The American guru of investing Warren Buffet has called derivatives “Weapons of Mass Destruction – WMDs”.
The world’s second-richest man made the comments in his famous and plain-spoken “annual letter to shareholders”, back in 2003. Mr. Buffett argued that such highly complex financial instruments are time bombs and “financial weapons of mass destruction” that could harm not only their buyers and sellers, but the whole economic system.
The subprime crisis of 2008 may have already vindicated him. But the WMDs are still out there. In spite of all the rhetoric, projects, programs and so on about risk management, governance and other fashionable managerial speak, the “deadly” instruments are at work, as JP Morgan found out in 2012.
On 15 March 2013 a US Senate Subcommittee published its report on a case named “the London Whale Trades”.
“JPMorgan Chase & Company is the largest financial holding company in the United States, with $2.4 trillion in assets. It is also the largest derivatives dealer in the world and the largest single participant in world credit derivatives markets. Its principal bank subsidiary, JPMorgan Chase Bank, is the largest U.S. bank. JPMorgan Chase has consistently portrayed itself as an expert in risk management with a “fortress balance sheet” that ensures taxpayers have nothing to fear from its banking activities, including its extensive dealing in derivatives. But in early 2012, the bank’s Chief Investment Office (CIO), which is charged with managing $350 billion in excess deposits, placed a massive bet on a complex set of synthetic credit derivatives that, in 2012, lost at least $6.2 billion.” (1)
“The Senate subcommittee’s damning report on the London Whale debacle raises serious questions about JPMorgan’s risk management and crisis management, painting a picture of executives who were clueless about the risks the London Whale was taking on, and then desperately tried to hide the true size of the problem from investors and regulators.” (3)
This article is about the “London Whale” trades and their consequences.
JPMorgan’s “London Whale” trade, as the series of corporate-credit derivative trades that led to at least $6.2 billion in losses last year have come to be called, “provides a startling and instructive case history of how synthetic credit derivatives have become a multibillion-dollar source of risk within the U.S. banking system,” the 301-page report issued by the Permanent Subcommittee on Investigations said. (12)
JPMorgan shares fell by about 33%, shaving around $51 billion off the firm’s market value. JPMorgan shares have since recouped those losses.
I will start by presenting the Chief Investment Office, then provide an overview of the financial instruments involved, and conclude with the “London Whale” trades.
The Chief Investment Office (CIO)
JPM is the biggest – 2,4 trillion USD assets – US Bank.
JPM’s Chief Investment Office, or CIO, manages $350 billion in excess bank deposits.
Ina Drew was the Chief Investment Officer (CIO). She resigned after the loss became known, ending her 30-year career.
Bruno Michel Iksil was the head of the credit desk in the London unit of JP Morgan’s chief investment office, reporting to Javier Martin-Artajo. A graduate in engineering from the École Centrale in Paris 20 years ago, Iksil had become so well known in the opaque $10tn market for credit default swaps – a complex type of insurance product – that he was nicknamed the “London Whale” and also known as Voldemort, after Harry Potter’s nemesis…Iksil was part of team based in JP Morgan’s London head office, which was supposed to hedge – or insure – the risks the bank was running. (4)
Julien Grout a trader who joined JPMorgan Chase (JPM.N) in 2009, reported to Mr. Iksil.
Achilles Makris was Mr. Martin-Artajo’s boss, running the London unit of CIO.
Iksil was fired in July, 2012, along with Macris, Martin-Artajo, and Julien Grout was suspended. The bank clawed back as much compensation as it could from all of them, which it said “amounts were roughly equal to two years’ worth of the person’s total compensation”. Grout left the Bank in December 2012.
The financial instruments: Credit Default Swaps (CDS)
The financial instruments deployed in the “London Whale” incident were credit default swaps, which are a type of credit derivatives. Lets have a quick overview of them.
A derivative is a security in which the price depends on or is derived from one or more underlying assets. Therefore, a credit derivative is a security in which the price is dependent on the credit risk of one or more underlying assets.
The credit derivative, while a security, is not a “physical” asset. As such, derivatives are not simply bought and sold as bonds are. With derivatives, the purchaser enters a contract that allows him or her to participate in the market movement of the underlying reference obligation or physical security.
