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Understanding JPM's Blunder That Cost It $2bn & Counting

Companies / Derivatives May 19, 2012 - 11:26 AM GMT

By: Submissions

Companies

Best Financial Markets Analysis ArticleSimit Patel writes: I feel it is imperative for all market participants to have a general understanding of how JPM's hedge blew up, something that some espouse as a black swan (think LTCM in 1998 & probably the exposing of MFGlobal's corzining of investor capital to cover losses on sour speculative bets). The MSM has been quick to cover this story on JPM's alleged felony with regards to its risk management and how a "hedge turned speculative". Whilst there are bits of true facts and opinions presented, a good chunk of it is quite literally bosom-dung. Zerohedge has put up a meticulously detailed analytical piece on how things went wrong and puts the CIO (chief investment office) decision making tree in soft focus - A must read for folks who want the fresh juice of the entire edifice on a grand scale. I'm merely going to share my analysis which contains alot of the stuff in Zerohedge's piece but also delve deeper into where more explanation is warranted. This isn't child's content, it is deep stuff (think quantitative finance) so take some time to really understand every sentence in this post and in Zerohedge's piece.


What was JPM Hedging?
Although no non-insider knows for certain, point and shoot guesses would likely be commercial loans on the books of JPM's commercial banking arm. I think this is an aggregated book meaning the portfolio of loans originated from US corporations and probably a few hundred million Dollars in consumer loans. Reasons for this is because due the CIO's hedging instrument of choice (read on for more details later). The size of this portfolio is unknown but should be huge, very huge (large enough that risk models weren't able to detect micro seismic faults before the markets turned against their hedge. I read that Jamie Dimon (JPM's CEO) has expressed willingness to testify infront of congress (remember Goldman's "$hity deal" buzzword during hearings on allegations of conflict of interest; "Timberwolf securities" ect...). Let's hope more light will be shed on this very elusive subject on what was actually being hedged and in what quantities.


The Hedging Instrument of Choice
As Zerohedge pointed out, the CIO probably wanted a cheap hedge against extreme tail risk (think global systemic risk; ie: Europe falling apart; non-idiosyncratic credit risk (non-company specific credit risk); many corporates defaulting at once) that would payoff (covering/lowering cash losses on the underlying loan book) amidst utter chaos and financial cataclysm. It is much cheaper to hedge such risks in aggregated form rather than buying protection on individual names.

Zerohedge rightfully opines the CIO's sole intentions were to protect against adverse market movements which risks' cannot be immunized through conventional covered loan risk management strategies.

To wit:

Quote:
Originally Posted by Zerohedge

2) JPM traders/risk managers are not stupid - can manage curves/levels in 'normal' market but firm needs 'extreme' risk hedge.

Critically - these guys are not dummies - they don't simply buy/sell index protection or curves (as some have suggested) in ultra-massive quantities (since risk models would flash) unless there is an edge. More importantly, they can manage risk at desk levels on term structures and exposures (and even jump-to-default risk to some extent) but on the aggregate portfolio there is a lot of un-covered risk of an extreme event (which seems ever more present) occurring.

The CIO decided to long the super senior tranche (a cocktail mix of 5Y, 7Y, 10Y maturities) of the CDX.NA.IG index. CDX.NA.IG is a composite CDS index of 125 individual US corporates (reference this back to the underlying portfolio being hedged).

Zerohedge explains that the CIO chose the super senior tranche due to its relative cheapness over subordinated tranches (junior, mezzanine, equity) due to the higher leverage it offered (less funding requirements, somewhat resembling a SS tranche of a synthetic CDO where upfront payments aren't necessary because potential losses will be buffeted by the lower tranches), but more importantly SS offers "(sensitivities) to spread movements (low), volatility (medium - due to hedging gaps), and correlation (high)." Correlation risk was what the CIO was implicitly hedging against. A rise in correlation indicates increasing latent systemic risks; hence the hedge needs to be highly sensitive to correlations.

The SS tranche also protects against conterparty risk (risk that the writer of the CDSs fail to payup in a credit event). Conterparties can include SPVs that structure synthetic CDOs. Losses due to such risk will be passed to the lower tranches before it hits the SS tranche (if the losses are huge enough). Hence the CIO's decision to be long the SS tranche was based on their prescient knowledge that only deep shocks would require such hedging and the SS tranche was perfect for this purpose.

