So You Wanna Talk About JPM’s Trading Loss and The London Whale
- Posted by kid dynamite
- on May 11th, 2012
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.
Matt Levine @ Dealbreaker: Whale Sushi On The Menu
NY Times DealBook: JPM $2 B Loss
WSJ: JPM $2 B Loss
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
Kid Dynamite is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com. If you click on my Amazon.com links and buy anything, even something other than the product advertised, I earn a small commission, yet you don't pay any extra. Thank you for your support.
The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.
This blog has morphed from a discussion of poker hands and theory into an evaluation of financial markets from the point of view of a former trader. More »
If you'd like to make a donation, I always appreciate it:
I'm also a member of the Amazon.com Affiliate program.
- The Kid’s Still Got It
- Is Anyone Surprised That Fish McBites Suck?
- Poker and Trading – Birds of a Feather
- Matt Kemp: Respect
- The Difference Between Women and Men: Dog Poop Edition
- You Can Not Make This Stuff Up
- Cut Punters – Jon Stewarts Skewers Congress on the Sequester
- A Classic Homebrew Error: Forgot To Add Priming Sugar!
- WYNN Q1 2013 Earnings Call Tidbits
- Why Won’t Bernanke Be at Jackson Hole?
- May 2013
- April 2013
- March 2013
- February 2013
- January 2013
- December 2012
- November 2012
- October 2012
- September 2012
- August 2012
- July 2012
- June 2012
- May 2012
- April 2012
- March 2012
- February 2012
- January 2012
- December 2011
- November 2011
- October 2011
- September 2011
- August 2011
- July 2011
- June 2011
- May 2011
- April 2011
- March 2011
- February 2011
- January 2011
- December 2010
- November 2010
- October 2010
- September 2010
- August 2010
- July 2010
- June 2010
- May 2010
- April 2010
- March 2010
- February 2010
- January 2010
- December 2009
- November 2009
- October 2009
- September 2009
- August 2009
- July 2009
- June 2009
- May 2009
- April 2009
- March 2009
- February 2009
- January 2009
- December 2008
- November 2008
- October 2008
- September 2008
- August 2008
- July 2008
- June 2008
- May 2008
- April 2008
- March 2008
- February 2008
- January 2008
- December 2007
- November 2007
- October 2007
- September 2007
- August 2007
- July 2007
- June 2007
- May 2007
- April 2007
- March 2007
- February 2007
- January 2007
- December 2006
- November 2006
- October 2006
- September 2006
- August 2006
- July 2006
- June 2006
- May 2006
- April 2006
- March 2006
- February 2006
- January 2006
- December 2005
- November 2005
- October 2005
- September 2005
- August 2005
- July 2005
- February 2001