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What Went Wrong: J.P. Morgan to Disclose Details on Multibillion-Dollar Derivatives Loss

On Friday's second quarter earnings call, J.P. Morgan will shed more light on its recent  $2 billion -- and counting -- hedging loss. We break down what went wrong.

Editor's Note: This article has been updated to include information about the upcoming second quarter earnings report.

Jamie Dimon
Jamie Dimon, J.P. Morgan
All eyes will be on J.P. Morgan this Friday, July 13 when the bank is expected to report second quarter earnings and offer an update on its multibillion dollar trading loss from a botched hedging strategy with credit default swap indexes. The bank may also reveal to what extent it has moved to unwind the complex trade by its controversial chief investment office.

According to media reports anticipating the second quarter earnings call, J.P. Morgan is expected to report second quarter earnings of $0.78 on Friday, before the market opens — almost a 40 percent decline from the same period a year ago.

Analysts have been trying to quantify the exact size of the trading loss ever since it was disclosed in May, but the bank has been secretive about the details of the trade as it needed to protect its position against hedge funds acting on the other side. Estimates are that the loss could rise to as high as $5 to 7 billion, or as high as $9 billion in a worse case scenario, according to the Benzinga's preview of the earnings call, given that J.P. Morgan reported net income of $3.7 billion in the second quarter of 2011, the trading loss could well wipe out any profits should they swell to this level. However, due to the fact that J.P. Morgan's debt and CDS spreads have widened, the company will be able to book a gain due to the Debt Valuation Adjustment ('DVA').This accounting mechanic allows banks to book losses on their own bonds as gains as the cost of buying them back in the open market falls. These gains must eventually be reversed as bonds mature at par.

The ongoing fallout from J.P. Morgan's botched hedging strategy with credit derivative indexes has left questions about the bank's risk management controls, specifically how a series of trades executed by the so-called London Whale were able to morph into a multibillion-dollar loss for the respected bank.


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J.P. Morgan first disclosed on May 10 that it had incurred a $2 billion loss from a hedging strategy executed by the bank's chief investment office in London in a synthetic credit portfolio. Taking the blame, the bank's chairman and chief executive, Jamie Dimon, called the hedge an "egregious mistake" that was badly vetted and poorly monitored, adding the words "sloppy and stupid."

Now financial regulators, including the SEC and the Comptroller of the Currency, as well as the F.B.I. are trying to piece together how the trading debacle occurred and why a bank that has been praised for its risk management skills could have let the risky position grow so large and tenuous. Although the loss didn't threaten J.P. Morgan's "fortress" balance sheet, or worry counterparties on the buy side, it has raised concerns about what went wrong and whether the bank's risk officers took their eyes off the ball.

Guilty of Pride

One chief risk officer for a buy-side asset management firm in New York who spoke to Advanced Trading on the condition of anonymity pointed to "hubris" as a key factor in the bank's hedging debacle. "When a firm like J.P. Morgan survived the financial crisis without huge losses like others, the impetus to improve risk management wasn't as strong," he says. "That led to many levels of hubris, which led to this."

When Dimon dismissed an April 13 earnings call analysts' concerns about the London Whale's positions "as a complete tempest in a teapot," that again was hubris, the buy-side risk chief adds. He also suggests that the head of the chief investment office, Ina Drew -- who reportedly was paid $14 million in 2011 and who tearfully resigned in early May after the initial loss was disclosed -- had a strong personality and had been in charge for a long time, which creates a sense of a fiefdom, free of risk controls.

At a Senate Banking Committee hearing on June 13, Dimon told lawmakers that the chief investment office's responsibility was managing a $350 million portfolio in a conservative manner, but that the losses occurred in a synthetic credit portfolio. When asked by senators if this was a hedge or designed to generate a profit, Dimon said the unit invests money and earns income. He explained that the purpose of the synthetic credit portfolio was to earn a lot of money if there was a move in interest rates or a global crisis, such as with European debt. "I consider that a hedge," Dimon told lawmakers. "So the hedge was intended to improve our safety and soundness, not make it worse."

Dimon has not disclosed details of how the trade was constructed, however. At the hearing, he declined to provide details because, he said, it could damage the bank's shareholders. But he did admit at the hearing that the trade had morphed into something more complex. "The way it was contrived, in January, February and March, changed in ways I cannot defend," said Dimon.

[The Top Dimon Testimony Quotes ]

According to Erik Kobayashi-Solomon, a market strategist with Morningstar in Chicago who edits the firm's OptionInvestor magazine, the losses didn't occur in J.P. Morgan's investment bank, but rather in the treasury department of its commercial bank -- the Chase part -- which has traditionally been "a sleepy backwater" for banks. While the treasury desk is a cost center, it is charged with hedging out risk to the firm, Kobayashi-Solomon explains. "If the hedge generated a profit, in a lot of cases, banks are happy to take off that hedge and book that profit," he says. "It's kind of a nudge-nudge, wink-wink hedging scheme."

Indeed, J.P. Morgan's chief investment office earned $4 billion in net income for the bank over the past three years, the Wall Street Journal reported, almost 10 percent of the bank's total profits over that time, causing skepticism at the hearing. "How can a bank take on too much risk if the point of the trade was to reduce risk?" asked Senator Tim Johnson (D.-S.D.).

Harpooning the Whale

The controversial hedging strategy evidently was so huge that it cornered the market and was detected by savvy hedge funds that saw strange movements in the credit derivatives indexes. They tipped off Bloomberg reporters that Bruno Iksil, a credit derivatives trader at J.P. Morgan, whom they nicknamed "The London Whale," was behind the trades. Bloomberg broke the story April 5. The story's emergence derailed the J.P. Morgan index arbitrage trade between the value of the index and the underlying credit default swaps.

According to experts, Iksil was using the Markit Credit Derivatives Index (CDX) North American, Investment Grade (IG) 9, which is based on the credits of major corporations, as a way to bet against the likelihood of defaults in corporate bonds. "It's supposed to represent the 125 most-liquid single credit default swaps in North American domiciled companies with investment-grade status," explains Otis Casey, director of credit research at Markit.

Emphasizing that he has no insight into what J.P. Morgan was doing, Casey speculates that this position was just one piece of a multileg hedging strategy. At the hearing, Dimon confirmed, "It was a complex series of transactions -- it wasn't just one thing. We're managing that risk down, it should never have gotten to that size."

One of the major problems that hurt J.P. Morgan was the fact that its identity became known to the hedge funds in the market, sources say. "The worst position to be in is when you've done a bilateral-negotiated trade, the street knows your position, it's big, and it's wrong," says Christian Martin, a former derivatives trader at Merrill Lynch who is now CEO of TeraExchange, which is building the equivalent of an ECN or a swap execution facility for OTC derivatives execution. According to Martin, the J.P. Morgan incident is another example of why transparency in pricing and anonymity in counterparties and clearing are so important for the buy side.

While the OTC derivatives market structure may have been a factor, though, other sources say the main issue was the size and complexity of J.P. Morgan's trades and the fact that the bank changed its Value-at-Risk (VAR) models. "The bottom line is, these guys got into a position that was too large and the market figured out who it was, and that is when investors look to exploit that," comments Tim Grant, managing director at Benchmark Solutions, which provides real-time pricing for the fixed income and derivatives markets.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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