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.
The bank is under no obligation to reveal such information publicly, but certainly regulators should know; and the situation supports the view that such standardized contracts should be traded on an exchange.
I am not optimistic that any of this will be revealed in the second-quarter earnings call in July, but I hope that someday the answers to the questions will be revealed.
Thomas J. White is a former executive vice president and head of credit at Dwight Asset Management and has held senior portfolio and risk management positions at MetLife and J.P. Morgan & Co.