How to Lose 2 Billion Dollars (for starters)

Losing $2-billion in six weeks is quite the feat for JPMorgan Chase & Co., the venerable U.S. bank that was, until last Thursday, widely respected for sound risk management.

But how exactly did the bank get itself into this mess? And what trade blows up this quickly? JPMorgan isn’t saying much – likely because the more it discloses, the more its rivals will have to use against it. But keen market observers are trying to figure it out, and the speculative theories have been narrowed.

To understand the trades, you have to start by looking back a few weeks. In early April, Bloomberg News reported that Bruno Iksil, a trader in JPMorgan’s chief investment office, had placed massive bets on the health of certain companies. His positions were so big that rival hedge funds claimed the positions were starting to distort the market.

Mr. Iksil works for JP Morgan’s chief investment office. This division, based in London, is supposed to hedge the bank’s risks, but some say that its ‘hedges’ are in fact risk trades designed to duck the proposed Volcker Rule that bans prop trading.

When news of this division’s massive positions broke, JP Morgan didn’t say much. Then out of nowhere it hastily put together a conference call on Thursday to disclose that the CIO lost $2-billion in about six weeks.

The first explanation for the losses relates to what is known as the basis trade, a hedging strategy for corporate debt. Assume you own a 5-year bond. If the issuer goes bankrupt, you never get your principal back. To protect yourself, you can purchase a credit default swap (CDS) that mimics an insurance policy. Just like your car insurance, you pay a premium (fee or ‘spread’) to the swap writer, and in return, if you car gets stolen, or in this case the company goes bankrupt, you get paid a lump sum. But for this hedge to work, the corporate bond spread (interst paid to you) must match the CDS spread (your insurance premium). If they line up, your net exposure is little or nothing.

Historically, this held up. If anything, investors had to pay just a bit more in premiums than they received in interest, and this small difference was known as ‘positive basis’.

Every once in a while, ‘negative basis’ would appear for random reasons, creating risk-free profits because interest payments you received amounted to more than the insurance premium you had to pay. When this happened, big name hedge funds and prop trading desks would pile in and exploit the anomaly. To them, it was free money.

The problem, though, is that this trade is predicated on bond spreads (interest) remaining equal to CDS spreads (insurance premiums). As Felix Salmon points out, the market is currently very screwy, and many CDS spreads (insurance premiums) are blowing out while the bond spreads (interest) hold tight. For example, UBS’s CDS spread (insurance premium) is 85 basis points higher than its corporate bond spread (interest received), and Deutsche Bank’s spread difference is 83 basis points.

Mr. Salmon believes this dislocation is what got JPMorgan in trouble. The way he sees it, the bank was selling insurance protection, betting that CDS spreads (insurance premiums)would go down rather than up. Ultimately, they went up, and the corresponding spreads didn’t. So your insurance premium went up, but the interest paid to you didn’t.

Think of it this way. If JPMorgan was using this trade as a hedging strategy, it means the company was probably short corporate bonds. [By going short, the banks benefits when the bonds do badly (decrease in value), while in the CDS market, it suffers because it has a higher chance of paying out.] But because JP Morgan was selling insurance protection, the lower CDS value from wider spreads wasn’t offset by any bond spread movements (higher interest payouts).

JP Morgan wouldn’t be the first U.S. financial institution to get dinged by the basis trade. Merrill Lynch posted a $16-billion loss in the fourth quarter of 2008 for the same reason.

A second theory is much more complex, but the main idea is that JP Morgan may have tried to hedge a position by placing various trades on an index of liquid credit default swaps. As the market rallied over the past few months, it forced JP Morgan to increase its position with this index. This resulted in massive mispricing because the bank made the index more expensive that the sum of its constituents (artificially propped up).

“This is akin to looking at the 500 names in the S&P 500 – weighting them and seeing that the S&P 500 index should trade at 1,200 but it is trading at 1,400…” Zero Hedge noted.

If this played out, rival hedge funds would have tried to short the index (betting it would decrease in value) because they knew it was too expensive. After they did, the index should have fallen right away, yet JPMorgan had to keep supporting it because it needed the hedge. The longer this went on, the more questions the other hedge funds asked, and eventually Mr. Iksil was discovered.

After building this position, JPMorgan could have gotten in trouble because the market stopped rising. The problem is that it couldn’t unwind its position because its rivals had figured out what it was up to.

That’s why Jamie Dimon may have said that more losses could come. If he’s stuck with these trades, competitor hedge funds are going to do everything they can to make sure JPMorgan can’t get out of them.

If this is the case, more losses are certain to be announced.

Attribution: Janamejayan

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About thecommonconstitutionalist

Brent is not a scholar. He’s not an author or speaker (yet). He hasn’t published a book nor does he write articles for magazines (yet). He has no advanced literary degree or pedigree (never will). He is just an American who writes and shares what interests him. He cares about the salvation of this country and a return to its Constitutional roots. He believes in God, country and family.
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2 Responses to How to Lose 2 Billion Dollars (for starters)

  1. jthomasin says:

    And republicans are not adamantly for Wall Street Reform,…. why not?

    • Actually, most “Republicans” are for big government solutions for everything, just like dems. Real Constitutional conservatives understand that in a free market (I mean really free, not what we have today) one cannot nor should they try to regulate pain or risk out of society. It can’t be done. If you want to regulate something, why not start with the biggest scam artists in this country, our Federal Government. A 2 billion dollar loss for them wouldn’t make it onto the radar screen. If allowed to by our Nanny government, the free market will take care of JPM.

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