Well, where to begin? The case is dripping with irony.
In order to discuss the implications of this trade let’s review, with whatever little information we have, the trade itself. The culprit is a trader Bruno Iksil at London’s JPM CIO desk, nicknamed London Whale. The instrument that he was trading is index CDX.NA.IG.9. To translate that into English it’s an index that contains 125 insurance contracts (CDS) on corporate American investment-grade debt (e.g. Alcoa, GE, etc). Figure 9 stands for series – the index is reissued every 6 months and is now at series 18. To understand such “synthetic” trade you have to think of it as insurance. This is what a credit default swap (CDS) is – an insurance. Imagine you have a house, traders would say – you’re “long” house and you buy an insurance contract on it (traders would say that you “buy CDS” or “protection”) to bring down the risk of owning the house. This way your risk is essentially zero (or at least we declare it for the purposes of this article): if the house value goes down you make money on insurance. In trader’s lingo you’ve entered a “basis trade” – a low risk low-return trade. Now, the guy who sells you the insurance (or writing the contract) is going long risk on the value of your house. He collects the premium and he doesn’t want anything to happen to your house. Traders would call this maneuver as “writing protection” or “selling CDS”. You see, you were long risk with your house before you bought protection on it – now you’re flat risk. The insurance seller is outright long risk, but synthetically, because he doesn’t own the physical house like you do. So this index, consisting of a collection of insurance policies, is an easy way for a trader or a money manager to express either positive or negative sentiment, while with the cash bond you can only express positive sentiment. With this index, if you’re bullish on the corporate bond market – you sell protection, betting that the corporate spreads will tighten; and if you are bearish – you buy protection, betting that spreads will widen.
To sum up:
Going long synthetically = selling CDS, aka selling insurance, aka writing protection, aka buying the index. (I know it’s a little confusing: selling insurance = buying the index; the index was structured in such a way so that it’s easier to understand that you’re going long risk)
Going short synthetically = buying CDS, aka buying insurance, aka buying protection, aka selling the index.
Jamie Dimon wants you to think that this trade was a hedge. Why? Because the upcoming Volcker Rule would prohibit banks to engage in speculative activity, that is taking an outright long or short position. But once you have a position and a corresponding hedge (or, as we discussed above, a house and an insurance policy on it) then everything is tip-top. JP Morgan is a deposit taking institution and, together with Citi, BofA, Wells Fargo, is a primary target of Volcker Rule. Of course, the original Volcker Rule did not have any exemptions – it prohibited any sort of proprietary trading; it is JPMorgan’s own lobbyists that pushed for that “hedging” exception, among other things. I just don’t see how Jamie Dimon “hedging” excuse logic works: if he’s trying to point that the trade was kosher but lost money then how many of such “risk-free” trades can be put in the future and dismissed consistently by the top management as “a tempest in a tea pot” before it blows up in their face? If you lobby to increase speed limit to 100 mph and drive at that speed you are not really breaking any laws, but should we all just feel safer because the rules are followed? And if the accident happens how can you then turn around and blame the rule? You lost money not because you complied with Volcker Rule, but because you used exception to the rule to put trades on that even you didn’t know how to manage. Now he says: “I was dead wrong to dismiss concerns.” No shit, Jamie.
Bruno Iksil was SELLING protection by amassing about $100bn long position in the index. He was on the hook for losses, he was essentially long risk. And he claimed this to be a hedge.
A hedge against what? If he was selling protection, then his original position would have to be a massive short in those corporate bonds (think of it as a “negative house”: you would have to buy the house, or sell CDS in order to bring your total risk to zero). The only way to achieve that original short position in bonds is either through similar index (perhaps a different vintage) or individual credit default swaps. But let’s assume, for arguments sake, without asking stupid questions of why he happened to have that original position in the first place, that it was a basis trade. A minus $100bn in corporate bonds CDS and a plus $100bn of CDX.NA.IG.9. How can one lose $2bn on such a “riskless, Volcker rule compliant” trade? Index price has fallen from about $100.6 at the end of March to about $99.3 in early May, but because I’m in generous mood and for simplicity, I will assume that the index moved just 1% against Bruno.
