In May 2012 JP Morgan Chase disclosed over 6 billion dollar trading loss on its “synthetic trading portfolio”. By its own admission the events that led to the company’s losses included inadequate understanding by the traders of the risks they were taking; ineffective challenge of the traders’ judgment by risk control functions; weak risk governance and inadequate scrutiny (Dimon, 2012). According to the New York Times, individuals amassing huge trading positions were not effectively challenged, there were regular shouting matched and difficult personality issues.
The Trades were done from the London Branch in which the unit was run by Chief Investment Officer Ina Drew, who later stepped down.
The transactions involved were a series of Credit Default Swaps (CDS), reportedly as a part of the bank’s hedging strategy. Trader Bruno Iksil, nicknamed the London Whale, accumulated outsized CDS positions in the market. An estimated trading loss of $2 billion was announced. However, the loss amounted to more than $6 billion for JP Morgan Chase
Credit Default Swaps
CDS is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of loan default. It’s the same complex financial instruments that doomed A.I.G during the 2008 financial crisis.
Let’s take a case where A Ltd. took a Loan and to hedge the position in case of default in payment of loan A Ltd. bought CDS to hedge the loan amount and A Ltd. will make regular payments to the Bank (seller of CDS i.e. protection). If A ltd. defaults in payment of the loan, then it received a one-time payment from the Bank, and the CDS contract is terminated.
Synthetic Trading Portfolio
Using a portfolio of CDS contracts, an investor can create a synthetic portfolio of bonds that has the same credit exposure (maximum potential loss to a lender if the borrower defaults on payment) and payoffs.
Hedging is a risk management employed to offset losses in investments by taking an opposite position in the related asset.
Value at Risk (VaR)
VaR is a method of measuring the loss in the value of the portfolio over a given time period of time. VaR can measure broader measures of calculating potential losses.
For example a Mr. A enters into a trade and calculates a daily 3% VaR as Rs. 10,000, this indicates that there is a 3% chance that on any given day, the trade might experience a loss of 10,000 or more or this can also be understood as, there is a 97% chance that on any given day the trade will experience either a loss less than 10,000 or a gain.
About JP Morgan Chase
JP Morgan was the largest financial holding company in the United States and had more than 2 trillion dollars in assets. It is also a global financial services firm with more than 250,000 employees. The company has more than 5,600 branches and is a strong market participant in mortgage lending, investment banking, and credit card spaces (Hoover’s Company Records, 2014). JP Morgan’s principal bank subsidiary, JPMorgan Chase Banks is also the largest bank in the United States.
JP Morgan Chase is the largest financial holding company in the United States. It is also the largest derivatives dealer in the world and the largest single participant in world credit derivatives markets. It has consistently portrayed itself as a risk management expert with a ‘‘fortress balance sheet’’ that ensures taxpayers have nothing to fear from its extensive dealing in risky derivatives.
What Actually Happened that lead to JP Morgan 6 Billion Trading Loss?
Imagine there is a movie hall with 300 seating capacity and you have purchased 200 tickets hoping that demand will rise and you can sell those tickets at a higher price. But instead, demand fell, prices fell and you had to sell the tickets and had to cut drastic losses.
Mr. Iksil, Chief Investment Officer of JP Morgan Chase, was well known for taking huge risky positions, due to his risk-taking capacity and dominance in the markets, he was called the “London Whale”.
The purpose of the CIO is to protect the bank from losses and interest rates by acting as a hedge credit risk. The CIO unit is not tasked to trade intended to boost profits. In 2009 alone the CIO group’s Synthetic Credit Portfolio (SCP) of financial derivatives generated 1.05 billion dollars for the bank.
Internal CIO management also disregarded their own risk metrics such as the VaR. This warning sign metric was ignored and then actually raised and they took a position so big that it could affect the whole market. The bets were made by traders in the London office of the U.S. banking giant JPMorgan Chase.
As per the opening statement of Senator Levin, “their trades—meaning their bets—grew so large that they roiled the $27 trillion credit derivatives market, singlehandedly affected global prices, and finally attracted a media storm aimed at finding out who was behind them”.