A Credit Default Swap is a is a type of credit derivative. It is a financial swap agreement, linked to a reference entity, and involving two parties, the buyer and the seller, also known as the investor. The buyer makes a sequence of payments to the seller (premium, fee or spread) for the duration of the contract and in exchange receives a pay off in the event of a predefined credit event, or default.
The credit events that trigger payment to the protection buyer are now clearly defined in the International Swaps and Derivatives Association (ISDA) credit derivatives definitions.
In simpler terms, a CDS is an insurance contract. The reference entity, a corporation or a government, is not a party to the contract. The are single-name CDS, involving only one reference entity, and index CDS, covering many entities.
A CDS index contract is an insurance contract covering default risk on the pool of names in the index. Index contracts differ slightly from single-name securities. The main difference is that a buyer of protection on the index is implicitly obligated to pay the same premium, called the fixed rate, on all the names in the index. In addition, index contracts restrict the eligible types of credit events to bankruptcy or failure to pay. In the case of a credit event, the entity is removed from the index and the contract continues (with a reduced notional amount) until maturity. (6)
In 2012 the total market for CDS’s was estimated at 10 trillion USD.
The Synthetic Credit Portfolio (SPC)
JPM told the Senate Subcommittee that the SCP was originally established to function as insurance or a “hedge” against certain credit risks confronting the bank. The 2006 New Business Initiative (NBI) that formally authorized the CIO to engage in credit trading said the purpose was to address the bank’s “cyclical exposure to credit.” In particular, according to JPMorgan Chase senior officials, the SCP was intended to provide the bank with protection during the financial crisis: it was a “macro” “anticipatory” hedge against “tail events.” (1), (10)
The graph below shows the portfolios of JPM’s Chief Investment Office. The “London Whale” trades were made in the synthetic credit portfolio (SPC). SCP sprung into being in 2007 with credit derivatives based on mortgage securities (ABX and TABX).
In 2008 JPM’s net notional synthetic credit portfolio was valued at 4 billion USD. In 2012 it was valued at 157 billion USD.
Total SCP 2011 revenue was 453 million USD, 400 out of which came out of the default of AMR, the parent of American Airlines. The SCP had bought high yield credit derivatives tranches resulting in the profit they made when AMR went bust. (11)
At the beginning of 2012, the ideal scenario for CIO would be to replicate the AMR gain. Was this possible?
From 2007 to 2011, Messrs. Martin-Artajo and Iksil generated billions in profits on a portfolio that featured bets on certain corporate credit indexes. In late 2011, they were asked by the bank’s executives to reduce the positions, but instead put on other trades that increased the size of the overall portfolio, according to the bank. At first, their move was profitable. But losses began to mount in mid-March, and Mr. Iksil had trouble explaining why, according to someone close to him, believing that market prices didn’t reflect underlying value. Mr. Martin-Artajo was exasperated. “These marks just don’t make sense,” he said, according to a trader who heard the comment.
The gist of all the stories is that the CIO was selling protection on the CDX.NA.IG.9 (going long) to balance out the tranches on the high yield index that they’d bought (going short, which turned out to be profitable when Dynegy and AMR Corp defaulted). (8)
The particular index (CDX.NA.IG.9) at the heart of this, according to the coverage, is the Markit CDX.NA.IG.9. It was launched in September 2007 with 125 investment grade names. Four have since defaulted, hence removed from the index: Fannie, Freddie, CIT Group, and WaMu. The index “rolls” to a new series every six months. Why then Mr. Iksil chose to focus on Series 9 of the index? One reason might be that Series 9 was the last index before the financial crisis properly hit, and it had high liquidity for structural reasons — it was “baked” into a number of structured products.(13)
According to The Wall Street Journal, Iksil turned his attention to the index earlier this (2012) year and took large positions in January and February before he stopped selling the contracts around the end of March. He is said to have made paper profits for the bank through the first two months of the year with a bullish stance on certain US companies and sold CDS offering insurance against those companies defaulting. The Wall Street Journal reported that hedge funds bought the protection as a way to bet against any rise in US corporate defaults and hedge against any downturn in the economy. But JP Morgan sold so many of the index swaps that the cost of protection on those companies dropped. Consequently, it had become much cheaper to buy CDS through the index than buying protection on the individual companies (7)
In April 2012 CIO’s trades in the CDX.NA.IG family of credit derivative indices were so large that hedge funds were complaining that they were distorting that entire market.
