Did falling correlations cause JP Morgan’s trading losses?

May 23, 2012


Many thanks to Scotty Barber for putting this chart together for me. It shows the extraordinarily high correlations that we saw within the S&P 100 at the height of the Lehman crisis; at the height of the Greece crisis; and then, again, for pretty much the entire second half of 2011. At that point, high correlations really did look as though they were the new normal.

Obviously, correlations within and across different asset classes don’t always move in tandem with each other. But in general, the RORO trade, as it’s known, (risk-on, risk-off) tends to send correlations soaring across the board. And I can’t help but wonder whether that huge plunge in correlations that we see at the beginning of 2012 was related to the way in which JP Morgan’s CIO blew up.

Remember that the CIO’s main job was to make hedges: buy buying or selling one thing, the idea was that the bank would protect itself against losses on some other thing. So in order for hedges to work, those two things need to continue to be highly correlated.

But if you look at this chart, the period when Bruno Iksikl was putting on his huge CDS index trade was also the period when correlations were falling at an almost unprecedented pace.

Jamie Dimon, from the day he revealed the losses, has had nothing but the harshest possible words for the hedges in question, saying that they were flawed and should never have been put on. But that’s easy to say in hindsight. Maybe they were really great hedges, in a high-correlation world — and then correlations fell apart, and the trades started moving against JP Morgan, and they had to get bigger and bigger in order to retain any hint of actual hedging capability. Obviously we don’t know for sure that’s what happened. But it’s certainly consistent with movements in correlations this year.


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