So You Wanna Talk About JPM’s Trading Loss and The London Whale

I know what’s on your mind this evening – JPM’s announcement of large trading losses related to the London Whale in their CIO division who was supposed to be hedging risks in other parts of the firm.   Let’s get to that in a minute – first, a story.

The first part of my Wall Street career was on the sell side (read: client facing) of a major bank.   We executed orders for clients and managed a large risk portfolio as a result of principal trades where we committed capital.   Our expertise was in ETFs, index arbitrage, program trading, index related trades, etc.   Anyway, the second part of my career was at an internal hedge fund on the buy side of the same bank.   Our group was essentially managing the bank’s capital – we were now a customer to other Wall Street firms.

Aside from my prop group, which managed a few billion dollars, there were a few handfuls of other groups, all under one umbrella.   The guy who ran that umbrella of trading pods – The Boss – would sometimes execute his own trades to hedge the accumulated risks of the groups under his domain.   Since my group had expertise in executions of likely hedging instruments, my boss had convinced The Boss that he should call us if he ever needed help executing a hedge.

One afternoon in early 2007, I was sitting there minding my own business when The Boss walked in.   He popped in, at most, once a month – it was not a common thing.  My boss happened to be out of the office that day.   I snapped to attention in my chair, and greeted him,

“Hey The Boss (name withheld, obviously), how’s it going?”  I cringed at my own greeting.

“I would like to short some $IWM”  He replied in his accent that was like a mixture of all of the Austin Powers characters except Fat Bastard – it was Dr. Evil meets Austin Powers meets GoldMember.

“No sweat.  How many?”  This was cake.

“One Billion Dollars.”  This reply sounded more like The Count from Sesame Street than it did Dr. Evil.

With a complete poker face I replied, “Ohhhh kay.  Let me just call stock loan.”

This was a big f’n order.  Monstrous.  Biggest single name order I’ve ever executed.  And The Boss wasn’t leaving.

I rang up stock loan: “Hey, I need a locate on some IWM.”

“Sure – how many?”

“Fifteen million.  It’s for The Boss.”

After a few keystrokes which I could hear through the phone: “Fire away – you got it.”

I hung up and started banging out some orders electronically to get started.  75k here on Instinet, then 150k on ARCA.   Then I called a broker and got a market on 250k.  SOLD.

The Boss was still standing over my shoulder.

“Umm, Boss, this is gonna take a little while,”  I didn’t want him breathing down my neck

“Sure, sure, I understand,”  he drawled in Austin Powers Composite Accent, “I’m not breathing down your neck.”

Yeah you are.  Anyway.  Another broker, another 500k.  10 minutes later, same story.  The Boss eventually left me to do my job, and I got the order done in about 2 hours without crushing the market.   The Boss was happy.  But enough about me.

My point is that The Boss chose IWM as an attempted hedge for the exposure under his umbrella of prop traders NOT because we were all long IWM – none of us were – but because it figured to be correlated to our exposures, with an even higher beta (which is to say that if I lost money on a billion dollar long portfolio, The Boss would expect to make even more money on a billion dollar short IWM position – this was by design, as his hedge was much smaller than our aggregate long notionals).

Which brings us to JP Morgan ($JPM – no positions).  I’m not going to pretend that I can give you any insight as to the level and details of JP Morgan’s credit exposures.   I think that’s the real problem with our banks – they are way too friggin’ complicated to understand for even the most seasoned of financial analysts (a group in which I am not placing myself, by the way).  The latest 10Q is a mere 176 pages, but that’s because they reformatted it to put double the text on each digital “page.”

The bottom line here is that JPM has a group, CIO, which acts kinda like The Boss in my story did, only they are looking at a bank the size of JP Morgan with TRILLIONS of dollars of exposure, not a handful of prop desks with less than ten billion in exposure.    The “hedge” put on by this group didn’t do the job it was intended to, hence the losses reported today.

Is this apocalyptic?  Well, my first email to two colleagues when I read this story was “This is exactly the kinda story that could crash the market.”  Why?  Well, if people were starting to trust that the banks knew what they were doing – and that’s a big IF – this story puts all sorts of doubt into that “trust.”  JP Morgan is supposed to be the biggest, best bank on the block – the one who f*cked up the least in the financial crisis, and the strongest one.   Although this loss is small in the grand scheme of things, 2008 is not so far buried in our memories that we’re not thinking “Oh yeah, I remember when Merrill Lynch started with a $ 2B writedown too…”   Having said all of that, I think that the story is still more likely to be blown out of proportion than it is to be indicative of the imminent demise of the US Financial System.  However, fear matters sometimes, and there is fear in the air.

I sent out a tweet tonight that said:

Dan Davies of @DsquaredDigest replied that he could think of several more, and added:

The problem here is uncertainty.   We don’t know WTF is going on inside the big bank balance sheets, and just when we start to (maybe) gain some measure of comfort that the crap may have been cleaned up, a grenade like this blows up in our faces and the fear comes back.   Today,  JPM noted that their new VAR (value at risk) model was flawed, and that they were going back to the old model.  That doesn’t build confidence.  As for the “delays marking to market” that I tweeted about – there may not have even been any delays – the delay just may have been in announcing the losses publicly: obviously JPM doesn’t announce their mark to market losses every day, but they felt compelled to make a statement once the losses reached a certain level.   We can only hope that the losses WERE realized accurately when they occurred, and not all at once overnight on a re-marking of positions from inaccurate levels, which would be troubling.

JPM CEO Jamie Dimon made quotes such as:

“These were egregious mistakes…“They were self-inflicted and this is not how we want to run a business.”

As the WSJ puts it:

“Mr. Dimon said the so-called synthetic hedge, using insurance-like contracts known as credit default swaps, was “poorly executed” and “poorly monitored.” He said that the bank has an extensive review under way of what went wrong, and that there were “many errors,” “sloppiness” and “bad judgment” on the bank’s part.”

but the scariest part is that (from Dealbook):

“Mr. Dimon added that it could “easily get worse.””

Again – not exactly a confidence builder.

In summary:  losing money in a group like CIO is not a big deal in and of itself – if the hedges are properly executed, we’d expect them to lose money as other areas of the bank made money.   It seems pretty clear, however, in this case the hedges were not well executed/well suited/well correlated to the underlying exposures.  When you’re talking about an entity the size of JP Morgan, it’s hard to ever make the “it’s no big deal” argument.  Now we wait, watch, and worry to see if there are other shoes to drop…

note: I’m going to intentionally leave aside the debate as to if these trades were “hedges” in the first place, or prop trades, as some have alleged.  I have treated it in the story above as a “hedge,”  but I’m not sure it really matters – if it was a hedge it wasn’t a good hedge.

related:

Matt Levine @ Dealbreaker: Whale Sushi On The Menu

NY Times DealBook: JPM $2 B Loss

WSJ: JPM $2 B Loss

Dealbook: Shock From JPM is New Fodder for Reformers

EDIT:  must read mega-post from Matt Levine at Dealbreaker:  The Tale of a Whale Fail.  If you only read one post, read this one.

or this one from Lisa Pollack @ FT Alphaville: Too Big To Hedge

or this one from SonicCharmer:  I’m Pretty Sure JP Morgan Lost $ 2B Just To Spite Me

-KD

 

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