You would have to have a naked exposure of $200bn to lose $2bn on a 1% down move. So his “hedge” defense doesn’t stand this simple test. Where is it coming from then? Jamie Dimon threw out “Macro hedge” and “economic hedge” explanations out there as well, probably to see which one sticks. (As a side note – I love it how they throw obscure financial terms to the public that are undecipherable to the general population hoping to blind us with the fancy lingo. Are they expecting us to say: “Oh, ok, Macro hedge – that explains everything!” and go on our way?) These are imperfect hedges that are supposedly protecting your portfolio against broad economy moves. With our house example it would be like having a house in NY and buying protection not on that particular house but on a similar house in Indiana or a basket of houses around the country. What’s risky about this sort of trade is that your NY house’s value will fall more than the value of protection on the Indiana house will rise. To make matters worse, in a frenzy to bring your risk to flat again, you start to frantically add on to your hedge to keep up with falling value of your NY house, thus making your final hedge much, much bigger than the original amount. Since Iksil was adding on his position for several months, my bet is that this is what happened: a small initial trade that gotten out of control when hedges didn’t behave in sync with the underlying.
And why such a theory should be far-fetched? Just look at the language that Dimon used to describe the situation.
“The synthetic credit portfolio was a strategy to hedge the firm’s overall credit exposure, which is our largest risk overall in this stressed credit environment. We’re reducing that hedge. But in hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored. The portfolio has proven to be riskier, more volatile and less effective as an economic hedge than we thought.”
But this isn’t the end of the story. In fact this is just the tip of the iceberg and things are bound to deteriorate further. “It could get worse, and it’s going to go on for a little bit unfortunately.” – Dimon said. And if he uses this kind of language – it most certainly will. The reason why things might get worse is that JPM haven’t unwound the position yet. The $2bn is a mark-to-market loss, a paper loss. Considering the fact that The London Whale didn’t get his nickname for nothing – he’s the only game in town in that particular niche of the credit market – trying to get out of that position is like running a herd of elephants through the narrow door. He simply won’t get the price that he wants. And everyone, and by that I mean guys who could possibly take the other side of the trade, the hedge funds, know it. They salivate of the prospect of killing the whale. Nothing personal of course, just business.
I am especially entertained by the hedge funds guys. You know, these are the kind of guys who don’t play by the rules, they want to be left alone in a sandbox, and have their own unregulated brawl with no rules, where only the strongest and the savviest survive. Imagine how surprised I was to read this in FT Alphaville. This is what the hedge fund guys began saying when they noticed that some desk in London was cornering the market:
“The hedge funds got more angry. It dawned on the hedge funds that they had no one to complain to. The hedge funds and banks had lobbied long and hard to keep this over-the-counter market in credit derivatives unregulated. Thus it is unregulated, and they had no one to tell, officially, about what they suspected — that a single player had cornered, and distorted the market by putting on huge trades.
And then they complained to journalists.”
Another ironic thing is that the $2bn loss, according to Barney Frank, is 4 times the amount JPMorgan has claimed the regulations will cost them. But with all those exceptions the freedom to lose money is intact, which I guess is more important for Jamie Dimon. Oh, and did I mention that JP Morgan is a bank, backstopped by taxpayers money in the case of unmanageable losses? Guys, I want you to appreciate the magnitude of the fuckup. 3 senior heads have rolled already 4 days after the news broke. Ina Drew, a CFO with 30-year career with the company, has submitted her resignation several times during the past few days with Jamie Dimon reluctantly accepting it. People don’t just leave the company if this was something trivial as they want us to believe, if it was just a little correctable screw up. You can’t unwind such a position without major losses, you can only put it to book-to-maturity and hope that everyone forgets about it. I think this is the only strategy Dimon has to deal with the situation. Should we hope that our regulators and congress won’t forget about it in an election year?