Quote:
Originally Posted by Zerohedge

These characteristics appear fantastic at first glance - not too sensitive to spread movements overall (ceteris paribus), volatility will cause some drama (as the position will need to be rebalanced), and while correlation is a big sensitivity it is directionally in our favor and has relationships in line with spreads that should help us.

The hedge would appreciate in price as spreads widen along with SS tranche correlations (IG index falls). There would be some form of payouts if any component defaults and will filter through the SS tranche before running down to the junior tranches. I would believe the CIO paid a slight upfront payment (a small percentage of the initial notional) and periodic interest payments (since CDX.NA.IG is trading on a conventional spread rather than upfront; again offering more leverage and making the hedge cheap).

Informed guesstimates of the initial notional (in the SS tranche) ranges from $200bn-$300bn. Again, no one knows the exact figure but from the monthly Depository Trust & Clearing Corporation (DTCC) report on outstanding notionals one can make a ballpark guess.


So What Went Wrong?
The CIO's hedge fared relatively well in Q1-Q3 '11 courtesy of European contagion and the Greek spillover, and the downgrade of US by S&P. Remember the panic ensuring the proverbial US downgrade (recruit pitting at Hitler's face)? Yes, as Zerohedge intelligently points out, that was just about the peak of tranche correlations as the markets settled down in a consolidation before beginning their arguably benign march higher - the bears would reminisce how odious it was.

To Wit:

Quote:
Originally Posted by Zerohedge

10) Nov2011: Fed/ECB start coord. global easing program -> starts to crush correlation as systemic risk is 'supposedly' removed from system.

And here comes the critical aspect of our story! The actions of the Fed/ECB/rest-of-world with massive and unprecedented easing efforts was perceived by the market as a tail-risk crushing event - i.e. they removed the systemic risk from the system once again.


11) JPM CIO office forced to sell IG9 protection to manage tranche position as correlation drops (think: delta rebalancing).


What this meant was very important. The tranche - which had been purchased as a hedge for JPM's aggregate (likely long) book required rebalancing as the 'models' used to price and risk manage such positions would have demanded some hedging of the hedge. This is similar to maintaining a delta-hedge on an option position as the market moves one way or another and volatility (a secondary parameter) changes. The trouble is - these systemic risk tranches are HIGHLY sensitive to this somewhat 'magical' measure.
The gist matters have already been succinctly presented by Zerohedge. The FED's Operation Twist (Maturity Extension Program) and cross currency swap lines with the ECB, and the ECB's 3Y LTRO having commenced in Dec11 proved detrimental to credit tranche correlations. IG credit (proxied as CDX IG9) rallied along with equities post the binary collusion of the two central banks. Zerohedge likened correlations to deltas (ie: RoC of an option's price relative to the underlying's). Although there are broad similarities, I would meekly note that deltas have either positive/negative empirical relationships to price whilst credit tranche correlations do not have - their relationship can be described as slightly idiosyncratic (meaning correlations may rise even if IG spreads compress, not necessarily when spreads widen). Regardless, the CIO wasn't concerned about IG spreads rising or falling but about correlations tanking to never seen before levels.

This is the bane of hedging via tranched credit products as the CIO undertook - correlations have to be dynamically managed. What was just described above marked the inflection point for matters over at the CIO's desks. As a result of a very rapid decline in correlations, the CIO needed to neutralize a good part of its 'short' credit exposure by shorting IG9 or by writing CDS protection on IG9 (same ends, different means). Zerohedge believes that the CIO did almost all of the re-balancing by shorting IG9 outright. The extreme RoC of correlations meant that the CIO couldn't sell IG9 protection in a gradual fashion that would preserve market normalcy; but rather frantically offer heavily into the index day after day after day... So much so that this operation created a gaping skew between the IG9 index and its intrinsic fair value (summation of individual names).

To wit:

Quote:
Originally Posted by Zerohedge

13) Mar/Apr 2012: JPM CIO corners IG9 index market as forced protection seller on tranche tail-risk hedge position.

