JPMorgan's Red Flag
Board: Macro Economics
Two billion dollars certainly doesn't seem to be the big money it used to be.
You'd certainly get that impression from the reactions of the press, public, government and business to the surprise delivered by Jamie Dimon to analysts on May 10, 2012 about a $2 billion dollar loss JP Morgan Chase suffered due to a position in a derivative security. Oh sure, Dimon played his role from Wall Street central casting as the blunt, plain speaking, "Mr. Accountable" executive with the following comments to shareholders on that first call (#1):
Regarding what happened, the synthetic credit portfolio was a strategy to hedge the Firm's overall credit exposure, which is our largest risk overall in its trust credit environment. We're reducing that hedge. But in hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored. The portfolio has proven to be riskier, more volatile and less effective than economic hedge than we thought.
I want to remind you that CIO has over $200 billion in its investment portfolio and unrealized gains as of March 30th of $8 billion. CIO manages all its exposures in total as a whole, and it doesn't in light of the Firm's total requirements.
We are also amending a disclosure in the first quarter press release about CIO's VAR, Value-at-Risk. We'd shown average VAR at 67. It will now be 129. In the first quarter, we implemented a new VAR model, which we now deemed inadequate. And we went back to the old one, which had been used for the prior several years, which we deemed to be more adequate. The numbers I just gave are effective March 30th, the first quarter.
What have we done? We've had teams from audit, legal, risk and various control functions all from corporate involved in an extensive review of what happened. We have more work to do, but it's obvious at this point that there are many errors, sloppiness and bad judgment. I do remind you that none of this has anything to do with clients.
Dimon followed it up with a re-taped, first-ever appearance on the May 13, 2012 edition of Meet the Press (#2) (emphasis added):
DAVID GREGORY: A few weeks ago, you dismissed all of this as a quote "tempest in a teapot." You've changed your view about this. How much worse will this get?
JAMIE DIMON: So first of all, I was dead wrong when I said that. I obviously didn't know, 'cause I never would have said that. And one of the reasons we came public was because we wanted to say, "You know what? We told you something that was completely wrong a mere four weeks ago. And— we took a $2 billion loss. And we made it clear it could get worse before it gets better. You know, could vol-- be volatile by a billion dollars possibly." I do-- I do want to put it in perspective, the company is going to earn a lot of money this quarter. And so it's a very strong company. We made a terrible egregious mistake. There's almost no excuse for it.
There was also the obligatory executive bloodletting. Dimon pushed the senior executive over the investment division to an early (and lucrative) retirement and named a replacement who immediately made three more executive changes. Despite the public changes and PR appearances, the collective reaction to the news is still a combination of yawn and question mark.
Were We Just Greenspaned?
Despite the apparent precision in Dimon's explanation on the conference call, pundits and press were confused about the nature of the loss and its longer term impact on the company. An additional five days full days after the announcement has yet to clear much of the fog. So what really happened? The public sequence of events looks something like this:
* JPM previous announced a plus or minus $200 million "variance" in its Chief Investment Office (CIO) portfolio at the end of its fiscal first quarter
* analysts at that time were not happy with the number, the $400 million dollar uncertainty over the exact value and not impressed with the explanation and grew increasingly concerned after finding JPM had taken a large position in some derivative instruments
* as recently as the April 12, 2012 timeframe, analysts expressed private and public concerns about the wisdom and health of JPM's position only for those concerns to be publicly dismissed by Dimon who stated everything was under control
* on May 9, Dimon taped a segment for Meet the Press and did not mention the pending loss announcement (understandable - the call had not yet been scheduled and info could not be shared) but also presented his normal "we're not all crooks / we're not all dumb" position about regulation
* on May 10, JPM scheduled an after-hours conference call with zero notice to discuss the surprise elements in its required quarterly 10-Q SEC filing
* on May 11, Dimon taped a new interview segment for Meet the Press addressing the recent news
* on May 13, Dimon forces the head of the CIO group into retirement and names Matt Zames to lead the department
* on May 14, Zames named two new heads of its "finance" and "risk management" departments and re-assigned trading strategy responsibilities from Achilles Macris to a new executive<<br />
So what actually happened with the money behind the scenes between roughly April 12 and May 10? It isn't clear even to analysts like CNBC's Mary Thompson who cover JPM but it looks something like this:
* the CIO group was attempting to increase profits earned from a portfolio of bank assets (not customer accounts, the bank's own money) estimated to be worth between $200 billion and $360 billion (depending on the source)
* much of that portfolio became concentrated in a single derivative "vehicle" called CDX-IG9, an index based upon the performance of a bundle of credit defaults swaps from 126 American companies (#3)
* traders around Europe began noticing trading volume in that asset, noticing more of the volume associated with JPM and began referring to that position (if not the trader staking the position) as the "London Whale"
* the underlying assets involved in that CDX-IG9 derivative dropped in price, producing a much larger drop in the value of JPM's position, resulting in the initial $2 billion dollar loss
A few critical facts are NOT clear at this time:
Did the underlying asset drop due to normal "random" factors or did speculators drive it down knowing of JPM's vulnerability? This is a key indicator of the competence of JPM's risk management team. As mentioned earlier, other traders throughout Europe began referring to the position as the "London Whale", implying the position had grown to dominate the entire market for the security. Because the position was a highly leveraged derivative position, any individual investor or collection of investors holding the underlying asset can trigger a tsunami in the derivative market just by making a few relatively minor waves in the primary market of the underlying asset. They can in fact trigger panic selling by the big dog (JPM) and make money on the counterparty side of the derivative bet AND buy back into to the primary asset at lower prices. If the derivative tanked due to "normal" fluctuations, JPM's risk management team clearly botched it's analysis of the asset and market. If the derivative tanked because the small fish figured out how to gang up on JPM's whale of a position, the risk management team has an even bigger failure to explain.
