There are several mysteries in JP Morgan Chase's announcement last week that it has lost $2 billion on a long position in an index of corporate credit default swaps.
I say this as an ex-employee of the old J.P. Morgan's corporate risk management department, a shareholder and an admirer of the institution. I respect the right of the firm to not reveal all until such revelation can no longer do harm to the bank.
However, JPM, as a leader and founder of modern risk management, should reveal more eventually because shareholders, creditors, counterparties and regulators deserve to know the answers. We all rely on the strength of risk management to compensate for the difficulty in understanding a modern global financial institution.
The first mystery is how does a long credit position result in a hedge? The press reports suggest that it was offsetting a hedge against the loan book, but if that were true the gains and losses on one side should offset those on the other side. Since that has not happened on a mark-to-market basis, something needs to be explained.
The second mystery is the statement that the bank changed VaR models, and then changed back. Daily value at risk is a standardized model of historical volatility and position size. The only thing that can change is holding period assumptions if you move away from daily risk. However, why would you go back and forth on such an assumption? A vigorous risk management system is always conservative and not manipulated to allow something that it was intended to control.
Whether VaR worked as intended depends on one's perspective. From my perspective, it did. VaR is a measure of risk on somewhere between 95 and 99 out of 100 days. It is not a measure of what happens on the 1 to 5 days when "tail risk" occurs. The number of days that the model is supposed to capture is part of the model's calibration when it is developed and back-tested for validity.
The VaR of JPMorgan's Chief Investment Office has been reported as being $67 million. I prefer to focus on the bank's overall VaR of $178 million. The validity of a risk management system is measured at the portfolio level. If there had been offsetting profits somewhere, JPM would not have been compelled to make this announcement. Similarly, if other activities were generating losses they would have been added to the preannouncement. These positions lost some $150 million to $200 million a day and as volatility increased the models should have been showing higher VaR levels than the $178 million and brought the position to management's attention. This is what VaR is meant to do.
The problem was the position could not be liquidated in a day. When that is the case, VaR is no longer the appropriate management tool. Stress tests are. JPM has been silent about what the stress tests showed and the bank should be clear about that.
The third mystery is why the bank allowed a mark-to-market position to become so large that it could not be liquidated in a reasonable period of time. This is when limits are supposed to be in place. Were they?
Even if limits were in place, there is the continuing mystery of how large the position is. The bank became the market, which you should only do when you have the financial wherewithal to hold the position to maturity, whatever the mark-to-market accounting does to you. And if you cannot hold a position through the market gyrations, it is an inappropriate position that should never have been put on. JPM has not been clear what part of the position has been offset and what part has been held.
I look forward to reading this blog going forward.
OK - so the emperor has no clothes. Mr. Dimon has allowed a great disservice to be done to the banking industry. I'm not so much concerned about the impact all this will have on JP Morgan Chase and the other so-called "too big to fail" institutions, but the impact this will have on the thousands of community banks in this country. Regulations, along with that other unsavory by-product, also roll down hill. Washington is ready to once again fire both barrels and they usually don't take real careful aim.
Then if we really want to peal back the skin of the onion--we must infer that the shere size of the exposure has caused Chase to be at risk--and as the largest TBTF--to force even Tea-Party Republicans and supposed bank-hating dems to come together for another bail-out. So if I lay out the time-line here as to what Dimon is thinking: 1) Greece/Spain etc look set to collapse, so he suffers a writedown, which is where we are today--and he has to take his beating now; but 2) the situation will be soooo bad that ECB FEds rush in and bail out the banks--causing a resurgence of his reference basket so he can close his positions at a huge profit. If the situation is soooo bad that the firewalls are overwhelmed, his exposure becomes soooo bad that he gets bailed out. This is the problem with the freedom to make these bets---the biggest of the big has a 2nd unseen bet on the table--that he is so TBTF that the US govt will not allow him to go down. I do not think that any of this was unexpected---that any mistakes were made---if his thinking follows the forgoing outline he must eat humble pie--but if it plays out as expected he makes a huge profit and is again smartest guy in the room------but hes using cheap Fed reserve $$$ to gamble---and the temptation also must exist that he engage in political rigging to assure that events unfold as planned. That is the real danger to allowing these guys to bet on what is in the end political risk----Dimon could be the Arnold Rothstein of Euro-politics.
In fact, I would go as far as to say that you have to look at the entire asset and hedging packages together. Some type of negative correlation is usually attempted, but ther is nothing illegal about taking a position that you feel strongly about after expert analysis and discussion on same.
Also, please remember that Bank of America's loss is some other entities gain. We can not look at one type of trade in a vacum. Especially when the institution earned 13.5 billion dollars last year, some of which I know comes from hedging, whether its new loan origination prior to funding or just good old MSR's that are almost hedged by every Servicing Institution. If you do not hedge your asset you can have a PHH situation. A major loss on the portfolio because it was not hedged!