Credit Default Mop-Up (Updated Twice)

The latest on the JPMC debacle is that Ina Drew, Chief Investment Officer there is all set to resign:

Executives said that within the last several months, Ms. Drew told traders at the bank’s chief investment office to execute trades meant to shield the bank from the turmoil in Europe. As the problems deepened on the Continent, Ms. Drew thought those bets could protect the bank from losses and even earn a tidy profit, these employees said.

If the purpose of the position was indeed to simply “shield the bank from the turmoil in Europe,” that indicates that this was a hedge. This was no hedge. It was a bet that went wrong. Furthermore, it was not a surprise to those who were watching the markets closely. See this FTAlphaville blog-post back from 4/18, that references a Bloomberg article back from 4/9:

JP Morgan’s Chief Investment Office (CIO) has been amassing such large positions in various credit indices that it is potentially:

  • Distorting the market.
  • Lining JP Morgan up for a loss, and/or a large unhedged exposure in the near future.
  • In violation, and/or against the spirit of the Volcker rule.
  • A sign that banks are getting awfully creative with the correlation models they use for hedging purposes. [link]

It talks about the “London Whale” (JPMC trader, Bruno Iksil) who amassed the large positions in the said credit indices. Specifically, the index known as Markit CDX.NA.IG.9, which showed a surprisingly large increase in volume in early 2012. Conventionally, a decrease is expected as investors switch to newer indices. Without getting sucked into the mire of details, it suffices to say that it is looking increasingly likely that this index was at the center of JPMC’s disaster. The implications of their actions, I think, are best said by Professor James Hamilton quoting Paul Krugman:

Paul Krugman suggests that in the case of the trades by the London Whale, JP Morgan “was just engaging in financial tricks of little or no social value”. One could argue that the role of leveraged bets through derivatives is to allow those who really know what the value of the underlying security should be to help guide the market to that correct valuation. But if you’re making your bet with somebody else’s money, where the deal is you get the upside and somebody else gets the downside, those leveraged bets aren’t so likely to be in the public’s interest. [link]

Many have commented on this, and almost all have said exactly what I was thinking, but much more eloquently. To conclude, I think this post by zerohedge says it best:

Press reports on JPM and the Whale badly underestimate the impact of the Volcker rule on the trading operations of the large banks.  But Jaimie Dimon seems to have handed his head to Chairman Vocker and the advocates of regulation with this error. [link]
In other words, this is going to make life a lot harder for a lot of banks. As usual, the smaller entities will pay a larger price for this. But this leads me to also question the optimal size of the net itself — too small, and it gets expensive to perform day-to-day activities. Too large, and you risk letting bets like the above slip through. How much is too much? But that is for another post. Meanwhile, if you want to read more about another potential crisis in the making, read this post by Professor Hamilton, on his blog Econbrowser.

 

Update: FT Alphaville has an exceptional analysis of the trades that led JPMC up to its current mess. If you don’t subscribe to that blog yet, do so now. It is a phenomenal resource.

“Synthetic credit portfolio”. That’s the book where the $2bn in mark-to-market losses took place for JP Morgan, according to an announcement made on Thursday. A result which has now cost them a their AA- rating from Fitch and landed them on negative outlook with S&P, as announced late on Friday.

FT Alphaville has analysed the credit trades that might be in that portfolio, in an attempt to reason through what may have gone on. The fact, however, remains that we know precious little. Why is that? Is this acceptable that after the financial crisis that this can happen to a bank, let alone a systemically important one like JP Morgan? [link]

Yet Another Update: Professor Tyler Cowen on his blog, Marginal Revolution, points to a Seeking Alpha post that adds a little perspective:

The banking unit of JPMorgan Chase alone made $12.4 billion last year. The holding company has over $2.26 trillion in assets and is the largest U.S. bank and 8th largest in the world. The holding company made $29.9 billion in operating income and just over $20 billion in net income for 2011.

So, this initial loss of $800M represents approximately 4% of its total net profit for all of 2011, less than 2.7% of its operating income. Certainly it’s not a good thing. But the reported losses, in and of themselves, are not likely to have a dramatic impact on JPMorgan’s long-term financial stability. [link]

Professor Cowen adds:

A $2 billion loss is about one percent of their equity and about 0.1% of their assets. [link]

A small amount, but it is still not a good idea to light a match in a room full of fireworks. This is a hot-button topic in an election year, and as the old saying goes: a billion here and a billion there, it eventually starts to add up…


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