As readers likely know by now, Jamie Dimon hastily arranged an after hours conference call today, in which he admitted to $2 billion in losses in the last six weeks from a trade by the “London Whale”, Bruno Michel Iksil in the bank’s Chief Investment Office, with as much as another potential $1 billion in losses in the offing. The position was a hedge involving credit default swaps, a product in which the firm has touted its expertise (a recent display occurring in a Frontline program we shredded).
Bloomberg reported on the story in early April, noting that Iskil’s postions were so large that he was driving prices. This is generally a sign of a basic failure in risk management. You never want to take a bet too large in a market if you might want or need to exit quickly, and highly leveraged firms in general are not in a great position to ride out adverse price moves, even if they believe the trade will work out in the end. This same mistake felled LTCM and Amaranth. Even more telling, Dimon made clear this trade was not a hot idea to begin with, repeatedly calling it poorly conceived, poorly executed, and not sufficiently monitored (update: Felix Salmon says he believe the trade was a cash-basis trade).
So much for JP Morgan’s vaunted risk acumen. As we’ve noted, one of the big reasons it wasn’t as badly hit in the crisis was that it took big CDS losses in 2005 on the Delphi bankruptcy (yes this is a rumor, but it is as pretty widespread rumor, and the sources are credible). The bank got cautious just as the subprime market was entering its toxic phase. So JP Morgan may have dodged the bullet at least in part by getting a wake-up call earlier than its peers.
But other issues seems even more important. First is that Dimon consistently misrepresented the seriousness of the exposures as soon as the press was onto it. Both Bloomberg and the Wall Street Journal were digging, and Dimon was dismissive, calling the concerns a “tempest in a teapot”. JPM shares are down over 5% in aftermarket trading. The CEO misled investors, but no one seems to care much about niceties like accurate and timely disclosure these days. This is the disclosure in the first quarter 10Q:
In Corporate, within the Corporate/Private Equity segment, net income (excluding Private Equity results and litigation expense) for the second quarter is currently estimated to be a loss of approximately $800 million. (Prior guidance for Corporate quarterly net income (excluding Private Equity results, litigation expense and nonrecurring significant items) was approximately $200 million.) Actual second quarter results could be substantially different from the current estimate and will depend on market levels and portfolio actions related to investments held by the Chief Investment Office (CIO), as well as other activities in Corporate during the remainder of the quarter.
Since March 31, 2012, CIO has had significant mark-to-market losses in its synthetic credit portfolio, and this portfolio has proven to be riskier, more volatile and less effective as an economic hedge than the Firm previously believed. The losses in CIO’s synthetic credit portfolio have been partially offset by realized gains from sales, predominantly of credit-related positions, in CIO’s AFS securities portfolio. As of March 31, 2012, the value of CIO’s total AFS securities portfolio exceeded its cost by approximately $8 billion. Since then, this portfolio (inclusive of the realized gains in the second quarter to date) has appreciated in value.
The Firm is currently repositioning CIO’s synthetic credit portfolio, which it is doing in conjunction with its assessment of the Firm’s overall credit exposure. As this repositioning is being effected in a manner designed to maximize economic value, CIO may hold certain of its current synthetic credit positions for the longer term.
The last comment would appear to imply that if they can’t unwind this trade at acceptable losses, they’ll move some of it into a hold to maturity book, where they aren’t required to mark to market. Charming.
Second is that, as Dimon himself volunteered, is that this failure of supervision strengthens the case for the Volcker Rule, although he also argued the strategy was Volcker rule complaint. Ahem, that says a lot about how Volcker’s prescription was translated into regulations. Banks that are backstopped by the public should not be taking proprietary trading bets, period. Hedge funds are the format for that sort of activity. And the idea that it’s too hard to figure out the difference between the two is nonsense. Traders can be required to flatten positions within a specified, short period, say three or four days at most. Although Value at Risk has a lot of shortcomings, it isn’t a bad metric for this sort of thing. Bear Stearns had a similar rule when Ace Greenberg was in charge (and remember Bear was an investment bank and a risk seeking one at that): traders we not allowed to hold positions longer than three weeks. Greenberg monitored them and required them to be closed out.
The real upside is that this may be the first real dent to Dimon’s image. The firm has gotten off scot free for dubious tactics during the Lehman and MF Global failures, and Dimon has taken to bullying central bankers and regulators (I’ve heard of incidents beyond the press reports of him browbeating Bernanke and later his Canadian analogue, Mark Carney). Dimon’s hyperaggression may simply by apparent success stoking an already overly large ego, or it may be the classic “the best defense is a good offense” strategy, of dissuading overly close scrutiny of JP Morgan’s health and practices. We’ll have a better basis for judging as the year progresses, since difficult trading markets will continue to test all the major dealers.