The release of the 132 page internal report by JP Morgan on the losses incurred by the so called “London Whale” offers investors and regulators a unique learning opportunity. The last 20 years of banking history includes many known tales (and likely many more unknown ones) of “rogue traders” and large trades gone wrong, with derivatives a feature in almost all of them. The decision by JP Morgan to release the report may have been somewhat political as it casts the blame on departed employees. Regardless, for outsiders the disclosure of such detailed information is a goldmine for understanding this incident and the many other similar incidents in recent decades. Whilst banks will be quick to say that they have taken action in response to such an incident, the frequency of these incidents implies that there is a deeper problem in the financial industry that is never addressed.
Drawing on the facts and opinions disclosed in the JP Morgan report, this paper seeks to explain how the losses occurred and what lessons can be learnt. The paper begins with a background on the derivatives involved and the risks that JP Morgan was taking. The next section presents a timeline of how and why the derivative prices changed during the course of 2011 and 2012. It also discusses the response of JP Morgan and other market participants to the price changes, and to the knowledge that there was a massive participant in the market (an employee of JP Morgan colloquially referred to as the London Whale) who was heavily exposed to such price changes. Finally, the paper identifies five key lessons that investors and regulators can learn from JP Morgan’s losses.
During 2011 the JP Morgan Chief Investment Office had bought insurance (i.e. short risk) to protect against a widening of credit spreads, which would be expected to occur if the global economic outlook deteriorated. This is a rationale thing for a bank to do, as if the economy declines defaults will increase and bank profits will decrease. At the end of 2011 JP Morgan senior management decided that this short risk position was no longer required and that the Bank should instead move to a neutral position. JP Morgan was also trying to reduce its risk weighted assets (essentially the amount of exposures and loans with risk weighting factors applied) to free up balance sheet equity. The derivatives involved in the short risk position created an exposure and thus required capital to be held against them.
The traders responsible for making this happen estimated that it would cost $500m to reduce risk weighted assets by 25% and to neutralise the short risk position. This was partly due to JP Morgan being a large participant in the derivatives that comprised the short risk position, and that conducting trades of such size would move the market. Rather than accept the estimated cost, trading staff were asked by the head of the Chief Investment Office to find alternative ways to achieve the dual outcomes. After minimal time investigating the options, the traders offered an alternative solution which they believed would be a much cheaper way to achieve the desired outcomes.
Rather than buying the exact offsetting positions to match the short risk position, the traders proposed to go long risk on other credit indices. Put simply, JP Morgan would be short risk on US high yield indices (credits rated below BBB-) and long risk on US investment grade indices (credits rated BBB- and above). The hope was the two indices would largely move in tandem and that the expected gains on the long investment grade indices would roughly offset the expected losses on the short high yield position. Senior management signed off on the alternative solution and the traders began to implement the strategy in mid-January 2012.
The crossover of names between the two main indices they traded was very low and the maturity dates of the two main indices were also mismatched. This introduced meaningful basis risk to the position, that is a risk that comes from the hedge being less than perfect as the offsetting items do not fully correlate. This was not an outright apples and oranges mismatch as there was a level of similarity and correlation, but it could be described as a case of mixing red apples and green apples and hoping that that no one noticed the difference. The models that JP Morgan used at the time assumed that the long and short positions were a good match, allowing for risk weighted assets to be reduced.
In the second half of 2011 markets turned fearful and credit spreads increased (that is the cost of buying insurance against credit defaults increased) as Greece appeared to be close to default. This changed around December 2011, when markets generally and high yield credit markets in particular went on a bull-run that lasted throughout 2012. In the rush to find assets that would deliver better returns than the less than 1% available on cash and medium term US government bonds, many investors, both retail and institutional turned to the US high yield market.