This meant that the JPM CIO office began to sell more and more protection at the index level which forced the index to trade differently to its intrinsic or fair-value. These kinds of disconnect are often arb'd by sophisticated hedge funds - but this time the arbs were being frustrated by a SIZE player dominating the market and soaking up their demand for protection (the funds would be buying protection on the index - the opposite of JPM CIO - while selling the underlying names protection).
Note: Iksil (the "London (wriggly sperm) whale") was inherently "long" IG9 index because he was selling IG protection (ie: short the spread, long the index). The Zerohedge description pertaining to the arbitrage opportunities simply means that the arbitrageurs would buy IG9 protection and sell individual protection (hence "short" IG9 index and "long" corporate credit) hoping that the basis would narrow when IG9 spread eventually widens.


What happens next is from the devil within all flesh: Greed. What was a "hedge of a hedge" (IG9 protection selling) turned into a market chasing, momentum trade which Iksil was overly effervescent about. He was chasing his own tail; the more he sold protection, the harder the index was bid, the larger the 'profits' on his hedge trade, the more he sold... ad infinitum in a vicious circular reference spell.

And then things start to change fundamentally; the mirage vanished while Iksil and the entire CIO realized the hideously obscene blunder they have committed being one of the top prop trading desks on Earth. I'm going to quote Zerohedge for the following sequence of events that makes me cringe.

Quote:
Originally Posted by Zerohedge

15) European sovereign, China slowdown, and US growth risks spur deterioration in credit risk - meaning losses on IG9 index position.


Between his huge size and the velocity of the shifts in the index as things began to go wrong fundamentally, Iksil was in trouble. Not only that but 'correlation' began to pick up and so the hedge of the hedge needed to be unwound...

16) JPM CIO faces huge losses from small move in spreads since they have sold so much protection and tranche unbalanced.

He found himself the dominant long player in a market in which fundamentals, technicals (arbs), and his own models (correlation) were saying unwind/short - which starts the pain trade for Ina and Bruno and more than likely this is when the bells started to go off in risk manager's ears and Dimon got the call...
The vulture phenomenon kicks in: The Hedge funds that knew the plight JPM was in started to short the basis and with much passion indeed (not only did they buy tons of IG9 protection along side the CIO but also shorted all other related credit indices, adding more pressure to the CIO's overloaded long exposure whilst also squeezing every last but of liquidity from the IG9 market like a blood thirsty daemon in a wild, unfathomable hallucination. In the days preceding Dimon's call to inform the world about JPM's $2bn material loss, IG9 spreads started soaring ad Iksil started to unwind his then-turned speculative trade. The spike in spreads accelerated post Dimon's call. Add the broad risk-off environment that has been buffeting global equity and credit markets for the last 2-3 weeks and one would see why actual losses would uncountably surmount $2bn. Zerohedge estimates losses will be north of $3bn.

And to end things off with the FED's curse:

Quote:
Originally Posted by Zerohedge

22) Summary: JPM tail-risk hedge imploded thanks to Central Banks' Systemic Risk reduction - unintended consequence...

The key factor is that if systemic risk had remained in even a 'normal' range of possible regions based on history, then the JPM CIO office would have had no need to over-hedge their tail-risk hedge position, no greed-driven need to press the momentum, and no need for such an epic collapse as we are seeing now.

The point is - this was a trader/manager with a good idea (hedge tail risk) that was executed poorly (and with arrogance) but exaggerated by the unintended consequences of the Central-Banks-of-the-world's actions (and 'models behaving badly' as Derman would say).

My synopsis of this tragedy? Over reliance on mathematical modelling (on hedging and risk management premises), human psychological weaknesses (greed), and sheer unfortunate luck. What could have been better done? Contrary from that MSM squawk about, JPM did the right thing initially. The hedge was operationally sound (loan books need to be hedge in out current environment of heightened credit and default risk) and the dynamic management of the hedge was routine and somewhat rudimentary. However, the trimming of the initial hedge exposure should have been conducted on a broader scale. Rather than performing this operation on a single OTC and relatively illiquid credit index, it could have been diversified through shorting protection on individual names, going long synthetic CDOs on similar IG credit and then having a much smaller position outright long IG9. It is not the sole error of over positioning a trade and the posterior consequences but the decision making dynamics behind the CIO's path actions. Risks of human error were not spread out, per se and that is one of the key take away points of this saga.

© 2012 Copyright Simit Patel - All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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