J.P. Morgan has fallen suddenly from its pedestal. The bank that dodged most of the bullets during the 2008 financial crisis has now joined the giant trading loss club. And it occurred using the same kind of derivatives that played a key role in the crisis that led to the great recession.
The bank held a conference call last night to coincide with the release of its Form 10q to confess that it will post a loss of $800 million in the second quarter, instead of the $200 million profit it had predicted previously.
It could get worse. “It could cost us as much as $1 billion or more [in addition to the $800 million lost already]," Dimon said. “It is risky and it will be for a couple quarters.” As J.P. Morgan unwinds its position, losses seem likely to worsen.
Needless to say, the cause was the chief investment office (CIO) with its $350 billion of "hedging investments" staffed by the likes of Bruno Iksil and Achilles Macris. During the first quarter conference call, Jamie Dimon said all the fuss about Bruno’s big positions was a “storm in a teacup.” Apparently not.
There’s a lot of speculation about what went wrong for Bruno, Achilles et al. Reuters has spoken to “two financial industry sources in Asia” who say they heard that “the J.P. Morgan trader” took a position that a credit derivative curve, part of the CDX family of investment grade credit indices, would flatten, but was caught out by unexpectedly sharp moves at the long end.
Equally, however, there seems to have been a risk modelling issue going on. Dimon implied yesterday that VaR had been mis-measured in the past quarter and that new VaR models introduced in the quarter were being withdrawn and the bank was reverting to its old ones.
J.P. Morgan’s 10Q shows the bank had only one day of (big) market-risk related losses last quarter. Alphaville points out that the reworked VaR in the CIO office averaged $129 million in Q1 2012, compared to $60 million in Q111 and $67 million as originally estimated.
Fortunately, J.P. Morgan has a fortress balance sheet, so it’s all fine. $2 billion may have been lost but Jamie Dimon pointed out that they still have $430 billion in liquidity on hand. Nevertheless, it’s all a little reminiscent of the panicked conference calls and sudden losses of the financial crisis, and there will be consequences.
1. Senior management looks incompetent.
In the first place, Jamie Dimon has lost his sheen. So has CFO Douglas Braunstein. In the wake of the first quarter conference call where both offered lots platitudes about just how innocuous the CIO was, both men look duplicitous, or out of touch. Or both.
“It’s a complete tempest in a teapot,” Dimon said, to recap. “Every bank has a major portfolio, and in those portfolios you make investments that you think are wise.”
“These positions that you’ve all been writing about are just simply part of that structural credit book, which, by the way, we’ve been reducing over time, and we are very comfortable with the positions that we have,” soothed Braunstein.
Bloomberg reported a few weeks ago that the CIO was Dimon’s baby and that he’d pushed the unit to seek bigger profits by buying higher yielding assets. Dimon should have kept closer tabs on what was happening there. In the circumstances, saying, ”I am not sure how many times I can say this: It was bad strategy, executed poorly,” which violated the “Dimon Principle,” seems insufficient.
Dimon’s armor is dented. Repercussions are unlikely to be immediate. If compounded by further errors, this could prove the beginning of the end.
2. Jamie Dimon’s been irritating U.S. politicians for some time. They may sense blood and increase regulation further.
Jamie Dimon’s spent a long time expounding his opinion that U.S. banks are unfairly targeted by U.S. rule makers and that the shackles binding them are too restrictive.
The loss suggests the shackles may not be binding enough. “The enormous loss J.P. Morgan announced today is just the latest evidence that what banks call ‘hedges’ are often risky bets that so-called too big to fail banks have no business making,” Sen. Carl Levin (D., Mich.), chairman of the Senate Permanent Subcommittee on Investigations and co-author of legislation that limits trading activities of big banks, said promptly yesterday.
Rules could yet be tightened as a result, further constraining banks’ ability to make (or lose) money. Reuters points out that the Federal Reserve wants to limit banks’ tri-party repo exposure to one another, but has so far resisted doing so.
3. The Volcker Rule may become more stringent.
It’s not clear whether the Volcker Rule could be strengthened at this stage, but Dimon was at pains to say the activities of the CIO were in adherence with it.
The Financial Times points out that this seems a serious loophole. Corporate offices like the CIO invest public deposits that the government guarantees: it’s subsidized capital. Banks need to hedge these investments, but J.P. Morgan’s hedge has lost $2 billion in a few weeks. And this is triple the net income last quarter from J.P. Morgan’s consumer and business banking division.
4. Heads will roll.
Bloomberg reported last month that J.P. Morgan had already been cutting "risk taking traders" from its CIO. It’s now planning to cut a few more.
Dealbook has a list of all of those who may yet find themselves in the firing line. First among them is Bruno Iksil. Second is Michael Cavanagh, head of treasury and security services. Third is John Hogan, chief risk officer. Fourth is Douglas Braunstein, CFO. If Braunstein goes, Dimon may be vulnerable. It’s not clear what’s happening with Achilles Macris.
5. Risk modellers will increase in status.
As we noted above, J.P. Morgan’s losses seem to have something to do with poor risk models. Basel is reviewing whether banks should replace their VaR models with something better. Doing so may itself be fraught with risk.
6. Risk aversion will increase everywhere, and revenues will stagnate.
Other banks will be doubly careful about the risk on their treasury trading books. Any revenue boost from this area will disappear.
“With banks building up the level of securities, other banks could similarly be stretching for revenues. We reiterate our view that this decade will show the worst revenue growth for banks since the decade of the Great Depression; either banks accept this fate or stretch for returns (as did MF Global) and suffer the consequences,” say analysts at CLSA.
7. Treasury traders have absolutely no hope of getting paid based on their profits.
Treasury traders don’t get paid particularly well anyway. Any hopes that this would change have now been dashed.
J.P. Morgan spokesman Joseph Evangelisti told Reuters the bank already uses "pay formulas" to mitigate the risk that staff in the Chief Investment Office might be tempted to make risky profits. The same apparently applies to traders elsewhere. Except for people handling the bank’s private equity investments, “no one at J.P. Morgan is paid on their profits and losses,” he said.
8. French traders will be shunned.
Bruno Iskil was French. So was Jerome Kerviel. So was Fabrice Tourre. French traders are already complaining of persecution.
9. J.P. Morgan’s deferred bonuses are suddenly worth less.
As of yesterday, J.P. Morgan’s shares were down 7.5 percent. The good news is that J.P. Morgan pays a very large proportion of its bonuses in cash.
10. Goldman Sachs suddenly looks more appealing.
We’ve been saying for a while what a wonderful place J.P. Morgan is to work at if you’re a trader.
The bank has unquestionably done a good job of earning consistent trading revenues outside the CIO. However, risk may now be reined in across the bank and the fact is that J.P. Morgan has had a big blowout – one of the worst ever. Goldman hasn’t.