The London Whale

Publication date: 28 June 2012
Author: David Munro, Consulting Market Strategist for OANDA Asia Pacific

Tagged with: Bruno Iksil, David Munro, J.P. Morgan, London Whale, OANDA, Sallie Krawcheck

The media has had fun portraying Bruno Iksil, the notorious “hedger” from JPMorgan’s Chief Investment Office (CIO), as a whale; a large and lumbering krill-eating mammal. While his short CDS (long credit or risk-on) position in the vintage Index of North American investment grade credits was probably large relative to the liquidity of that series and possibly, his trading limits, Iksil’s long-term impact on JPMorgan could be more qualitative than quantitative. The JPMorgan ship is not likely to capsize, but the salt water splashed upon its open credit trading wound may sting.

David Munro, Consulting Market Strategist for OANDA Asia Pacific

A US$2billion loss (that admittedly could get much larger) doesn’t seem terribly significant when one considers that the CIO was managing assets in excess of US$350 billion. Bradley Keoun of Bloomberg reported that “by 2010, the VaR on his [Iksil’s] trading book was about half of JPMorgan’s entire CIO.” US$2 billion out of capital of $175 billion equals a loss of 1.1% of capital. JPMorgan will easily recover from this and probably report a significant quarterly profit, but their reputation as the gold standard in banking risk management has been tarnished.

Simplicity, Not Complexity

Most reports about Iksil delve into the details of his credit positions and itemise the credit series, corporate names, maturity, liquidity, speculate on his hedge fund counterparts, and determine whether he was increasing/decreasing/spreading risk or simply prop trading the bank’s balance sheet. While recognising that the size of the loss compared to the overall profitability of the bank is moderate, the media are drooling at the prospect that “Teflon” Dimon may finally have a bit of a comeuppance.

While the inability to comprehend complexity is a problem within financial institutions, complexity is an inappropriate excuse in Iksil’s case. In a recent Financial Times article, Sallie Krawcheck notes that “the JPMorgan loss demonstrated once again that risk measurements have struggled to keep up with complexity.” But a US investment grade credit index is not complicated. All we need to do is overlay the credit index (inverted) with the S&P 500 index and it becomes clear that, in terms of movement and, until recently, magnitude, the indices have traded identically. Indeed, many traders spread or hedge credit indices against stock indices. It would be difficult to sell the notion that a simple long futures position on the S&P 500 index is complex.

Volatility Research and Trading

Mark to Magic

JPMorgan’s CIO appears to have followed a classic self-destructive progression of authorising a rapid increase in trading capital, reducing VaR assumptions (leading to increased limits), a drift towards off-the-run securities and dodgy portfolio revaluations.

Hedge funds have taught us that their returns tend to deteriorate when their assets increase too rapidly. It takes time to develop skills and behavioural composure required to manage large sums of money. Successful small hedge fund managers often become unsuccessful large hedge fund managers.

Similarly, banks chase profits by allocating more capital to winning traders. Bruno Iksil has reportedly been a profitable trader over the years and made more than $100 million in 2011, which could have led to an increase in his limits.

The reduction in VaR assumptions that led to halved reported risk is an old trick. When historic volatility is high, switching to a recent and lower volatility measure will increase trading limits. When recent volatility has been high, switching back to a lower historic volatility measure will give you more rope. The risk manager must have been involved in doubling trading limits by halving VaR.

The decision to manage a portfolio of credit risk by selling less liquid off-the-run series instead of the liquid current series (or the series on the books) is not uncommon. Losing credit and rates traders have been known to trade illiquid off-the-run products in an effort to “repair” a portfolio, exchanging extra pips now for a difficult exit later.

The final faux pas, marking your book at levels materially different from the market and other departments at the same institution, is serious and could be the issue that puts the kibosh on aggressive proprietary trading at JPMorgan.

Conclusion

Reducing VaR, increasing trading limits, and trading off-the-run less liquid contracts are all signs that the traders and their manager are trying to increase position size in the hope of capturing larger profits. Losses were reputedly not evident due to less-than-accurate mark-to-markets. No model will uncover this sequence of events as models are often tools used to increase limits. A good dose of sober trader oversight might have helped prevent JPMorgan’s imminent detoxification.

Sources:

JPMorgan Chase And The London Whale: Understanding The Hedge That Wasn’t. Seeking Alpha, 17 May 2012. http://seekingalpha.com/article/596871-jpmorgan-chase-and-the-london-whale-understanding-the-hedge-that-wasn-t
JPMorgan’s Iksil Said to Take Big Risks Long Before Loss. Bradley Keoun, Bloomberg, 2 June 2012 http://www.bloomberg.com/news/2012-06-01/jpmorgan-s-iksil-said-to-take-big-risks-long-before-loss.html
JPMorgan’s Whale: A Tale of Two Prices. John Carney, CNBC.com, 1 June 2012 http://www.thestreet.com/story/11565517/1/jpmorgans-whale-a-tale-of-two-prices.html?cm_ven=GOOGLEN
JPMorgan Shows Fighting Complexity is Futile. Sallie Krawcheck, FT.com, 23 May 2012 http://www.ft.com/cms/s/0/3efae110-a4c0-11e1-9a94-00144feabdc0.html – axzz1x0CjSaes
JPMorgan Chase’s Huge Loss Exposes the Risky Side of Banks. Ken Bensinger, Los Angeles Times, 31 May 2012. http://www.latimes.com/business/la-fi-jpmorgan-bank-20120531,0,6221274.story
Wall Street Compensation and JPMorgan: It’s Déjà vu All Over Again. Jake Zamansky, Forbes.com, 01 June 2012 http://www.forbes.com/sites/jakezamansky/2012/06/01/wall-street-compensation-and-jp-morgan-its-deja-vu-all-over-again/
Credit Index and S&P 500 data, Bloomberg LP.
JPMorgan: Don’t Grab The Falling Knife; The ‘Whale Trade’ And What It Means For Investors. Colin Lokey, Seeking Alpha, 22 May 2012. http://seekingalpha.com/article/610491-jpmorgan-don-t-grab-the-falling-knife-the-whale-trade-and-what-it-means-for-investors?source=forbes

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