Reeling from JP Morgan's exposure
More than the losses themselves, JP Morgan's core competency breakdown has shocked the market – and will make regulators even more keen to tighten the reins.
Markets have, sadly, become accustomed to revelations of rogue traders or financial bets gone badly wrong at investment banks. JP Morgan, however, was probably one of the handful of global institutions least likely to announce $US2 billion of trading losses in a quarter, with the potential for another $US1 billion.
Markets, particularly in the current volatile environment, can, of course, move against even well-constructed hedging portfolios but in this instance JP Morgan’s chief executive, Jamie Dimon, described the bank’s hedging strategy as poorly executed, poorly monitored, with many errors, sloppiness and bad judgement within the bank. The mistakes made, he said, were "egregious" and "self-inflicted".
The losses came from within what the bank calls its chief investment office, which is supposed to take a global view of the group’s risks and hedge them – take offsetting positions – to protect the bank’s balance sheet.
Bank critics, however, have described the CIO as a proprietary trading desk in disguise and the revelations overnight would tend, whether or not JP Morgan actually intended to make bets rather than take out insurance, to support that view.
The damage stems from an attempt to insure against losses in JP Morgan’s credit portfolio, using credit default swaps. It would appear that there was some misalignment between the way the credit book and the synthetic trading JP Morgan traded – that it misjudged the correlations between the two.
Dimon said yesterday that JP Morgan’s synthetic credit portfolio had proven riskier, more volatile and less effective as an economic hedge than it had previously believed.
For some weeks there have been rumblings in the markets, and in the press, about very large long positions in CDS taken out by a trader in JP Morgan’s London office, large enough to move the market. Last month, when asked about those reports, Dimon said they were a "complete tempest in a teapot" and that every bank had a major portfolio of investments to offset its exposures.
Last night he said the bank had "egg on our face" and deserved any criticism it received.
While the detail of what occurred is murky, it would appear that the London desk took a bullish view on corporate debt earlier this year and sold credit protection on a scale sufficient to move the market. Inevitably that would have attracted attention from hedge funds and others betting against it, which could have forced or exacerbated the mark-to-market losses.
There are also suggestions that JP Morgan changed the model for valuing risk that it used to develop its hedging strategies to one that has been demonstrated to have been flawed – and is now reverting to its original one.
More than the losses themselves, which are relatively inconsequential in the context of a bank as massive as JP Morgan, the disclosures shocked markets because they revealed, as Dimon conceded, a breakdown in the core competencies and processes of a globally significant institution and one which had, deservedly, prided itself on its risk-management skills. Investment banks are well aware that their trading operations are a major source of risk and need to be closely monitored and managed. Other major investment banks have, despite the market volatility, got through the March quarter unscathed.
The JP Morgan losses and the breakdown in its controls will undermine the attempts by the big US banks to weaken the "Volcker Rule," which aims to limit their proprietary trading.
While hedging aggregate balance sheet risk isn’t proprietary trading – punting with bank capital – the JP Morgan experience says that poor hedging can produce similar outcomes. That fact that it is JP Morgan will make US regulators even more motivated to tighten the regulation around trading activities.
There is a big push by regulators generally to bring over-the-counter derivative trading into the sunlight and onto transparent platforms. At this stage, however, the opacity of CDS trading doesn’t appear to have been a major factor in the losses – the entire market, it appears, was very well aware of the position JP Morgan had taken.
Nevertheless, the latent danger in derivatives and the kind of arbitrage strategies routinely conducted by banks and hedge funds has again been demonstrated by the JP Morgan experience and can only increase the determination of regulators to find ways to better regulate their trading and the institutions that trade them.