In an earnings conference call on 13 April 2012, as part of JPMorgan’s award-winning investor relations, CEO Jamie Dimon dismissed the London Whale story as a “tempest in a teapot.” Determining accurate prices for infrequently traded investments such as the bets made by Mr. Iksil can be difficult, and J.P. Morgan routinely reviewed the valuations made by traders. The oversight process by the bank’s so-called valuation control group includes input from outside pricing companies and brokers, which the group uses to set what it considers an appropriate range for various investment positions. The arrangement is a common risk-management practice among large banks…In Mr. Iksil’s case, though, the high valuations didn’t sound any alarm bells, according to people familiar with the internal investigation. The reason: The values claimed by the trader were within the broad range set by the oversight group, so it approved the valuations. (5)
Interestingly, the loss started at 800 million USD, then became 1,2 billion, then 2 billion, then 3 billion and ended up above 6 billion. This raises the ever important question of how the positions in index CDSs are valued.
Boaz Weinstein, manager of Saba Capital, was on the other side of this trade, while JPM incurred losses exceeding $6 billion, Weinstein pocketed millions in profits. In the hedge fund game, a business in which ruthlessness is prized and money is the ultimate measure, Mr. Weinstein is what is known as a “monster” — an aggressive trader with a preternatural appetite for risk and a take-no-prisoners style. He is a chess master, as well as a high-roller on the velvet-topped tables of Las Vegas. He has been banned from the Bellagio for counting cards. (2)
Were the derivative trades a proprietary bet aimed at producing profits, or a hedge of the bank’s exposure? “I think it’s pretty clear from the Senate paper that it was not a hedge, it was a bet,” Mr. Weinstein said at a conference in New York on 21st March 2013. (2)
“The whale trades also demonstrate how derivative valuation practices are easily manipulated to hide losses, and how risk controls are easily manipulated to circumvent limits, enabling traders to load up on risk in their quest for profits.” (1)
Postscript: A Salomon Brothers Whale
In 1987 Craig Coats Jr. was Salomon’s head of government-bond trading. After the stock-market crash in October 1987, Gutfreund, Salomon’s CEO and Coats decided to buy $2 billion worth of the newly issued 30-year United States Treasury bond. It turned out it was the wrong thing to do. It cost the firm 75 million USD in losses and was aptly named “the whale”.
(1) JPMORGAN CHASE WHALE TRADES: A CASE HISTORY OF DERIVATIVES RISKS AND ABUSES, Majority and Minority Staff Report, United States Senate, 15 March 2013
(2) The Hunch, the Pounce and the Kill, How Boaz Weinstein and Hedge Funds Outsmarted JPMorgan, by Azam Ahmed, The New York Times, 27 May 2012
(3) JPMorgan Chase Wins Actual Award For Its Handling Of The London Whale Debacle, Mark Gongloff, Huffington Post, 22 March 2013
(4) JP Morgan trader ‘London Whale’ blows $13bn hole in bank’s value, Simon Neville and Jill Treanor, The Guardian, 11 May 2012
(5) J.P. Morgan ‘Whale’ Was Prodded, The Wall Street Journal, 3 August 2012
(6) CDS index tranches and the pricing of credit risk correlations, Jeffery D Amato and Jacob Gyntelberg, BIS Quarterly Review, March 2005
(7) Chart of the Day: London Whale trading, Farah Khalique, Financial News, 11 May 2012
(8) The high yield tranche piece, FT Alphaville, 17 May 2012
(9) JPMorgan Chase and the London Whale: Understanding the Hedge That Wasn’t, Ron Rimkus, Enterprising Investor, 17 May 2012
(10) It’s purpose limited only by one’s imagination, Lisa Pollack, FTAlphaville, 19 March 2013
(11) Humongous credit derivatives cake proves inedible, Lisa Pollack, FTAlphaville, 19 March 2013
(12) Senate Report Blasts JPMorgan Executives, Including Dimon, Over ‘Whale’; Kate Kelly, CNBC, 14 March 2013
(13) Thar she blows! Lisa Pollack, FTAlphaville, 18 April 2012