The Moral of J.P. Morgan's Derivative Debacle

Recently, Morningstar OptionInvestor subscribers have been writing in to ask me to ask about the situation at  J.P. Morgan Chase (JPM) and how such a firm could lose $2 billion (or maybe $5 billion? $7 billion?) as a result of a derivatives trade. The root cause of their concern is that if J.P. Morgan--one of the best banks run by some of the smartest people in the world--can lose so much so suddenly, why should someone like me be fooling around with options?

My short answer is that J.P. Morgan's problems have not been caused by options, but by bad decisions and exacerbated by unregulated markets. We--as well-educated investors trading in transparent, well-regulated markets and with a good understanding of the value of the underlying instruments in which we are investing--have little to worry about.

The long-form answer is below.

Background
These losses did not occur in J.P. Morgan's investment bank, but rather in the treasury department of its commercial bank (that is, in the Chase part not the J.P. Morgan part); also, the first person to resign as a result of the scandal was J.P. Morgan's chief investment officer. To the uninitiated, "treasury" sounds important and "CIO" might make one imagine someone like a youthful George Soros. However, it turns out that the treasury department of a bank has traditionally been a sleepy backwater and CIOs are usually more akin to your local certified public accountant than to Soros.

The treasury function basically takes in depositors' money and tries to find the safest, highest-yielding investment possible, such that it can receive more from its investments than it pays out in interest to its depository clients. Because most accounts in a bank are demand deposits (that is, you can go to a bank branch and "demand" it to pay out the total amount in your account without suffering a penalty), a good bit of the money that a treasury department handles is invested in so-called overnight money markets, which facilitate very short-term loans (and which are right now paying close to no interest as a result of the Federal Reserve's easy money policy). However, some portion of that money is invested longer term--usually in very high credit-quality bonds. The CIO's role is making sure that the bank is squeezing as much water as possible out of the overnight loan market rock and that as much cash as possible is invested as prudently as possible in longer-term investments at rates higher than the overnight ones.

The losses at J.P. Morgan, in fact, seem to have occurred because of this second treasury/CIO function.

J.P. Morgan held a great deal of depositors' cash in the long-term market. Any time that one invests in bonds long term, one must concern oneself with how rates are likely to change during the course of the investment. To illustrate, if you buy long-term bonds that are yielding 5% and at some point the market interest rate on those bonds moves up to 10%, you will keep receiving $5 a year for every $100 invested, but the price of the bond will fall so that your 5% face-value bond yields 10%. (In other words, for bonds, prices go down when yields rise.) Also, in the case of a bank, rising yields mean that you will start having to pay your depositors more interest, so not only will you suffer an unrealized loss on the value of your bond position, but you will also wind up with lower profitability to boot because you are having to pay out more of that $5 worth of interest to your customer.

Because no bank wants to be in this situation, J.P. Morgan's CIO and risk managers approved a hedging transaction. Hedging means to make a transaction that will damp the effects of a sudden price movement in the securities you own. In J.P. Morgan's case, it looks like the treasury department was trying to hedge out its exposure to long-term bonds.

The most straightforward way to do this hedging is in the credit default swap market. CDSs are insurance contracts that protect the holder from financial loss if a company goes bankrupt. Inasmuch as they are insurance contracts, just like the ones you take out on your home and your car, they fulfill an important function in the financial markets. However, one weakness of CDSs is that they are traded on over-the-counter markets, and the OTC markets are not as transparent and well-regulated as public markets such as the  New York Stock Exchange or
 Nasdaq (NDAQ). Another weakness of CDSs is that the market is rather small and illiquid, especially compared with the size of the bond market as a whole.

The Birth of the London Whale
Keeping this background in mind, let's take a look at J.P. Morgan's recent problems. J.P. Morgan's treasury department, holding a large amount of corporate bonds and wanting to insulate itself from a possible future increase in interest rates, began to hedge in the CDS market. The details of J.P. Morgan's hedging strategy are a bit arcane, so I will not go into detail here, but suffice it to say that the firm was selling insurance of a given maturity and buying insurance of another maturity. These trades had to be made in a certain proportion--called the "hedge ratio"--and because the size of the bank's portfolio was so large, it had to make some very large transactions.

