Derivatives Trades Gone Wild: What We Can Learn About the JP Morgan Experience

May 11th, 2012 by under Uncategorized. No Comments.

The $2 billion loss in credit default swaps JP Morgan Chase sold on the Markit North America Index Grade Index is less about its potential to precipitate a crisis in financial markets as it is a stark reminder that even the purported best risk managers in the business can occasionally make huge mistakes.  And unlike Long Term Capital Management or Amaranth LLC where arcane derivatives transactions ultimately took these companies down, this episode in derivatives trades gone wild is more of a flesh wound to JP Morgan’s one highly regarded risk management capabilities than it is a systemic risk event.  Certainly it calls to mind whether other less well-buttoned down banks (or so we thought) have engaged in similar transactions and there is a virtual certainty that at some time we will observe another headline worthy derivatives fiasco at a major institution.  But what exactly can we take away from the JP Morgan experience? (For some of my additional perspectives please see the pieces below)

First, it sparks another round of debate over the Volcker Rule with regard to the extent to which banks can use derivatives in their business activities.  One thing is for sure – the transaction points out the oftentimes blurred lines between speculation and hedging which bedevils regulators in implementing the Volcker Rule.  And this will ratchet up the debate on this issue in Congress.  But it will still not offer any real solution to distinguishing what constitutes a hedge strategy versus a calculated bet.

Moreover, the lack of transparency about the nature of the transactions does not help either.  All we know is that the trades were supposed to be hedges against credit losses from other segments of the bank’s business such as from loans to companies, banks and sovereigns.  To guard against adverse credit movements in its underlying unhedged position, it could have bought CDS to protect against downward movements in the economy.  Instead the selling of CDS does not appear to be a hedge at all and may be complicated by a host of other factors not known at this time including the effectiveness of the so-called hedge.  It is unclear how correlated the CDS position was with the aggregate unhedged position which could have resulted in significant basis risk as well.

There are serious concerns regarding the level of risk and regulatory oversight of these transactions.  As these trades have been stated to originate out of the Chief Investment Office under Bruno Iksil, it is interesting that this group had been under some scrutiny in the media only a month earlier.  So, what I’d like to know is what were the risk management group and regulators doing during that period?  Why weren’t the trades in the group being dissected and analyzed well before now?  It wasn’t like this was news.  With the positions of the group in these particular CDS sitting at about $150 billion, representing between 1/3rd and 2/3rds of the total market notional value of that CDS, I find it odd that the company would have permitted that large an exposure.  In other words what were the position limits in place for this group?  That much concentration introduces all sorts of counterparty and liquidity issues, and makes it extremely difficult to unwind the transactions at those levels – again, this is a bit of déjà vu when thinking about Amaranth LLC’s situation.  In that case, aggressive traders racked up impressive short-term performance increasing positions in complex derivatives facilitated by poor models and risk oversight.  Sound familiar?

It is interesting that reports are circulating that JP Morgan had just moved to a new value-at-risk (VaR) model in the first quarter of 2012 (which is a tool risk manager’s use to gauge risk exposure under extreme conditions) which was found to be inadequate, forcing the company to go back to the original model.  So we have another example of where yet again risk models were not well developed and failed to detect elevated risk levels ahead of a problem.

The good news is markets will not crumble as they did in 2008 because of this latest derivatives mess.  But a few important points are worth highlighting.  First, despite the misstep by JP Morgan, derivatives are essential tools in managing risk and should be available to banks under tight controls.  In other words – Derivatives don’t kill markets, people kill markets.  Getting the governance, incentives, processes and controls in place for using derivatives is what is needed.  Clearly even well-run shops have trouble at this and so we need smart regulation that allows derivatives to be used for hedging risk but that reduces the over-engineering that often takes place.  Second, a firm can be burned as much by its assumptions and views of where the market may head as by the complexity of the transaction.  Thus greater appreciation for the art and the science of derivatives much occur at banks.  Third, this latest derivatives problem underscores the need for strong and vigilant risk management.  Finally, the need for strengthened micro-prudential regulation is clear.  Much time has been spent since the crisis in enhancing macro-prudential regulation, but the safety and soundness regulators face an enormous task at ferreting out risk time bombs with the staffing levels and expertise currently in place.  The spectre of the 2008-2009 financial crisis has heightened our sensitivities to bank mistakes and the attention to JP Morgan is understandably justified.  We need to use this as a case study of how to craft stronger risk management and regulatory support and implement such enhancements quickly.