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The JPMorgan Whale's Disastrous Trades Were No Hedges

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. 

It was no secret that the credit derivatives positions could cause profit pain. The first quarter filing says so: "This asymmetry in accounting treatment, between loans and lending-related commitments and the credit derivatives used in credit portfolio management activities, causes earnings volatility."

The bank may now be calling the positions an "economic hedge" but, in hindsight, they look to me like a series of trades designed to generate income that spiraled out of control on incorrect or ignored risk information and lack of control over traders.

"It was there to deliver a positive result in a quite stressed environment," Dimon said on the May 10 emergency conference call, "and we feel we can do that and make some net income."

Dimon underscored the lack of correlation between the derivatives position and the risk on underlying assets when he admitted that $1 billion in profits were taken on available for sale securities to mitigate the $2 billion loss of the credit derivatives. As of March 31, JPMorgan had $370.8 billion in available-for-sale debt securities at cost – the same portfolio that Dimon said had $8.4 billion in unrealized gains as of March 31. More than 50% of that portfolio consisted of mortgage-backed securities. Corporate debt made up only $60 billion or 16% of the portfolio.

A huge mark-to-market loss on derivatives was offset with a well-timed sale of assets with previously unrealized gains.

Not a lot of synchronicity there, if you ask me.

Francine McKenna writes the blog re: The Auditors, about the Big Four accounting firms. She worked in consulting, professional services, accounting and financial management for more than 25 years.



(12) Comments



Comments (12)

"Eggheaded"? I'm about as far way from eggheaded and nerdy as a girl who wears Louboutins can get. I take a risk every day writing about these issues because some readers react without reading, make personal comments with no knowledge of the person, and lack an open mind and a bias free desire to learn something new.
Posted by Francine McKenna | Friday, May 18 2012 at 9:00AM ET
@mcnet Thanks and thanks. Your second point on the net receivables means net buyers is probably the most technical part of the column. I talked it over with sources who should know. They agreed with my interpretation. If I find out I was wrong I will make a correction.

Posted by Francine McKenna | Thursday, May 17 2012 at 11:59PM ET
Typical eggheaded accountant analysis that tries to record activity for "fair disclosure". Show me a bean counter that ever took a risk or produced something of value. All they do is look over the producers shoulders and look for ways to criticize. Revenge of the nerds at its finest.
Posted by Donuts | Thursday, May 17 2012 at 10:05PM ET
I disagree the conclusion in this point

"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."

I believe the correct interpretation is, at March 31 the Cumulative MTM on the credit derivatives portfolio was positive. As a result the fair value was a net receivable.

We can't conclude that JPM was a net buyer, we can only conclude that the value of its buys and sells were positive at 3/31.
Posted by mcnet | Thursday, May 17 2012 at 5:10PM ET
Thanks for supplying the accounting technicals on the 'when is a hedge not a hedge' section of my piece this morning.

I appreciate the support,

Posted by mcnet | Thursday, May 17 2012 at 4:43PM ET
The fact that it didn't qualify for hedge accounting doesn't prove that it didn't or at least wasn't intended to reduce the over-all risk to the firm. Some employees should be held accountable for hedging, and others for sucessful speculation.
Posted by kvillani | Thursday, May 17 2012 at 3:37PM ET
Excellent insight. Waiting to see the same in general press.
Posted by HarrisonH | Thursday, May 17 2012 at 2:11PM ET
McKenna is correct. This was anything but a vanilla hedge. This was cowboy risk taking for profit. And it will happen again, and again, and again until policy makers separate high risk trading activities from commercial banking activities. The TBTF banks have proven that they are more than just TBTF, they are Too Big to Manage and Too Big to Regulate.
Posted by commobanker | Thursday, May 17 2012 at 1:54PM ET
Two thoughts: (a) the author makes clear that complex accounting is rampant with the net effect of making financial statements increasingly opaque to investors; and, (b) complex accounting provides accountants with more opportunities to write pointless analyses and get them published. At least the author is honest and filled her piece with "appears to me" and "if you ask me". Is she hoping to get a job from the lawyers who are churning away at the class action suits that are likely to follow? Or perhaps her objective is to be asked to testify in Washington? Rubbish that should not have cleared the editorial review.
Posted by micha | Thursday, May 17 2012 at 1:35PM ET
Well that is insightful--how could a commercial lender hedge loan risk by betting that the credit risk of a broad basket of companies would improve? Or how could betting against the basket of near-bankrupts the preceeding year be "hedging" a commercial loan position. The best anybody could say was that these things were laying off risk on other bets? It would appear that this 2012 bet was set up to fail--it was too stupid--too obvious--it appears that the bank was in fact attempting to create a defense of roguishness good and bad luck to cover up what appears to be insider trading the previous year re AMR bankruptcy. If I were DOJ Id be making inquiries about the caveman's connections re AMR. Forget this 2012 stuff--its too obvious to be credible.
Posted by OLDER&WISER | Thursday, May 17 2012 at 1:32PM ET
Interesting that a $2 billion loss by the largest bank in the US is getting so much attention from our politicians and press yet trillions in tax payer funds are squandered with little comment?
Posted by jrobbins | Thursday, May 17 2012 at 1:31PM ET
Time to account for all trading book activites with PDs LGDs and EADs, and the same capital treatment as the banking book.
Posted by Old School Banker | Thursday, May 17 2012 at 1:16PM ET
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