Having benefited from risk management failures of others such as the investment bank Bear Stearns, JPMorgan appears to have made an "egregious error" that has cost its stakeholders $2bn (£1.2bn) plus a considerably greater amount in reputation and franchise value.
While details are sketchy, the losses relate to a position taken to "hedge" a $300bn-plus investment portfolio managed by JPMorgan's Central Investment Office.
The large investment portfolio is the result of banks needing to maintain high levels of liquidity, dictated by volatile market conditions and regulatory pressures to maintain larger cash buffers against contingencies. Broader monetary policies, such as quantitative easing, have also increased cash held by banks, which must be deployed profitably.
Regulatory moves to prevent banks from trading on their own account – the Volcker rule – have encouraged the migration of trading to other areas of the bank, such as liquidity management and portfolio risk management hedging.
Faced with weak revenues in its core operations and low interest rates on cash or secure short-term investment, JPMorgan may have been under pressure to increase returns on this portfolio. It appears to have invested in securities including mortgage-backed securities and corporate debt to generate returns above the firm's cost of capital.
Managed by staff including recruits from hedge funds, in 2011 the CIO portfolio contributed $411m to JPMorgan's earnings, below its contributions of $1.5bn in 2008 and $3.7bn in 2009. JPMorgan's disclosures show that the unit took significant risk. Based on a common measure known as VAR (Value at Risk), the potential statistical loss for a single day was $57m in 2011, similar to the $58m of average risk in the bank's larger investment bank and trading business.
The losses relate to an attempt to hedge the exposure on this portfolio. As hedging would reduce the returns, the strategy adopted appears to have been to buy insurance against default in the short term (to end 2012) and finance the hedge by selling insurance against default in the medium term (to end 2017). The structure took advantage of the difference in pricing of insurance between the two maturities of around 0.60 per cent-0.70 per cent per annum. The strategic view was risk would increase in the near term but abate over time. It is questionable whether the position could be regarded as a true hedge. It is complex and relies on the correlation between the bank's underlying positions and trades. The effectiveness of the hedge also relies on the changes in credit pricing for different maturities. The simplest way to reduce risk would have been to sell off existing positions or offset the positions exactly.
Given JPMorgan vaunted risk management credentials, it is surprising the problems of the hedge were not identified earlier. While the $2bn loss is significant, the fact that the bank restated its VaR risk from $67m to $129m (an increase of 93 per cent) and reinstated an older risk model suggests an even more significant failure of risk modeling.
The episode points to failures on the part of parties other than JPMorgan. Banks are obliged to report positions and trades, especially certain credit derivatives. This information is available to regulators in considerable detail. Regulators, external auditors and equity analysts who cover the bank did not pick up the potential problems, perhaps relying on assurances from the bank's management, without performing the required independent analysis. While some see a need for more regulation, it is not clear a prohibition on proprietary trading would have prevented the losses. In practice, it is difficult to differentiate between legitimate investment and trading or hedging and speculation.
JPMorgan should survive this. But the episode raises deeper issues. How many other such problems in other firms remain undiscovered? How has earnings pressure in banks affected their risk taking? How do regulatory initiatives and monetary policy actions affect bank liquidity, risk taking and trading? The most important question is whether any action short of banning specific instruments and activities can prevent such episodes.
Bankers and regulators have always been seduced by an elegant vision of a scientific and mathematically precise vision of risk. But as GK Chesterton wrote: "The real trouble with this world [is that]... it looks just a little more mathematical and regular than it is; its exactitude is obvious but its inexactitude is hidden; its wildness lies in wait."
Satyajit Das is the author of 'Extreme Money: The Masters of the Universe and the Cult of Risk' (2011)Reuse content