Obviously, the laws of supply and demand cannot be repealed in the CDS market. When a lot of something is being sold (that is, supplied) the price will necessarily go down and vice versa. Because of the size of J.P. Morgan's trades, other participants in the CDS market--mainly hedge funds and other investment banks--very soon started to see the prices on the insurance contracts change significantly (for example, imagine your $800 per year car insurance policy suddenly dropping to $600, and the $500 per year home policy suddenly rising to $750).

With prices going so wonky, hedge funds jumped at the opportunity to make arbitrage profits. Again, the details are arcane, so I will not go into detail here, but in essence, the hedge funds believed they could arbitrage the price discrepancies seen in these CDSs against related CDSs. Just when the hedge funds thought that the price discrepancy could not get any larger, J.P. Morgan entered the market again and further distorted prices (hedge ratios have to be adjusted periodically to adjust for the passage of time and the change in underlying prices). This is when CDS market participants started talking about "The London Whale."

This situation continued for some time, and hedge funds became angrier and angrier because their arbitrage trades were not working out for them and were eating up more than their share of trading capital, as well. This is when the London Whale got a new nickname in some circles--Voldemort--the evil, nearly all-powerful villain of the Harry Potter series. ​

Unwinding
In a regulated market, what J.P. Morgan had done--building up huge positions in a given product--would be illegal. You probably know it as "cornering the market" and may even recall the name of the Hunt Brothers in relation to the silver market in the 1970s. But CDSs are traded OTC, and the OTC market is--what is the euphemism?--"self-regulated." As such, the hedge funds which had built up positions against J.P. Morgan's could not request relief from a regulator and instead turned to the media. The media began to report about the London Whale, and analysts and investors began to hear about something going over at J.P. Morgan.

Meanwhile, the J.P. Morgan treasury team had also begun to realize that the market for the CDS instrument they had been using to hedge was not large enough to keep their hedge ratios up to date, so rather than rethinking the strategy altogether, it looks as if they started transacting in related and riskier, more volatile instruments. Eventually (probably just about the same time CEO Jamie Dimon was questioned about the situation during an earnings call), J.P. Morgan realized the situation was getting out of hand and reportedly sent a firefighting team from the New York investment banking division to help out its London treasury cousins. These firefighters realized the precarious position of the hedging scheme gone wild and advised that the structure should be "unwound."

So these firefighting friends of the Voldemort Whale went into the CDS market and mentioned that they would like to buy back the contracts they had previously sold and sell the contracts they had previously bought. The hedge funds, now in a position of strength, told them they would be happy to take the other side of these trades, for a price.

The price for J.P. Morgan wiggling out of this predicament has been announced at $2 billion, but one sell-side analyst has estimated that the final bill will be closer to $5 billion (and I have even seen a $7 billion figure bandied about lately). These losses will be netted out against some gains, so the end loss out of the treasury department will be some fraction of these headline numbers. (Jim Sinegal, our analyst in charge of covering J.P. Morgan, reports the company announced the net losses will be roughly $800 million this quarter, with more possible in the next quarter.) Still, the effects on shareholders have been nontrivial. Roughly $30 billion has been shaved off the market value of the firm, and the company announced May 21 that it would suspend its $15 billion stock-buyback plan.

The Moral of the Story
First, the public should not blame derivatives for the J.P. Morgan loss any more than one would blame an insurance policy when a reckless driver has an accident. People were making bad decisions and used derivatives to express those bad decisions. 

Second, if one is going to make an investment, one should understand the investment vehicle one is using. I believe that the people in charge of this strategy did not understand what they were doing and instead relied on a single number (the hedge ratio or the Value at Risk--VaR--or whatever) in a mechanistic way.

Third, although there is likely not a Wall Street executive who would agree with me, I believe this incident speaks to the need for greater regulation of what have heretofore been self-regulated OTC markets. J.P. Morgan shareholders realize there are at least 30 billion reasons why this is true (and more if you start counting up money lost during 2008-09).

Fourth, issues of liquidity and market depth do matter. Single-name option markets are not nearly as liquid as stock markets, so we as option investors must always consider how our actions in the market will affect the market as a whole, especially for smaller names with less depth in the market.

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