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JP Morgan: we only lost $2 billion, nothing to worry about

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May 11, 2012 – Comments (2)

Continuing with the theme of risk and corporate governance, JP Morgan recently announced that it lost $2 billion on a trade gone wrong. When analysts raised concerns over the bank's risk level on a conference call, Jamie Dimon dismissed the concerns, saying that they were a "tempest in a teapot."

Well, in the grand scheme of things, $2 billion isn't THAT much money for a large bank like JP Morgan.

OK, that was sarcasm.

It appears, from the article, that the trader involved was not a proprietary trader, where the bank trades for its own profit, and theoretically on its own account. He was also NOT a rogue trader. However, what Bruno Iksil, the trader involved, was trying to do was this:

 1. JP Morgan owned a lot of high yield bonds

2. It wanted to hedge away that default risk.

3. So, Iksil sold credit default swaps on an investment grade corporate bond index. Those derivatives pay out if the corporate bonds default. They're unlikely to, so they should have expired worthless.

3a) That basically means he used derivatives to go long corporate bonds. It's a bit like as if he sold put options.

3b) However, derivatives are inherently leveraged.

4. He forgot about 3b and/or was very, very confident in his investment thesis. But other investors bet against him. 

5. I haven't been following the bond market, but Iksil's bet went wrong. He'd levered himself up. And JP Morgan lost a mere $2 billion - although it seems like it could lose a further $1 billion if the market goes the wrong way.

(Iksil was betting that  the credit default swaps would expire worthless, meaning that JP Morgan would pocket the premium. Thus, if their high yield bonds defaulted, which is more likely, they could use the premium $ to offset the loss - except that Iksil had to sell quite a lot of swaps to get enough premium $!)

Basically, a failure of risk control.

Dimon ran JP Morgan very conservatively leading up to the crisis. He took justifiable risks during the crisis. Those paid off. In terms of JP Morgan's corporate governance, I don't see any red flags leading up to 2009. In fact, I think the bank was very well run!

But after the crisis, JP Morgan is a different bank than before the crisis. The JP Morgan of 2009 and onwards is riskier, and more opaque. While chances are low that the bank's internal culture has changed for the worse, this is a worrying incident.

And from a social perspective, Dimon has been absolutely adamant that regulators should get out of the way and let the bank take whatever risks it feels it can ... except that Iksil clearly thought that the above risk was worth taking, and he lost $2 billion.

Now, this is one trading loss. It's not going to endanger JP Morgan's capital ratios. But the problem isn't whether or not JP Morgan loses $2bn from time to time. The problem that regulators are trying to avoid is what happens if a large number of major banks lose lots of money, and that affects their capital ratios.

It feels a bit paternalistic that regulators should try to protect banks from themselves. However, the rest of society relies on banks to lend us money to start businesses. If the banks take on too large risks, and their capital ratios get impaired, there won't be money to start businesses. Money market funds could start to look shaky. There will be knock on effects - like 2008 and 2009. Warren Buffett's first two tenets of investing are 1) don't lose money, and 2) see 1). But Dimon has forgotten that, or he thinks he can control the risk, or whatever.

Going with the thread of not losing money, this is why I've stayed out of JP Morgan. There are less risky banks that were selling at a better price (like Wells Fargo). While JP Morgan is cheap now, I'd rather stay out until I could figure out how risky the bank really is.

2 Comments – Post Your Own

#1) On May 11, 2012 at 2:06 PM, Option1307 (30.58) wrote:

Good thoughts, +1.

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#2) On May 11, 2012 at 2:16 PM, EnigmaDude (58.61) wrote:

Great post.  I think the cultural repurcussions will ultimately be what destroys JPM's value after this incident.  For example they may lose customers as a result of this news. I don't expect that the share price will recover for quite some time.

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