Understanding JPM's Blunder That Cost It $2bn & Counting
Companies / Derivatives May 19, 2012 - 11:26 AM GMTBy: Submissions
Simit Patel writes:
I feel it is imperative for all market participants to have a general understanding of how JPM's hedge blew up, something that some espouse as a black swan (think LTCM in 1998 & probably the exposing of MFGlobal's corzining of investor capital to cover losses on sour speculative bets). The MSM has been quick to cover this story on JPM's alleged felony with regards to its risk management and how a "hedge turned speculative". Whilst there are bits of true facts and opinions presented, a good chunk of it is quite literally bosom-dung. Zerohedge has put up a meticulously detailed analytical piece on how things went wrong and puts the CIO (chief investment office) decision making tree in soft focus - A must read for folks who want the fresh juice of the entire edifice on a grand scale. I'm merely going to share my analysis which contains alot of the stuff in Zerohedge's piece but also delve deeper into where more explanation is warranted. This isn't child's content, it is deep stuff (think quantitative finance) so take some time to really understand every sentence in this post and in Zerohedge's piece.
What was JPM Hedging?
Although no non-insider knows for certain, point and shoot guesses would likely be commercial loans on the books of JPM's commercial banking arm. I think this is an aggregated book meaning the portfolio of loans originated from US corporations and probably a few hundred million Dollars in consumer loans. Reasons for this is because due the CIO's hedging instrument of choice (read on for more details later). The size of this portfolio is unknown but should be huge, very huge (large enough that risk models weren't able to detect micro seismic faults before the markets turned against their hedge. I read that Jamie Dimon (JPM's CEO) has expressed willingness to testify infront of congress (remember Goldman's "$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:
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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. |
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.
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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. |
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:
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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. |
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:
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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). |
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.
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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... |
And to end things off with the FED's curse:
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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). |
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