When is a hedge not a hedge? Most of the talk about the losing JPMorgan derivatives trade has been nothing but trader chatter – long on speculation and short on facts.
CEO Jamie Dimon may be spinning the trades as a "hedge" but there's no hedge here for financial reporting purposes. JPMorgan's credit derivative positions did not qualify for hedge accounting and are, therefore, reported at fair value. Since the bank's credit derivatives didn't take advantage of hedge accounting treatment under U.S. generally accepted accounting principles, they're nothing, in my book, but a bet.
Hedge accounting, a complex and very specific accounting treatment under Financial Accounting Standard 133, requires a company to recognize all derivatives as assets or liabilities in its financial statements and report them at fair value. If certain conditions are met, a derivative may be specifically designated as a "hedge" of the exposure to changes in the fair value of an asset or liability.
When accounting for derivatives, the value must be adjusted by marking to market. This creates large swings in the profit and loss account. The primary benefit of "hedge accounting" is the linking of the timing of the financial statement impact with the economic impact of the specific risks hedged. You record the gain or loss from derivatives at the same time you record the gain or loss from the hedged risk, such as a loan portfolio. With an effective hedging strategy, gains and losses should largely offset each other.
JP Morgan's first-quarter report to the Securities and Exchange Commission valued its credit portfolio at $1.8 trillion. That includes loans held for investment, loans held for sale (which are carried at cost or fair value, whichever is lower), and loans accounted for at fair value.
To manage these credit exposures, the bank's chief investment office in London bought and sold credit protection consisting of single-name and portfolio credit derivatives. None of the credit derivative receivables and payables was designated as a hedge for financial reporting purposes. At March 31, the fair value of credit derivatives was a net receivable balance of $1.57 billion. That means JPMorgan was a net buyer of credit protection on the loan portfolio.
On a conference call with analysts on April 13, JPMorgan Chief Financial Officer Doug Braunstein said the positions many hedge funds were complaining about at the time – those being put on by JPMorgan's "London Whale," Bruno Iksil – were meant to hedge investments of excess deposits the bank makes in "very high grade" securities. Braunstein said the positions in the CIO in London were meant to offset the risk of a "stress loss" in that credit portfolio.
If you want to use "hedge accounting" treatment to smooth out the rough bumps of unexpected billion dollar losses, a derivative must be "highly effective" at offsetting the risks being hedged, and you must designate and document the hedge relationship. JPMorgan may have chosen not to use hedge accounting when it otherwise could have. Dimon's admissions of sloppy, uncontrolled management of these trades tell me that onerous documentation requirements were probably avoided whenever possible. The documentation requirements for hedge accounting are extensive.
More likely, the derivatives could not be proven to be "highly effective" at offsetting the credit portfolio risks. "Highly effective" generally means that the effect of changes in the hedged risk is offset by the derivative in a range of 80% to 120% for any possible changes in the hedged risk. Anything less than "highly effective" would not qualify for hedge accounting. Correlation can be relatively high but still not qualify for hedge accounting therefore exposing the bank to huge swings in mark-to-market impact on profits.