Did JPM's own attempt at accelerating the clean-up of the position hasten its decline? Again, the answer to this question will be a key indicator of major problems in JPM's risk management. Once the nature of the investing mistake was clear to JPM management, they had to balance two competing goals -- getting out as quickly as possible before other players detected the vulnerability (and possibly before JPM's "best and brightest" reputation was tarnished) versus selling too quickly and triggering an over-correction that could tank the asset entirely. If JPM's own clean-up efforts did hasten the drop, it would indicate a certain lack of strategy and fortitude on the part of the team that made the original bet.
Exactly WHY did JPM establish and grow this risky position? Dimon made it clear that the position involved a hedge used for the company's own portfolio used to reduce exposure to risk in credit markets. No customer assets were involved and the position was not aimed at protecting the firm's operations on behalf of customers (e.g. providing liquidity for assets traded on behalf of its customers). Reading between the lines of Dimon's public comments and comments from others covering JPM indicates that the position was not a "hedge" position at all -- there wasn't some other asset JPM held that was expected to go UP if this asset went DOWN. Instead, JPM was simply speculating that this asset would go UP to produce income for the firm and its bet failed.
How much more is there to lose? Dimon mentioned that there may be another $1 billion in losses yet to hit the books. Yet there's no way for investors (or regulators) to independently confirm the accuracy of that estimate because JPM has not explained the structure of the original bad bet. Frankly, JPM has likely not even figured out internally how it plans on "unwinding" the position. Is JPM keeping mum thinking that opacity will provide cover from other vultures who might gang up on JPM like other institutions ganged up on Bear Stearns?
Jamie Dimon and his merry team of executives have enjoyed a reputation as straight shooters, the best and the brightest -- bright enough to ease back on JPM's derivative and mortgage exposure while nearly everyone else in the industry was racing blindfolded to the cliff that became the 2008 collapse. The press is already asking questions about whether Dimon misled investors or whether his tarnished reputation will make it easier to tighten regulations restricting these types of bets.
Despite the company holding its annual shareholder meeting today May 15, 2012, no new details on the nature of the trade were provided or new estimates on future losses that still might hit the books. More shareholders were upset over losses JPM is incurring over bad mortgages than the $2 billion dollars lost on this one trade. Even if tighter regulations are imposed, how can any teeth in such regulation be implemented with clarity capable of guiding executive decisions about the million shades of grey involved with managing a worldwide portfolio denominated in dozens of currencies reflecting the political, economic and social risks across hundreds of countries.
So why is this $2 billion dollar loss important?
Just look at the following dominoes being lined up:
* a political stalemate and vacuum in Greece threatens the structure of existing Euro bailout agreements
* doubts about Greece's economic health and possible exit from the Euro to the drachma is already triggering capital flight out of Greece
* a leadership change in France also raises the prospect of a change in France's future choices between austerity versus stimulus
* a recent state-level election in Germany signaled major dissent with key policies of Angela Merkel
* the UK is officially back in recession
* some recent US economic statistics are good but overall indicate growth is slowing or stalled
* nothing will happen legislatively in the US prior to the November elections
* nothing is likely to happen AFTER the November election, regardless of who wins, due to post-election rancor and score settling
* the US has major tax rules expiring AFTER the election that will require political action to renew or alter
* the US has major budgeting agreements already at risk for collapsing which could spook worldwide markets
* China's skyrocketing GDP growth (above 8%) shows signs of faltering and internal accounting issues that cast doubt on how much of that 8% is real
* China's leadership is due for its once every ten years makeover and one of its rising stars is now involved in a murder mystery, throwing the entire leadership transition process into chaos
In other words, every hard statistic and soft interpretation of the worldwide economic picture indicates most of the world remains stalled if not falling backwards. Nearly every government with a role to play as leader or troublemaker is in chaos or paralysis. The worldwide economic system that needs to move money around smoothly to support recovery is instead sputtering and the governments responsible for managing the system are paralyzed and in the worst possible position to respond to surprises.
Now think about JPM's two billion dollar loss. Four weeks ago, JPM's best and brightest either thought the underlying issue was a $200 million dollar problem or that it wasn't a problem at all. In four weeks, either the problem BECAME a two billion dollar problem or it had been present longer and was just detected. One doesn't have to be terribly pessimistic or paranoid to imagine a situation -- maybe one in the next two or three weeks -- where a sudden market surprise triggers another banking freeze and liquidity crunch. Imagine a TBTF bank like JPM decides in that situation that it really needs to free up two billion dollars to match up to some outflow. If the firm was looking for that stash in a derivative based investment, it was already exposed to a HUGE risk of getting that money during a liquidity crunch. Now it faces not just a liquidity problem but an actual loss and its inability to provide liquidity adds fear to the market, exacerbating both the larger liquidity crisis and possibly its losses in its derivative bet.
There's absolutely no law or regulation that can be written to provide a simple-to-follow, simple-to-enforce checklist of dos and don'ts that can prevent these types of failures in judgment. It's possible that not a single person at JPM did anything even remotely illegal or unethical -- though clearly no one's ruling out dumb. There are probably tens of thousands of permutations of investments that could produce similar losses. The real lesson here is that the complexity of safely managing portfolios as large as those controlled by these TBTF institutions is beyond the ability of humans and as many supercomputers and algorithms we care to throw at the problem. The only way to protect the larger system is to strictly limit the size of the players in the game.
How many more reminders do we need? How many more reminders do you think we'll get?