JP Morgan's $2 Billion Loss, Explained
Originally published on Fri May 11, 2012 12:17 pm
What just happened?
What was the trade?
The trade came to light earlier this year, when reports surfaced of a "London Whale" — a trader at JPMorgan who had accumulated a position so big it was affecting the whole market.
The trade involved an index of corporate credit default swaps. These are essentially insurance policies that pay off if a company can't make payments on its debts. (Credit default swaps became a household name during the financial crisis, when they were central to the blowup of AIG, a giant insurance company.)
JPMorgan took the big hit when it tried to back off from the trade and had to sell at a loss.
Doesn't the Volcker Rule ban banks from this kind of trading?
The Volcker Rule, adopted after the financial crisis, will ban commercial banks from "proprietary trading" — using their own money to make speculative bets.
But the rule allows banks to make trades to hedge their risks. JPMorgan, not surprisingly, argues that this trade was a hedge gone wrong, not a speculative bet.
As regulators have been writing the details of the Volcker Rule, there has been a big debate over what counts as a hedge and what counts as a speculative bet.
Those pushing for a strict version of the rule argue that, to count as a hedge, a trade must hedge against a specific risk. So, for example, if a bank made a loan to a company, it could buy insurance that would pay off if the company defaulted on the loan.
The banks have been arguing for a broader definition. They want to be able to make trades as a hedge against their entire portfolio, not against particular, specific risks.
That's exactly the argument JPMorgan made about the trade that just went bad.
"The purpose of this is to hedge the macro risk of the company," a JPMorgan exec told ProPublica last month. "It's what we are supposed to be doing."
What's the bottom line?
JPMorgan has more than enough money to cover the loss it announced yesterday. The bank made nearly $6 billion in profit in the first quarter of this year alone. And other profitable trades mean the bank's current net trading loss is less than $1 billion.
But the news is likely to have an impact beyond the numbers.
It will hurt JPMorgan's reputation. Less than a month ago, CEO Jamie Dimon called media coverage of this trade "a tempest in a teapot."
Cut to yesterday's conference call: "The portfolio has proved to be riskier, more volatile and less effective as an economic hedge than we thought," Dimon said. "There were many errors, sloppiness and bad judgment."
JPMorgan has widely been viewed as the best risk manager among the big banks. Throughout the financial crisis, JPMorgan made a profit every quarter.
This mistake will not only dent this reputation. it will give more credibility to those arguing for a narrower implementation of the Volcker Rule to restrict the trades banks can make with their own money.