JPMorganMark Lennihan
The trusting investors who thought JPMorgan Chase & Co. ran a bulletproof trading operation are now going through their own version of the five stages of grief.
First they panicked from the initial shock of learning the bank lost $2-billion (U.S.) in just six weeks. Then they lashed out at the banking sector. Now they're asking one crucial question: How could this happen?
Coming out of the financial crisis, many people assumed that major American banks were cleaning up their acts – that they had rid themselves of the superspeculative trades that caused firms like Merrill Lynch to lose $15-billion in just one quarter. Yet since September, a rogue trader at UBS lost $2-billion, MF Global collapsed amid bad bets on European debt and now JPMorgan has succumbed to a staggering trading error.
The stinging lesson: Even the most sophisticated and savvy traders screw up.
In JPMorgan's case, few people outside the bank understand how its chief investment office in London got tangled in such an intricate web. But they do know that Bruno Iksil, nicknamed the London Whale, placed complex bets on corporate bonds and was ultimately blindsided by the market moving in the wrong direction. Although his bet was supposed to be hedged, or risk-free, and had been approved by the bank's internal risk management department, the complex trade still collapsed.
For that very reason, opponents of the Volcker Rule – which would make it illegal for banks to engage in most proprietary trading, or betting in capital markets with their own money – are left with very little to say.
Before Thursday, JPMorgan chief executive officer Jamie Dimon strongly opposed the rule, arguing that his bank and many others had already shut down their risky trading departments. Now he admits that JPMorgan is stuck with "egg on our face" because the latest loss proved that even so-called hedged positions are extremely dangerous. A hedged trade is one that a financial institution will set up to reduce – or, ideally, eliminate – the risk of losing money if the market moves against it.
David Shimko, a derivatives and risk management consultant who teaches at New York University's esteemed Courant Institute of Mathematical Sciences, argues that it is almost impossible to remove all risk in any trade. Even worse, most banks don't try. If you look closely enough at the trading activity of bank treasury departments, he said, you can see "they're not really hedging. They're just speculating. But the trades happen to be classified as hedging for accounting purposes."
He offered a simple example. Gasoline refineries are exposed to two key commodities: the oil they buy, and the fuel they sell. To hedge themselves against oil, a refinery can purchase long-term contracts at predetermined prices. In its accounting statements, this makes it appear as though it has cut its risk in half, because one of two commodities is hedged.
But what the refinery has really done is put all of its eggs in one basket – its business is now it is wholly dependent on gasoline prices. Extrapolate this many times over and you start to see what happens in credit derivative markets every single day.
Alan White, a derivatives professor at the University of Toronto's Rotman School of Management, agrees. Asked whether hedges are ever risk-free, he said: "The answer is never, or almost never."
This is a big problem, he added, because these trades employ massive amounts of leverage. In other words, banks borrow enormous sums of money to amplify their potential gains. But debt also amplifies losses. If someone borrows $5 to invest in a $10 stock, a 20-per-cent drop in the stock price amounts to a 40-per-cent personal loss. (Because the $5 that was borrowed must be paid back, the $2 loss is absorbed by the investor alone and $2 is 40 per cent of his original investment.)
This scenario is more extreme in the derivatives world, where leverage isn't employed at a simple 2-to-1 ratio, but often at 15 to 1, Mr. White said. That means any losses in the market are amplified by 15 times, and offers an explanation of how JPMorgan lost $2-billion in just six weeks.
But while leverage has been talked about for years, spurred by the shocking revelation that many investment dealers toyed with 40-to-1 ratios leading up the financial crisis, investors are still shocked every time there is a new credit loss. Their attitude: This again?
In large part, this is because few people understand just how big the derivatives market is. According to the Bank for International Settlements, the total value of outstanding derivatives globally was $648-trillion, as of Dec. 31. That beats the stock markets many times over. "There's this whole business out there that investors scarcely know about," Mr. White said.
Every term, he tells his derivatives students the same thing. "You probably don't know it, but this is the biggest market in the world – by a long shot."
Tim Kiladze