How JPMorgan Lost $17.5 Billion

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How JPMorgan Lost $17.5 Billion - 5/12/2012 4:54:35 PM

kalikshama

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http://www.forbes.com/sites/petercohan/2012/05/12/how-jpmorgan-lost-17-5-billion/

JPMorgan Chase (JPM) lost $17.5 billion this week. It all springs from a bad trade that’s still going bad — to the tune of $2 billion and potentially $3 billion. But then there’s the 9.3% plunge in JPMorgan’s market capitalization — adding another $14.5 billion in shareholder losses. And of course, there’s the additional capital it may need to raise in light of S&P’s and Fitch’s concerns about its creditworthiness.

In my conversations Friday with reporters from Smart Money and the Boston Globe, I could not answer a basic question: What happened? According to the May 12th New York Times, JPMorgan decided to make a bet on a very obscure corner of the derivatives market. And due to the scale of JPMorgan’s trading, hedge funds figured out its identity and placed bets against the bank that are continuing to make profits for them at JPMorgan’s expense.

JPMorgan operates a Chief Investment Office (CIO) that is responsible for this bad bet. The CIO takes the portion of the bank’s $1.1 trillion in deposits that the rest of the bank does not know how to lend or invest and trades that money — with the idea of making a profit for JPMorgan. In 2009, CIO’s net income peaked at $3.7 billion — generating 147% more profit than it had earned in 2008. Back then, JPMorgan had made a lucky bet on U.S. government guaranteed mortgage-backed securities.

Since then, CIO has not been as big of a profit center for JPMorgan. In the summer of 2011, it looks like it started to go further out on the risk/return frontier to earn a profit. The CIO observed that the premium to insure against a default of companies in an index of American companies was greater than what it cost to buy protection against the default of each of the individual companies in that index.

So it called big Wall Street brokers to announce that it wanted to sell insurance on this index – with the memorable name, CDX IG Series 9 — that would protect buyers in the event that one of 121 big American companies – including General Mills, Alcoa, and McDonald’s – went bankrupt. If a company on the index went bankrupt, the CIO would pay a claim, otherwise it would collect the quarterly premium.

JPMorgan initially made money on the position and so did a club of hedge funds ”focused on credit opportunities,” according to the Times. By January 2012, CIO’s brokers called hedge funds almost daily and they figured out that the secret seller was Bruno Iksil, JPMorgan’s London Whale.

JPMorgan had two ways to win on its bet. Its cost of insuring CDX IG Series 9 would drop either if the companies in the index continued to do well or if JPMorgan sold so much insurance that the supply exceeded the demand.

This January and February, hedge funds began to realize that JPMorgan’s capital limitations meant that it would eventually stop selling more insurance on this index. Moreover, according to FT Alphaville, those hedge funds concluded that the premium for insuring the index should have been above the premium for each of the 121 companies individually.

The hedge funds decided to bet against JPMorgan to profit from a rise in the premium as the market corrected for this mis-pricing of the risk.

With the economy apparently getting better, the hedge funds were losing money on their trade as they paid their quarterly insurance premiums. And the hedge funds were angry because they believed that The London Whale was manipulating the market and causing them to lose money on their bet.

Moreover, since CDX IG Series 9 was unregulated, there were no government officials to whom they could voice their complaints. So the hedge funds leaked their suspicions to Bloomberg in early April.

And this leak seems to have spooked The London Whale — along with the cost of insuring against four particularly risky companies in the CDX IG Series 9 — Radian, MBIA, Sprint Nextel, and R.R. Donnelley & Sons. Perhaps this spooking caused JPMorgan to stop selling more insurance to artificially depress the premium.

In any case, by late March, people started getting antsy about the economy and the index jumped — making the hedge funds happy. According to the Times, JPMorgan’s first quarter losses were not big enough to make the bank acknowledge the criticism but thanks to media coverage, the index spiked — and so did JPMorgan’s potential insurance claims if the companies in the index went bankrupt.

This matters because JPMorgan has been fighting the sort of regulation that would block such reckless gambles. Ultimately, people who deposit money in a bank want the money kept safe. And as long as the government has enough money to cover all the losses from a collapsed banking system, FDIC insurance protects depositors in the event that bets like JPMorgan’s send a bank down the tubes.

But what caused JPMorgan to lose money was its highly speculative trade against hedge funds that was being made artificially profitable by using JPMorgan’s capital — your deposits — to push down the price of insurance below the so-called free market rate.

Given the $23.7 trillion in cash and guarantees used to bail out financial institutions in 2008, depositors and taxpayers have good reason to question the kind of “free market” that Wall Street’s $5 billion in Washington campaign contributions and lobbying fees has bought.

Perhaps deposit-only banks would be a better alternative.