During 2012 the average price paid for secondary high yield bonds went from 99% of par to 106%. Whilst high yield bond prices rose materially, investment grade bonds rose comparatively less. Investors wanted yield and moving from less than 1% on government bonds or cash, to 2-3% in investment grade bonds wasn’t enough. 6-10% returns on high yield bonds seemed a much better option.
In response to the trade not working as expected in February and March of 2012, JP Morgan sought to increase its long risk position in the investment grade indices. Some of the traders viewed this as necessary defending of the position, meaning they believed that if they didn’t keep buying and increasing their holdings the market price would fall and they would suffer greater losses. This continued buying lead to JP Morgan being an outsized holder in the investment grade indices, with no real ability to meaningfully reduce their position as they had been the only buyer of such large size at their entry price.
Stories surfaced in April that the “London Whale” was a JP Morgan employee who was very long risk of one particular tranche of the investment grade indices. Other market participants took the opportunity to trade against JP Morgan in an attempt to squeeze it into crystallising losses on the long investment grade position. What had been a mark to market loss of less than $1b at the end of March 2012 (after adjusting for some dubious mark to market practices by the traders) blew out to a loss of $5.8b by 30 June 2012. JP Morgan eventually closed out the position and took the loss; its gamble to avoid the cost of buying the direct offsetting position for $500m had failed dismally.
Lessons We Can Learn
Lesson 1 – Risk Management is a Second Class Citizen
The most obvious question raised by the known facts and the report itself is “Where was the sanity check?” The risk department, the finance department and senior management never challenged the strategy and in some cases encouraged it. The risk managers involved were either significantly out of their depth or of weak fortitude, (perhaps both) with no challenge raised to the clearly mismatched trading strategy or to the outsized positions.
Whilst it is easy for the report to say that the problem has been fixed as new limits have been put in place and many more risk staff have been added, the reality is that it takes a diligent risk manager asking probing questions to discover many of the problems that hide in the dark corners of a bank. The diligent risk manager must then be brave enough to raise the alarm when something is discovered. This requires trust built through a company culture that encourages questioning of the complex and opaque risks that banks are knowingly and unknowingly exposed to.
Rather than focussing on employing and developing diligent risk managers, the vast majority of a typical risk department budget is spent on hiring armies of undertrained staff and building complex IT systems. Whilst this might impress investors and regulators, the number of risk staff with (a) direct hands on experience through the credit cycle, (b) the intelligence and experience to identify emerging material risks and (c) the gumption to call out potential problems is very few at the line management and executive levels of most banks.
Probably the biggest impediment to hiring and retaining exceptional risk staff is that they are typically paid substantially less than their sales and trading compatriots. Inevitably the smartest people in banks end up in sales or trading functions with second rate staff left to police risk taking. Exceptional risk managers are more likely to be found working for hedge funds, distressed debt funds and credit funds. In these roles their ability to uncover the problems and avoid them or exploit them delivers outperformance to their investors; results which are recognised and well remunerated. The old adage that a penny saved is a penny earned, is turned on its head in banks with a penny saved worth a small fraction (if anything at all) of a penny earned. It is almost unheard of for a risk manager to be rewarded for avoiding a big loss, but rewarding a salesperson or trader for a big gain is standard bank practice.
On the weak fortitude point, the culture of many banks is that risk staff do not generate profit, thus their opinions are of lower value than profit makers in a sales or trading function. When arguments arise between a risk manager who says no and a salesperson who says yes, the salesperson can often protest “up the line” and have their superiors talk to the risk manager’s superiors and have the decision reviewed or reversed. Risk managers who say no are often singled out as not being team players. This short sighted view ignores the possibility that that a salesperson is focussed on one-off gains and their next bonus, and is not acting in the long term best interests of shareholders.