Mr. Iksil, “has been selling protection (CDS) on an index of 125 companies in the form of credit-default swaps. Needless to say, the companies in the index did not improve. The initial 100 million dollar position that the CIO office held in the CDX IG 9 index was essentially cornering the market and when there were no willing buyers, the firm had to sell at a massive loss. Bruno Iksil and the London CIO office were steadily racking up daily losses in the hundreds of millions of dollars by investing in synthetic derivatives (i.e. Credit Default swaps or CDS).
In April of 2012, the press began running stories about the identity of the “London Whale”. The massively over sized trades in credit default swaps began to affect credit markets worldwide.
By the end of the week on May 11, 2012, when the firm held a hastily convened conference call regarding transparency around the London Whale trades, JP Morgan suffered a loss of 14.4 billion from its market capitalization as JP Morgan stock price fell 11.47% in two days.
By the end of May, the synthetic derivatives portfolio alone had lost 2 billion dollars.
By the end of June, the trading losses doubled to 4.4 billion and eventually reached 6.2 billion by the end of the year.
CEO Jamie Dimon, Chief Risk Officer John Hogan, and CIO head Ina Drew, “approved the temporary increase in the Firm-wide VaR limit, and Ms. Drew approved a temporary increase in CIO’s 10-Q VaR limit.
After the Storm
After 9 months of digging into the facts behind the whale trades, to learn what happened, the Subcommittee collected nearly 90,000 documents, conducted over 50 interviews and briefings, and has issued a 300-page bipartisan report.
The investigation brought home one overarching fact: The U.S. financial system may have significant vulnerabilities attributable to major bank involvement with high-risk derivatives trading. The four largest U.S. banks control 90 percent of U.S. derivatives markets.
The investigation also concluded that JP Morgan traders, who were required to book the value of their derivatives holdings every business day, used internal profit/loss reports to hide more than half a billion dollars in losses in just 3 months.
The Corrective Steps taken by JP Morgan
After the opening statements of Senators, in the testimony of Ashley Bacon (Chief Risk Officer) mentioned steps that was taken to improve the firm-wide risk management. These steps were:
- the Firm appointed a new Chief Risk Officer for CIO in May 2012. Additionally, the Firm took steps to ensure Risk’s independence and the appropriateness of staffing levels.
- the Firm has overhauled the CIO Risk Committee. The committee now meets on a weekly basis, and attendees include other members of senior management, from within and outside of CIO.
- CIO implemented numerous new or restructured risk limits covering a broad set of risk parameters.
- JP Morgan has conducted a comprehensive self-assessment
of the Risk organization, and as a result, we are implementing a
series of improvements.
Recommendations of senator after JP Morgan whale trades:
- When it comes to high-risk derivatives, Federal regulators need to know what major banks are up to. We should require those banks to identify internal investment portfolios that include derivatives over a specified size, require periodic reporting on derivative performance, and conduct regular reviews to detect undisclosed derivatives trading.
- When banks claim they are trading derivatives to hedge risks, we need to require them to identify the assets being hedged, how the derivatives trade reduces the risk associated with those assets, and how the bank tested the effectiveness of its hedging strategy in reducing risk.
- We need to strengthen how derivatives are valued to stop inflated values. Regulators should encourage banks to use independent pricing services to stop the games.
- At major banks that trade derivatives, regulators should ensure the banks can withstand any losses by having adequate capital charges for derivatives trading.
- The derivatives trading that produced the whale trades damaged a single bank. But the whale trades expose problems that reach far beyond one London trading desk or one Wall Street office tower.
Too Big to Fail?
After 2008, the financial crisis and subsequent Great Recession damaged many global and domestic financial services firms. While the government bailed out universal banks and monoline financial institutions alike, both governments and the public clamored for action against banks they deemed “too big to fail”.
In the opening statement of Senator Mccain, he states that JP Morgan completely disregarded risk limits and stonewalled federal regulators. It is unsettling that a group of traders made reckless decisions with federally insured money, and that all of this was done with the full awareness of top officials at JP Morgan. This bank appears to have entertained-indeed, embraced-the idea that it was quote “too big to fail”.
Even after 9 years of this unwanted event, what can we learn even as a small trader in the financial markets?
- Avoid taking over sized positions, or it could turn out into collateral damage
- Build and strictly follow your risk management techniques
- Follow stop losses