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Protesters hold signs as JP Morgan Chase & Co convenes its annual shareholders meeting at the bank's back-office complex in Tampa, Florida, May 15, 2012.


A clearer picture of how JPMorgan Chase traders managed to find themselves stuck with a position losing $2-billion (U.S.) is beginning to emerge -- a hedge against systemic risk that backfired.

JPMorgan has offered few clues, other than characterizing the problem trade as a hedge.

It's been known since April, thanks to great reporting by Bloomberg News on the so-called "London Whale," that JPMorgan Chase & Co. was aggressively selling huge amounts of insurance against defaults by U.S. corporations. That, on its face, seemed counterintuitive. A bank, by nature, is already very long credit risk. Going even longer corporate credit risk by selling insurance against defaults is the opposite of a hedge.

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There had to be something else at play.

The idea now among some players in the derivatives market is that this was a second-step transaction, a hedge of a hedge. So what was the first step?

Zerohedge blog has an idea, which we've tried to summarize below.

JPMorgan may have looked last year to hedge its corporate debt holdings against systemic risk - or the kind of financial maelstrom that causes a lot of debts to go bad at once. (Think of the financial crisis of 2008, when a lot of otherwise healthy companies all ran into trouble at once because of how bad financing markets were.) In late 2011, concern about systemic risk was on the rise. That manifested itself in what's known as correlation -- all assets moving together. So JPMorgan may have put in place a hedge at that point, purchasing assets that would increase in value as systemic risk rose and correlation increased.

However, central banks acted in late 2011 to reduce systemic risk, and the markets started to turn around. Correlation started to drop.

JPMorgan's hedge now no longer worked well. To offset that, the bank then starts to sell credit insurance (offsetting its bearish position with a bullish one, if you want to think about it that way.) So far, so good. But then somehow, JPMorgan overdoes it. The bank sells too much insurance. The hedge of the hedge isn't balanced. Then, whoops, the market starts to shift back amid concern about systemic risk picks up again amid renewed fears over Europe and other global problems. Correlation rises. The first hedge should work, but now the hedge against the hedge is too big and losses on the second overwhelm any gains on the first.

At about this point, JPMorgan's position starts to become obvious to others in the market, who push hard to take advantage, and the losses pile up even faster.

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