How to Lose $2 billion Dollars
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My Ignite slides for Foo Camp 2012, which looked at hedging, risk, and regulation in the context of JPM's recent loss. Posted here for slide-sharing; to see the video, go to http://blog.noupsi.de/post/26805278864/lose-2billion-ignite
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How to Lose $2 billion Dollars
- 1. How do you lose $2 billion dollars?
- 2. Traders use models to determine “fair value”
- 3. “And then that happened…”
- 4. Hedging reduces risk Married Put Option - 50 put, $50 stock $60 $40 $20 Profit/Loss Stock $0 Put Overall -$20 -$40 max loss! -$60 $0 $25 $50 $75 $100 Stock Price
- 5. So now. JPMorgan. “This trading may not have violated the Volcker Rule, but it violated the Dimon principle.”
- 6. Step 1: Invest excess deposits in high-grade corporate bonds
- 7. These companies wouldn’t default… Beware of systematic risk.
- 8. Step 2: Prudently hedge with credit default swaps Protection buyer t1 t2 t3 t4 t5 $ $ $ $ $ t0 tn Protection seller
- 10. Oh, wait. No double-dip recession! European Central Bank backstopping European banks!
- 11. Step 3: SELL insurance.
- 13. 1+1=5
- 14. Step 4: Go big or go home
- 15. “Markets can remain irrational longer than you and I can remain solvent.” -John Maynard Keynes (maybe)
- 18. “In hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed, and poorly monitored…” -Jamie Dimon
- 19. $JPM stock -23%
Notes de l'éditeur
- For the average person, this is a pretty difficult thing to do. Hedge funds like Amaranth and LTCM have managed it. Recently, so did JPMorgan. And you should care, because this loss is likely to have a significant impact on financial legislation.
- Traders develop a model of an instrument’s “fair value”. Some of these models look at quantitative relative value, correlations across instruments. Others look at the cash flows underlying a business. Once you have a fair value, you buy and sell around it.(trader screens Image byPawelKopczynski/Reuters)
- But even when you’ve made a good bet around a solid model of fair value, things can go wrong. What you’re seeing here is a graph of a Chinese lumber company after news of corporate fraud. This kind of thing happens to airline stocks when a plane crashes, or drug stocks if a trial fails. Good trading is also about managing risk.
- A hedge is a trade put on to offset potential losses on another position. A put option is a common way to hedge stock. As the stock price increases, the value of the put decreases, BUT the trader wins on the stock. If the stock price drops, the put is worth more. The max loss is the amount paid for the option. It’s a little like buying insurance.
- In 2008, bank proprietary trading desks lost quite a lot of money. The Volcker Rule is a regulation that prevents banks from prop trading, but DOES allow them to hedge. But if you’ve been following the news recently, you know that sometimes things go wrong. Sometimes you can lose money…maybe even $2-5 billion dollars…. Let’s walk through how.
- Banks take your deposits and invest them in relatively secure assets. JPM has $1.1 trillion in deposits. High-grade corporate bonds have a slightly higher yield than govt bonds and are considered safe, so they’re a common investment.
- Even though most blue-chip, investment-grade companies are generally safe, there is still some risk. There’s default risk for individual companies (remember 2008; WAMU and CIT no longer exist). But more generally, there is broader economic risk. Correlations change during crises, and even “safe” assets can suddenly become risky. So what you’re hedging against is the possibility of all of these companies going bad at once.
- The CIO’s job was to hedge JPM’s portfolio against some unforeseen disaster. The simplest way to hedge credit risk is by buying a derivative called a credit default swap. Kind of like that put option, buying a CDS is like insurance. Buyers pay premiums for protection in the event of a default. Sellers have to pay out the par value of the bond if something goes wrong.
- So what we’re talking about is similar to buying insurance. To hedge the portfolio, the CIO likely did a few things. It bought short-dated protection on investment grade bonds, some CDS, AND high-yield bonds. It was hedging the risk of the American corporate debt, concerned about a double-dip recession and European contagion.
- But then the economy improved and the risk of default seemed less and less significant. So the CIO decided to reduce the initial hedge – but not by selling what they’d bought! Instead, trader Bruno Iksilstarted selling protection on a DIFFERENT, long-dated index that tracked the same market…and collecting the premiums.
- CDX.NA.IG.9 is anindex of North Americancorporate CDS’, expiring in 2017. The constituents are the same type of investment-grade companies JPM held. Essentially, the CIO was selling the long-dated index to pay for the shorter-term protection. He sold TONS and collected premiums. He bought not-so-much.
- That bet on riskiness over time is called a curve-flattener trade. Normally long-term interest rates are higher than short term, because more things can go wrong over time. A flattener trade is like betting that in the short-term credit situation is riskier than the long-term.
- So what’s the effect of all this selling? That CDX IG index is based on the real prices of underlying CDS. And suddenly, the mathematical relationship between the two was skewed. The historical relationship between the IG and other indices went weird, too – this slide shows the resulting deviation from the historical/quantifiable relationship between the cost to insure investment grade (IG) vs high yield (HY) CDX’s.
- And hedge funds noticed this. So they started to buy it up, betting that the values of the index and the underlying would converge. This index is not at fair value. Ironically, JP Morgan’s own Asset Management Unit, which manages client investment accounts, was also buying what the CIO was selling.
- But the JPM trader kept selling, and the hedge fund traders got pissed. Their trade made sense, but they were still losing because the seller kept at it. They leaked the story to journalists…”London Whale”, “Voldemort” etc. That’s when the news broke…and possibly when Jamie Dimon learned the full extent of what happened.
- And thenthings started to crap out in Europe again. Hedging a curve flattener trade requires active rebalancing, the ratio is constantly changing. The combined pressure from hedge funds, illiquidity, and deteriorating conditions made it too expensive (or too time consuming) to maintain, and that’s when things really went to hell. At that point, JPM’s CIO just had on a massive directional bet.
- And the story isn’t finished. JPM has a massive position and needs to unwind, so other market participants will make them pay up. Jamie Dimon has said the bank plans to “maximize economic value for shareholders”– so, rather than fire-sale-ing, they’ll wait and see what happens.
- Right now, that $2 billion is a mark-to-market loss. But the irony is that to ride this out, they’ll need to hedge the hedge, so other indices might get weird. They might lose a lot more.I want to emphasize that hedging is a sane and correct thing to do. Sometimes a good hedge goes bad, and you lose money on it. But what happened here was ill-advised and terribly executed.
- In this case, losing $2 billion isn’t that serious. JPM made a lot more than that in profit last year. But it does raise questions about what kind of regulation is necessary to avoid bailouts. Hedging is a very hard thing to regulate, and probably the wrong thing.
- Although this hedge was clearly egregious, there are a lot of gray areas in determining what’s a hedge. The real problem is that FDIC-insured banks are allowed to be too big to fail. It’s hard to lose $2 billion dollars if you don’t have the ability to place giant bets.