JPMorgan FAQ: How to Lose $2 Billion

05/11/2012 9:30 am EST


Igor Greenwald

Chief Investment Strategist, MLP Profits

It takes hard work and sophisticated hedging acumen to turn a sure thing into a shocking loss, writes senior editor Igor Greenwald.

Q: I heard that JPMorgan Chase (JPM) lost $2 billion sometime between lunch and dinner yesterday. Is the world going to end before my sale of JPMorgan shares settles?

A: It’s more like $2.3 billion, not counting various potentially relevant offsets. And even for a heavy hitter like JP, losing that much scratch takes a few weeks at least, it seems.

Technically, the money was lost sometime after JPMorgan CEO Jamie Dimon described concerns over the trades in question as a “complete tempest in a teapot” on the bank’s earnings conference call April 13. Realistically, the die was cast much earlier. Obviously, tempests in teapots aren’t the deal they used to be.

Still, apocalypse will probably have to wait. You’ll likely have to settle for an ordinary butt-whooping, to be described in apocalyptic terms on the Torture Channel.

Q: I’ve grown quite used to the image of Dimon as the globe-bestriding banking genius tied down by a bunch of tiny killjoy regulators in cheap suits. Any chance we could keep that going?

A: Absolutely. Any idiot can make a few bucks paying 1% for a one-year CD, leveraging up 10:1 and buying federally-guaranteed mortgage-backed securities yielding 4%.

To go from that to a $2.3 billion loss takes extremely specialized hedging skills and uncommon big-picture acumen that could be throttled by intrusive government regulations at any moment. By all means, let’s enjoy it while we can.

Note reports that Dimon personally encouraged the London office at the center of the mess to take on more risks and was kept well-informed about its subsequent trading strategy.

And yet, weeks after insisting all was well, here he is saying the trades violated “the Dimon principle.” Observe how by naming an undefined principle after himself the chief executive implicitly separates himself from the “egregious mistakes” of unnamed underlings.

Q: I’m in a particularly masochistic mood today. Can you tell me what actually happened?

A: In 2009 or thereabouts, some innocent took money that could have been spent extremely profitably on JPMorgan shares and instead handed it over to a teller at one of company’s branches. Dimon and Co. took this almost free money and invested it in some higher-yielding securities that have appreciated handsomely since.

At some point, the brain trust decided that those securities should be hedged against the prospect of another panic, and bought protection in the form of either credit-default swaps or other bets calculated to pay off should the credit markets tank again.

But then this winter, the credit markets started doing so well that JPMorgan decided it was a little too well hedged, interfering with its imperative of making money. So it decided to hedge the hedges, not by unwinding them but rather by selling credit-default swaps on an index tracking US corporate debt, in London.

Except that the market in question proved too small to do this efficiently. The bank’s principal trader, promptly nicknamed the London Whale, ended up getting played by hedge funds that were only too happy to let the Whale sell them progressively cheaper credit-default swaps, until it had beached itself in a highly illiquid position.

At that point, the sorry spectacle was leaked to the press, a little more than a week before earnings were due, at which point superiors finally stopped the whale from throwing good money after bad. It was only after the results came out—entirely coincidentally, no doubt—that the liquidation of the ill-fated hedges-of-hedges began, resulting in the inevitable bloodbath.

Q: So how bad is it? Should I start a canned food drive for the JPMorgan executive commissary?

A: Well, it’s only $2 billion “and a bit,” the bit in Dimon’s parlance reportedly worth $300 million. Plus, the London office has already offset that by realizing a $1 billion gain on security sales, from its pool of securities that had $8 billion in unrealized gains.

So the running tally for the earnings hit in the current quarter stands at $1 billion, except that the bank says it could lose another billion on top of that. So that’s a potential $3.3 billion haircut, before any offsetting realized gains.

Based on analysts’ prior estimates, the bank would still make at least $3 billion after tax in the current quarter in that worst-case scenario. So it’s probably OK to just take those cans to a local food bank instead.

Q: Did JPMorgan break the Volcker Rule, which bars US banks from speculative trading, by trading so aggressively?

A: Not at all. It was only hedging after all, even if it was actually hedging other hedges.

As Dimon has repeatedly pointed out, the Volcker Rule can in theory be interpreted in any way a regulator pleases, which means that in practice it will mean what Dimon wants it to mean, and nothing more.

You see, if I take my racetrack winnings to a poker game, I’m legitimately hedging them. And if I take your federally insured deposit to a London financial casino, who will tell me I can’t?

Q: If this is as easily manipulated as all that, why did the information finally come out?

A: It came out because the hedge funds betting against JPMorgan’s “London Whale” benefited from flushing his exposure into the open, so that his trades would ultimately be reversed, at great cost, when the orders to de-risk came from New York.

Also, because the results released a month ago had understated the average risk recently run by the London office by a factor of two. The error had to be corrected in the official 10Q filed with the Securities and Exchange Commission yesterday, before it became a material misstatement.

Make too many of those and you can’t be a banking genius anymore. For Dimon, that’s one risk too many.

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