J.P. Morgan’s $2 billion ‘Stupid Mistake’

The bad news from the financial industry just doesn’t seem to stop. J.P. Morgan has just announced that it has lost $2 billion and possibly a further $1 billion loss due to its chief investment office (CIO). This loss occurred in a matter of six months. There had been previous warnings to the top management of the bank by key advisors that the trades the CIO was indulging in were not safe and were not in line with risk management practices.

These losses are accredited to the use of credit default swaps. Initially the bank traded in them to reduce credit risk. Bruno Iksil an employee at the CIO is considered responsible for this loss. His big positions while trading, which affected the market often earned him the nickname London Whale. He mostly sold credit default swaps on companies that were listed in the corporate grade index called CDX1G9. This price distortion invited an opposite reaction from rivals who bet against Mr. Iksil not just on the index but on individual members in it as well. The protection selling continued unabated, till he dug himself too deep in to be able to cover his losses. They expected as he lost value he would turn to them to buy rather than sell credit default swaps.

In this case the hedge was not used to protect against credit risk, but work as an instrument of risk itself. J.P. Morgan’s proprietary trading has done well for them right through the financial recession. According to a report by The Telegraph a new risk evaluation model developed by J.P. Morgan turned out to be not so adequate. Numbers that were run through the older model saw risk levels so dangerously high it resembled a casino model.

In strong contrast Goldman Sachs, Bank of America and Morgan Stanley all posted staid results. J.P. Morgan‘s CEO Dimon stated that the bank in an attempt to reduce its exposure to these positions saw a loss that amounted to $2billion. In the process it has lost its rating from A+ to AA-, as it is expected to recover from its loss only in the next 12 to 18 months.

The CIO has been responsible for assets being held by J.P. Morgan to triple in value ($350 billion) since 2007. Clearly the gains made by the CIO were very high and thus they were given much leeway. This latest debacle will bring back into focus discussions on the Volcker rule and its recommendations on proprietary trading. The Volcker Rule’s earlier drafts emphasized the need to differentiate between market making and proprietary trading. It was noticed banks were indulging in speculative trades to gain rather than to offset risk. Mr. Dimon was one of the more  vociferous opponents of the Volcker rules proposed ban on proprietary trading. It however looks like that this recent incident is only going to help the case for increased regulation and monitoring of proprietary trading.

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