Morgan was -- is -- using its Chief Investment Office to gamble with taxpayer-backstopped funds?

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You want proof that JP Morgan was — is — using its Chief Investment Office to gamble with taxpayer-backstopped funds?

The CIO unit also had a lower cost of capital than other parts of the bank, an artificial advantage that gave it an incentive to take more risk and behave in a less disciplined way, people familiar with the unit said.

“It was very large, but was never very transparent, and it wasn’t clear that they had an appropriate funding cost,” said the source with direct knowledge of the CIO.

In any unit of any bank, one of the key drivers of profit and loss is the internal cost of funds. If you’re paying 1% for your funds and earning 3%, then you can claim profits of the difference, 2%. But if your cost of funds is increased to 2%, then your profit is halved at a stroke. For someone like Ina Drew, who was charged with turning hedges into profitable trades, the easiest way to do that would always have been to simply get Jamie Dimon to decrease the CIO’s cost of funds.

And at JP Morgan, just like at any other bank, the cheapest cost of funds is always deposits. JP Morgan has hundreds of billions of dollars in excess deposits just because it’s too big to fail, and has an implicit government backstop. It’s bonkers that it should then be able to take the resulting ultra-low cost of funds, and turn it into eight-figure bonuses to people like Drew, all for taking that money and playing on derivatives indices in London.

As John Macaskill points out, the CIO, by its own faulty measurements, had for the past two quarters more money at risk than JP Morgan’s entire investment bank — and that was with a more lenient risk measurement and with a lower cost of capital. In reality, the CIO’s risk levels were vastly greater than those at the investment bank, as we discovered after the blow-up.

If JP Morgan wants the CIO to be taking that kind of risk, it has to significantly increase the CIO’s internal cost of funds. The CIO is at heart a hedge fund (it’s designed to put on hedges), and JP Morgan should extend it billions on the same kind of terms that it would extend money to top prime-brokerage clients. The CIO’s secret weapon, all these years, has been its artificially low cost of funds. If that number were more realistic, maybe JP Morgan wouldn’t have ended up parking such an insanely enormous amount of money there.

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