JPMorgan (JPM) announced in early May that they had experienced a large loss from a hedging strategy gone wrong. The details of the trade are uncertain, but enough information has surfaced that a basic outline of the scenario can be guessed at.
The bank’s Chief Investment Office (CIO), where the company’s overall investment hedging is controlled, is the source of the mistakes. Over the past five years, their CEO, Jamie Dimon, changed the scope for the office to profit generation, instead of hedging the risks inherent in their normal banking operations, such as interest-rate and currency fluctuation risks, according to Bloomberg Businessweek.
What were they trading that caused such huge losses? Yup, you guessed it: credit default swaps, which are the same securities that caused the recent recession. Credit default swaps (CDS) are insurance-like contracts between two parties, where the first party makes payments to the second party in return for insurance if the bond defaults. Not only can you buy CDSs on individual bonds, but also on bond indexes, which rise in less-than-desired economic conditions because of corporate bond default risk. They are often used to speculate on changing credit conditions.
JPMorgan was betting on the worsening of credit conditions in 2011, but the European Central Bank gave long-term loans to euro zone banks, which caused the bond market to rally. This caused their bets to become vulnerable to further rally, so the London-based CIO started making bullish bets to offset some of the risk. They were selling the credit insurance on a bond index that is said to expire in 2017, but they were protecting that bet by buying insurance for 2012 expiration.
The 2017 expirations they had sold were more expensive than the 2012 that they had bought, which would have been a profitable trade because a loss in one would be offset by a profit in the other. The problem though, is that they were trading the position too much. It had gotten so large that they might have even pushed the prices of a CDS index. Some hedge funds realized the artificial price movements and tried to profit from them, but JPMorgan continued to push the position larger.
The hedge funds reported a loss for the trade, which caused some of the traders to contact the press about the situation. Other hedge funds put two and two together and realized that JPMorgan had such a large position that they were pushing the prices around, and they took opposite positions of them. The credit conditions deteriorated, and since so many traders were jumping on board, things quickly went south for JPMorgan.
Why not just exit the position quickly? With such a large position and credit conditions going bad, there are major liquidity issues with the securities. If the credit conditions worsen, not many other traders will want to take a position on that side of the trade. Without anyone to buy the position back from JPMorgan, they are stuck with the securities, and amounting a massive loss from them.
Because of the massive loss, debates over regulation have been brought up again. It also raises questions as to the bank’s motive for their position in the credit insurance market, and whether it was for insurance or a speculative bet.
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After the May 10 conference call, where Dimon announced the loss, investors in the bank pushed the stock price down over 23% to the stock’s lowest point, which was June 4, but it has since recovered.
Their mistakes have given lawmakers and regulators more ammunition to further attack the banking industry. They have already been attempting to limit the amount and kinds of risk banks can take, and this situation will likely push them to further limit it.
Below is a list of banks that will likely be affected by further regulation. Do you think they will maintain their profitability?
List sorted by market cap.
Interactive Chart: Use the Compar-O-Matic to compare market caps for the stocks mentioned below:
2. The Goldman Sachs Group, Inc. (GS, Earnings, Analysts, Financials): Provides investment banking, securities, and investment management services to corporations, financial institutions, governments, and high-net-worth individuals worldwide. Market cap at $49.5B, most recent closing price at $93.82.
4. Morgan Stanley (MS, Earnings, Analysts, Financials): Provides various financial products and services to corporations, governments, financial institutions, and individuals worldwide. Market cap at $29.64B, most recent closing price at $13.93.
(Written by Danny Guttridge)
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