There are a couple of sharemarket adages which, if heeded, could have saved JP Morgan Chase, if not the entire $US6 billion-plus it lost on a flawed credit derivatives strategy, then the best part of it.
"Your first loss is the best loss" is one; "don’t chase your losses" is another.
When one reads the 129-page report compiled by a JP Morgan management committee that reviewed the events leading up to those losses, it appears obvious that the decisive moment came when the group’s chief investment office, which used the firm’s own capital to hedge against its overall risk (and, where possible, make money by doing so), decided to prioritise the group’s earnings over risk. It’s not an unfamiliar story.
The CIO used a synthetic credit portfolio to offset the bank’s overall credit risks. In late 2011 it was looking at a major overhaul of that portfolio because the bank generally had a more positive view of the economic outlook but also because the group was trying to reduce its risk-weighted assets in anticipation of the new Basel III capital adequacy requirements.
The plan was to shift the portfolio from a net short position to a more neutral one by unwinding some of the positions. As that process started, however, the traders involved realised that it was proving more costly than anticipated.
JP Morgan’s chief investment officer at the time, Ina Drew, made the fateful decision to give the traders more "flexibility" in terms of reducing the bank’s risk-weighted assets, telling them to be more sensitive to the profit and loss impacts. At the time, by the end of January 2012, the mark-to-market losses were about $US100 million.
The traders then added substantially to the portfolio and by the end of March the mark-to-market losses had grown to $US718 million.
Analyses the bank ran at the time appeared to show the portfolio was balanced but that the market was "dislocated" and that the losses were temporary and manageable. They proved anything but temporary and manageable.
Part of the problem the bank subsequently discovered was that there was a question mark about the integrity of the "marks" used to value the portfolio as well as mathematical mistakes in the modelling of the portfolio – a new model that wasn’t properly tested. It replaced a model that showed the group’s risk limits had been exceeded in January. These issues are being investigated by the FBI and regulators.
The management report, and a separate report by a JP Morgan board sub-committee were part of an intense internal review of what went wrong within the CIO and the bank’s governance structures that has led to a string of departures of former senior executives and cost chief executive Jamie Dimon half his bonus. (He had to settle for a meagre $US11.5 million of remuneration that included a bonus of "only" $US10 million).
JP Morgan has overhauled, or is overhauling, its risk-management procedures and personnel and imposed far stricter limitations and more granular risk limits on the synthetic credit portfolio within the CIO.
Ultimately, however, what happened to JP Morgan is not dissimilar to what has happened periodically and fairly consistently to banks elsewhere, with traders chasing a loss position and almost inevitably disguising it, for a time, in the hope they can make it good by increasing the scale of their bets rather than taking their medicine and minimising the losses by closing their positions out. Those strategies rarely end well, or cheaply.