JPMorgan Losses Help Set New Precedent
In May of last
year Jamie Dimon, JPMorgan’s chief executive, announced that the bank had lost
over $2 billion on credit default swaps market. Now the losses are around $6.2
billion with estimates that they could end up totaling over $9 billion as the
story is back in the headlines this week. The United States announced on August
9th that they plan to arrest two JPMorgan employees who were
involved in the trade. The Securities and Exchanges Commission is breaking new
ground as it is not only leveling civil charges against the bank but is also
seeking to extract a rare admission of guilt from JPMorgan.
The losses stem from JPMorgan’s chief
investment office in London which is in charge of hedging the firm’s risk. In
April, this investment office began making a series of investments in credit
default swaps that totaled over $100 billion. A credit default swap acts like
insurance against default risk for a bond holder. If a bond holder is concerned
with the default risk of the bond issuer they can purchase a CDS from a CDS
seller who then ensures the underlying debt between the bond holder and the
bond issuer, in exchange for a certain premium.
Bruno Iksil, nicknamed the “London
whale” for his large positions, and other JPMorgan investors from London gambled
on CDSs such as these and lost big. They were making trades based on the Markit
CDX.NA.IG.9 Index which tracks the corporate bonds of 125 high-quality
companies. CDSs can be purchased for different interval periods; the longer the
period the more expensive the CDS because the risk is greater over a longer
period of time. By charting the varying costs of these CDSs you get a graph
like the one below which shows the cost-spread for an index very similar to the
one the JPMorgan investors were tracking:
The JPMorgan
investors placed bets that this curve would flatten, meaning that difference
between the premium cost of a short term CDS and long term CDS would diminish. So
they bought CDS protection on the short term, and sold CDS protection on the
long term. Essentially, they were betting against their first hedge, by selling
insurance on the long term. If the curve were to flatten, Iksil and the
JPMorgan investors would profit because the short term swap price would rise
faster than the long term swap would fall.
In order to maintain the flattener
trade they had to rebalance it regularly in order to keep the ratio of
protection purchased at the short end to protection sold at the long end at a
certain level. If this ratio changes the trade increases in risk and volatility.
In an attempt to keep this ratio the JPMorgan investors were forced to pump
more and more money into the index to the point where rebalancing was
impossible. The image below depicts how the net notional value of the index
nearly doubled in three months as JPMorgan scrambled to rebalance the trade.
Since JPMorgan’s trades made up such
a large portion of the notional value of the CDX.NA.IG.9 Index they were no
longer able to operate in secrecy. Outside investors were able to determine
what JPMorgan’s position was and accordingly took counteractive positions
designed to gain from the trades that JPMorgan had to make in order to continue
to rebalance its trade. Low liquidity in the CDS market made it difficult for
JPMorgan to cut its losses once it became clear that its strategy was not
profitable. This explains why the trades have continued to lose value since
JPMorgan announced the losses last May.
These losses have brought about
change in the banking world as the Securities and Exchange Commission is
requiring JPMorgan to admit guilt in the trades. This requirement sets a
precedent as the SEC is breaking tradition with its policy of allowing defendants
to neither admit nor deny wrong-doing. This rare push for admission of guilt is
a result of a policy change by the new SEC chairwoman Mary Jo White. She
believes accepting responsibility for wrongdoing will benefit the public and may
help to open the public’s eyes towards the various markets banks are involved
in.
Sources:
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