If you have a bit of time today, the official JP Morgan post mortem on the London Whale affair is well worth reading. The whole thing is 132 pages long, although the executive summary — which is very clearly written — is only 17 pages.
One thing the report certainly does is reinforce my conviction that you can’t hedge tail risk. The losses all took place in something called the Synthetic Credit Portfolio, which was described as a “Tail Risk Book” — something designed to make money “when the market environment moves more than three standard deviations from the mean based on predictions from a normal distribution of historical prices”. In other words, JP Morgan is well aware that market moves are not normally distributed, and therefore it has a whole derivatives book in place to protect itself against inevitable unexpected events.
The whole point about tail risk, however (a/k/a “black swans”) is that you can’t anticipate exactly what it’s going to look like before you see it. In this case, the biggest tail event was the publication of stories, in the WSJ and Bloomberg, talking about JP Morgan’s positions. Those stories had a massive effect on the mark-to-market valuation of JP Morgan’s positions At the beginning of the first trading day after the stories appeared, it looked as though JP Morgan might be facing a one-day loss of $700 million; in the event, the final official number was $412 million. Ina Drew, the person in charge of the portfolio, sent an email to JP Morgan’s CEO and CFO, in which she observed that the move was “an eight-standard-deviation event”.
The report doesn’t say how many eight-sigma events the CIO has ever seen: my guess is that this is the only one. But here’s an idea of how crazy eight-sigma events are: under a normal distribution, they’re meant to happen with a probability of roughly one in 800 trillion. The universe, by contrast, is roughly 5 trillion days old: you could run the universe a hundred times, under a normal distribution, and still never see an eight-sigma event. If anything was a black swan, this was a black swan. And it didn’t help JP Morgan’s “tail risk book” one bit. Quite the opposite.
Another thing the report does is show just how difficult it is for any large organization to actually implement what managers want. At JP Morgan, for instance — where the CEO has an unusually large degree of power and knowledge of what is going on — the whole firm was meant to be reducing its “risk-weighted assets”, or RWA, since the higher a bank’s RWA, the more capital it needs under Basel III. And yet somehow, by the time this directive trickled down to the London Whale, it had been watered down and misinterpreted to the point at which the office’s RWA actually went up — substantially — rather than down.
What’s more, there’s a constant theme running through the report of managers being told what they want to hear, rather than the truth, especially with regard to substantial losses. When those appear, no one wants to tell Ina Drew about them; instead, the traders do everything they can to try to either fudge the numbers or attempt to trade their way out of the position.
Interestingly, one way that numbers were fudged was to use the favorite tool of quants around the world, the Monte Carlo analysis. After the Bloomberg and WSJ stories appeared, for instance, one trader drew up an analysis of just how bad the position could get. He modeled nine extreme event like a “bond market crash” or a “Middle East shock”, and found that in six of them, the portfolio lost money, with the losses ranging from $350 million to $750 million. This analysis did not go down well:
This trader sent his loss estimates to the other on April 7. According to the trader who prepared the loss estimates, the other trader responded that he had just had a discussion with Ms. Drew and another senior team member, and that he (the latter trader) wanted to see a different analysis. Specifically, he informed the trader who had generated the estimates that he had too many negative scenarios in his initial work, and that he was going to scare Ms. Drew if he said they could lose more than $200 or $300 million. He therefore directed that trader to run a so- called “Monte Carlo” simulation to determine the potential losses for the second quarter. A Monte Carlo simulation involves running a portfolio through a series of scenarios and averaging the results. The trader who had generated the estimates did not believe the Monte Carlo simulation was a meaningful stress analysis because it included some scenarios in which the Synthetic Credit Portfolio would make money which, when averaged together with the scenarios in which it lost money, would result in an estimate that was relatively close to zero. He performed the requested analysis, however, and sent the results to the other trader in a series of written presentations over the course of the weekend. This work was the basis for a second-quarter loss estimate of -$150 million to +$250 million provided to senior Firm management.
In the event, of course, the portfolio ended up losing not $150 million, not even $750 million, but more like $6 billion, with some $800 million of those losses taking place in the six trading days leading up to April 30, long before the decision was made to liquidate the position. Which just goes to show how useful stress tests are. (Remember, the initial worst-case estimates were put together after the WSJ and Bloomberg stories appeared, which means that JP Morgan was acutely aware, at this point, of the risk that the market would move against them just because their positions were public.)
There is one big omission in the report — and that’s any discussion of how the ultimate losses in the portfolio grew to be so enormous. Where did the initial $2 billion estimate come from, and how did it grow to $6 billion by the time all was said and done? The report basically ends when the potential losses were made public, and doesn’t spend any time discussing how Jamie Dimon and his senior executives handled everything from there on in.
From the perspective of JP Morgan’s shareholders, there are two big things to worry about in this whole episode. The first is weaknesses in risk management, which the report goes into in great detail. The second is the way that senior management responds to a crisis, and whether it can do so while keeping its head and minimizing losses. On that front, the report is silent. Did a panicked reaction to the early losses result in a “dump everything immediately” response which ended up causing an extra $4 billion in damage? Who was responsible for those $4 billion in losses, and how avoidable were they? Those questions are never asked, let alone answered.
JP Morgan has looked in great detail at its crisis-prevention architecure: it’s time, now, too look at its crisis-response architecture, too. Because sometimes, it seems, the latter can cause more damage than the former.