Did falling correlations cause JP Morgan’s trading losses?

By Felix Salmon
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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I hope not. That would probably mean more facile references to ‘black swans’ and other exculpatory nonsense, when what is at issue is VaR/balance sheet gaming via “hedging” — that is, legalized fraud. (Also, it would make them about as stupid as those guys at LTCM.)
I realize it probably isn’t “wonky” and exciting enough, but please try to focus on the fraud/crime aspects a bit more.

Posted by Foppe | Report as abusive

I also hope not, since presumably correlation risk is one of the things they’re supposed to be hedging in the first place…

Posted by absinthe | Report as abusive

Foppe, from that chart I would say that falling correlations have more in common with pigeons than rarer birds.

Posted by TFF | Report as abusive

Anyway, to answer the question asked in your title: no, it did not. Thinking in terms of explained variance by a variable, I would say that ‘having a casino mentality’ has much more explanatory value — causal power? — than falling correlations do. Unless, of course, you want to argue that smoking in gas station is a perfectly healthy behavior to engage in.
TFF: indubitably.

Posted by Foppe | Report as abusive

Are correlations guaranteed? Just wondering.

Or is it like W after Katrina: “nobody could have foreseen it”?

oh, o.k. It’s just bad luck.

Posted by KenG_CA | Report as abusive

No, no. No.

The problem this time and always is in the volume–the size of the position. Iskil’s position was itself market-distorting, and that brought in more players, which distorted things further. All the “correlations” change when some smart guy piles in so many chips into a single sector or index or whatever. That’s what happened. Lately, that’s pretty much what always happens.

Posted by Eericsonjr | Report as abusive

What Eericsonjr said. JPM was creating the relevant correlations.

Posted by Greycap | Report as abusive

“What Eericsonjr said. JPM was creating the relevant correlations.” (GreyCap)


There’s damn near no pond big enough for these TBTF Whales to swim in any more. Now JD/JPM has beached itself into a blood-thirsty, locked-in position that it can’t escape, at least not without a truly creative solution. But no problem – JD’s always the smartest guy in the room, no matter where he goes, or so he thinks. Now he gets to prove it – if he can.

Posted by MrRFox | Report as abusive

MrRFox, that is why I’m skeptical of the meme that the market is rigged against small investors. More than ever before, small investors have the information available to make quality choices — and the big guys playing fancy games are pushing against their own inertia. Might not be a level playing field, but it is the closest I’ve seen it in the 30 years I’ve been investing.

Posted by TFF | Report as abusive

@TFF – functionally, the individual may be more nimble and have a broader range of markets to play in than the Whales, that’s probably so. Still, after the FB thing, it sure looks like it pays to be inside the “whisper loop”.

Posted by MrRFox | Report as abusive

@MrRFox, I try to avoid situations where the “whisper loop” is relevant.

Like I said, it might not be a level playing field, but it is closer than it was 30 years ago. And the big players have their own problems (among other things — they pay half their profits in bonuses to the traders while eating all the losses).

Sometimes it isn’t so bad to be a small, unsophisticated investor.

Posted by TFF | Report as abusive