Lesson 2 – Don’t be Wrong and Extremely Long
As long as financial markets have been operating, there has usually been someone willing to take an outsized position in the hope of an outsized gain, particularly when the capital at risk is not their own. If you are the only buyer of an asset and the only one supporting the price you are taking a substantial risk. Unless you have the fundamentals spot on and can convince others of your investment rationale being superior you could be overwhelmed and forced to sell when hit with mark to market losses. Concentration risk is not just about having diversity in your overall loan book or portfolio. It is also about whether there are other buyers willing to take your place if you change your view and want to sell. JP Morgan’s position became so big, its only real strategy was to hold to maturity and assume it had the fundamentals of the trade right.
Lesson 3 – The Fundamentals Win in the End, so do Your Homework Before Investing
At no point in the JP Morgan report is it ever mentioned that anyone had investigated the fundamentals of the various indices and had determined that they were highly correlated and the prices would always track each other closely. There is no mention that anyone checked the percentage of the names that overlapped between the two main indices that were supposed to be a hedge. Rather, it seems that a group of traders came up with an idea based on very limited research, which was green-lighted by management and risk staff without any assessment of the fundamentals.
Anyone with a basic knowledge of banks knows that people employed to facilitate trades generally have very limited time for fundamental research. The classic proof of this point is the US subprime collapse. Those who looked at the fundamentals and found awful loans being packaged up and sold were not surprised at the collapse, but many traders involved talked of a 25 standard deviation event as if the collapse was completely unforeseeable. In this instance, JP Morgan willingly entered into an unknown risk with an unknown potential for loss and suffered enormously for not doing its homework.
Lesson 4 – Derivatives are not a Panacea for Every Risk
The mixed messages from the head of the Chief Investment Office to the traders over what outcomes were most important is an issue highlighted in the JP Morgan report. Traders were encouraged to establish a position at little or no cost that did something that would have otherwise cost $500m to hedge perfectly. Derivatives are not a panacea for making risks disappear. Derivatives are an alternative way that businesses can go long or short a particular risk, which may or may not be a good hedge for the actual risk they are trying to offset. In an effort to save $500m, JP Morgan’s creativity saw it lose something in the order of $5.8b.
Lesson 5 – Compensation is Always an Issue
The report concluded that compensation was not an issue in this case. This assertion defies common sense implying that the traders involved did not think they would be rewarded any less if they said “There is no other suitable solution, we need to spend the $500m” rather than “We think we’ve found a way to do this at no cost.” It also defies common sense given the traders were found to have been manipulating the valuations for the March 2012 quarter end. Would pride alone explain their desire to cover up the extent of the losses?
For any salesperson or trader, their individual profit or loss directly impacts and is typically the biggest contributor to their bonus and to their ongoing employment. The bias is almost always to delay the losses to the next quarter or year (if possible) and bring forward future gains to the current period to maximise their bonus prospects. It should not surprise anyone that the traders involved stretched the rules on marking to market their positions towards the end of the March quarter. Neither should anyone be surprised that they took such a gamble with other people’s money when they likely stood to gain handsomely if their creativity in generating a solution “saved” their firm $500m.
For many people, the most surprising aspect of the “London Whale” incident is that an institution as highly regarded as JP Morgan allowed such a gamble to be taken with shareholders’ money after it had performed so much better than its peers in the financial crisis. For those who know the culture and behaviours of commercial and investment banks generally, this would not have come as any great surprise. The behaviours and culture common amongst almost all institutional and investment banks have long encouraged short term profits and speculative risk taking, and will continue to do so until fundamental reform is forced upon them. This reform will need to filter right through the industry and through the management hierarchies of each bank to have any chance of changing a deeply embedded industry culture of taking great risks using a highly leveraged capital base.
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This article has been prepared for educational purposes and is in no way meant to be a substitute for professional and tailored financial advice. It contains information derived and sourced from a broad list of third parties, and has been prepared on the basis that this third party information is accurate. This article expresses the views of the author at a point in time, and such views may change in the future with no obligation on Narrow Road Capital or the author to publicly update these views. Narrow Road Capital advises on and invests in a wide range of securities, including securities linked to the performance of various banks.