How J.P. Morgan's 'Whale' Loss Got Bigger

Back in May, the big news was that  J.P. Morgan Chase (JPM) had lost $2 billion on a derivatives hedge gone wrong. I wrote an article then entitled, "The Moral of J.P. Morgan's Derivative Debacle," which explained what was going on from a derivatives perspective--at least as much as was possible from the information available at the time.

Recently, media outlets are reporting the $2 billion losses have swollen to anywhere from $5 billion (according to the Financial Times) to as much as $9 billion (according to a New York Times quote of J.P. Morgan's internal worst-case estimate).

Many people read this news and think "Wow! Derivatives are so dangerous and complex that J.P. Morgan doesn't know if it's lost $2 billion or $9 billion!"

In fact, the ballooning of the loss estimates has less to do with derivatives than it does with a micro-cap rubber plantation in Indonesia. Allow me to explain...

A Micro-Cap Rubber Plantation in Indonesia
Early in my career, I met a man who was running a small "micro-cap, value-stock" hedge fund that was doing well, both in terms of returns and in assets under management. I was looking to get into the hedge fund world at that time, so I invited him out for dinner to learn more about his fund and hopefully land a job.

After a few drinks and some good food, the manager (who shall remain nameless) confided in me the secret to his investment success: "I invest only in global micro-cap firms that hold a lot of cash on the balance sheet." He then proudly told me about a great investment he had found in Indonesia--a rubber plantation that held the equivalent of $0.40 of every dollar on the balance sheet in cash (the remaining $0.60 was the land occupied by the farm). The company was trading as a penny stock on the Jakarta exchange. He had been buying it for the last six months and had enjoyed terrific returns on the investment so far. 

While that might sound like a sensible strategy (and he certainly had plenty of clients), my interest in working for him lasted only as long as the dessert course. Why? As he was explaining his rubber plantation investment, I soon realized that his returns were only thanks to a thin market and the animal spirits of people who didn't know any better.

This manager would find a "great" company--under his definition of "great"--and would start buying it. In order to build his position, he would just start hitting the "ask" price. When he did so, whoever else was holding the stock saw his trade go through and decided to offer their shares at a price higher than the previous trade. When this trade went through as well, someone else decided to offer his shares at an even higher price. After a few days or weeks of this, the price of the shares of the target company had risen substantially, just because sellers understood there was someone willing to pay any price to buy the shares.

If the manager were the only one bidding for the shares, he would not be able to show unrealized profits--his action was driving the price up, so his average purchase price would be the average price of the shares over that period. However, the manager was operating in a market, not a vacuum, and in a market, other people see the price action of stocks and make decisions based upon that action--this process is called "herding." So investors saw the price of the stock go up and up and up, and thought "Wow! Somebody must know something! I'd better buy this stock!" And they would go ahead and hit the ask price for the stock, and the price would go up even more than if the micro-cap manager were in the market alone.

This is a perfect example of what people term a "crowded trade." The market price of the asset--which usually gives an indication of the instantaneous worth of one's position--is not a very good measure of wealth in cases like this. This is because the market price shows the last price paid for the asset in question, and not necessarily the price at which the asset can be sold if you want to take profits. What the manager had done was to basically create an extremely illiquid money market mutual fund and charge clients 2% of AUM and 20% of unrealized profits to do so!

Indeed, the story of this small-cap value manager ended badly. The Asian currency crisis began to unfold, and the speculators who had helped the manager bid up the plantation's stock price suddenly headed for the doors. Desperate to sell the shares and increase liquidity, the speculators drove the plantation's stock price down very quickly. In the next quarterly update, the manager's investors saw their investment values plummeting, and some got cold feet and asked to withdraw their funds. This meant the manager had to go into the market and try to sell his position (roughly 10% of the market capitalization of the plantation) to the same speculators who were trying desperately to get out of their own positions. When all was said and done, the manager closed the fund and returned what money was left--which was very little--to his friends, family, and institutional clients.

Can I Take a Mulligan Please?
As described in my first article about J.P. Morgan's debacle, CEO Jamie Dimon decided it was best to close the Treasury Department's "hedge." His firefighting team went back into the marketplace and, in essence, told the other market participants they wanted to take a mulligan on all the London Whale had made over the previous months. In other words, they said--hat in hand--that they wanted to buy back all the CDSs they had sold and sell all the CDSs they had bought.

In doing so, they first ran into trouble because the trade sizes had been so large (perhaps more than $100 billion in notional value) that they ended up in the same position as the rubber plantation manager. J.P. Morgan's positions represented a significant proportion of the volume in some of the products they were trading, so when they wanted to sell, there were not that many buyers--at least not that many who wanted to buy at the price J.P. Morgan wanted to charge!

The second reason they ran into trouble was because everyone in those markets--mainly hedge funds and other banks--knew J.P. Morgan had to reverse out its previous trades. Whenever the person on the other side of the negotiating table knows you must make a trade, you are guaranteed not to get a very good deal.

Decisions vs Derivatives
While it may seem trite, the saying "Guns don't kill people; people kill people" has bearing in this case. Derivatives may be the instrument people use to express ill-considered investment decisions, but the root fault lies with the decisions themselves.

The fact that merely a month ago, J.P. Morgan's losses were estimated to be $2 billion, and now they are reportedly estimated to be as bad as $9 billion is not a function of the instrument, but rather a function of market dynamics. This is not to say that derivatives have not played their part in exacerbating a bad situation. Certainly, the complexity of some "fancy" derivatives (like indexes of credit default swaps) exceeds the human capacity to fully comprehend. In the attempt to make sense of the complexity, people with fancy degrees in mathematics, statistics, and physics build sophisticated mathematical models. But these models are not able to fully capture the complexity, either--they are, after all, created by humans and are thus subject to the weaknesses of their creators.

Despite Dimon's testimony to Congress that this was a one-off event and that derivatives markets have no need of greater regulation, I for one believe there is a strong case to be made to the contrary. A well-functioning, well-regulated market is to finance what well-built, well-maintained roads are to interstate commerce.

J.P. Morgan, like all large banks, is receiving the implicit (and at times explicit) support of the U.S. government, and, more importantly, U.S. taxpayers. Since they are sharing the road with the rest of us, I believe they should be made to obey safe speed limits.