JPMorgan Chase & Co.
- Pages: 12
- Word count: 2961
- Category: Credit
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JPMorgan Chase & Co. is the leading financial services firm in the world with operations in over fifty countries. It was founded and based in the United States where its corporate headquarters is located in New York City. It has six core businesses: Investment Banking, Retail Financial Services, Card Services, Commercial Banking, Treasury & Securities Services, and Asset Management (JPMorgan Chase & Co.). This bank came to be JPMorgan Chase & Co. in 2000, when the Chase Manhattan Bank, originally founded in 1799, merged with J.P. Morgan & Co., originally founded in 1871. It also had many predecessors such as Chemical Bank, Bank One, and Manufacturers Hanover Trust Co. (JPMorgan Chase & Co.). Over the years, JPMorgan Chase & Co. played major roles in certain transactions and events.
For example, this bank was involved in the First World War where it helped the British and the French by arranging a $500 million Anglo-French loan which was, at the time, the largest foreign loan in Wall Street history (JPMorgan Chase & Co.). It also supported the European Allies by becoming their purchasing agent. Furthermore, many of its predecessors helped revolutionize banking throughout the years. For instance, they introduced automated teller machines (ATM), helped in the formation of electronic banking networks, and helped pioneer the earliest forms of online home banking services (JPMorgan Chase & Co.). Moreover, there were key mergers and acquisitions that shaped the company. Some acquisitions include Bank One (2004), Washington Mutual (2008), and Bear Stearns & Co. Inc. (2008). Although JPMorgan Chase & Co. succeeded in becoming a global leader in many areas of business, it recently suffered a steep downfall due to derivative trading.
Derivative Debacle Overview
In May 2012, Jamie Dimon, CEO of JPMorgan Chase & Co., announced a trading loss of $2 billion on synthetic credit positions (Shorter, Murphy, & Miller, 2012). The unit mainly responsible for this loss was the Chief Investment Office (CIO). This London-based unit oversees the company’s investment exposure and is therefore heavily involved with risk management such as dealing with interest and foreign exchange rate risk. It also manages certain types of credit risks that result from daily operations of different lines of business (Shorter, Murphy, & Miller, 2012) There were several people who were directly involved with the derivative debacle. Jamie Dimon played a key role since he was responsible for restructuring the CIO in a way to create a larger emphasis on making profits by dealing with much riskier financial derivatives. Within the CIO, there was Ina Drew who was hired by Jamie Dimon to be the head of the CIO. She was pressured by the CEO to switch positions from being a hedger to a speculator for the company in order to seek profit. Therefore, Drew had created the trading strategies for the unit to carry out (Fitzpatrick & Zuckerman, 2012).
While managing the CIO, Drew hired Achilles Macris as a trading supervisor in the London office. Working alongside Macris was Javier Martin-Artajo, who was the managing director. Both were responsible for carrying out Drew’s strategies and oversaw the trades (Fitzpatrick & Zuckerman, 2012). Reporting to Mr. Martin-Artajo was Bruno Iksil, a key trader in the CIO. He is known as the “London Whale” since he would take on large and risky positions when trading. As a consequence of the derivative debacle, all four individuals of the CIO left the firm shortly after the loss was reported (Fitzpatrick & Zuckerman, 2012) Investigations of the trading loss are still being performed today by institutions such as the U.S. Securities Exchange Commission (SEC) and the Federal Bureau of Investigation (FBI) (Henry & Viswanatha, 2012). Since of May 2012, the trading loss has escalated to at least $5.8 billion (Seligson, 2012). Some analysts believe that this loss can increase to upwards of $9 billion (Seligson, 2012). “Final losses will depend on various unknowns, such as the proportion of the suspect trades that have not been liquidated or unwound, future movements of the indexes, the speed at which the bank tries to unwind those trades, and the size of the subsequent losses from the remaining positions.” (Shorter, Murphy, & Miller, 2012). Events Leading Up to the Debacle
The decision making that led to JPMorgan’s major derivative loss can be traced back several years to the financial crisis of 2008. JPMorgan, being one of the largest banks in the world, issued billions of dollars in corporate debt. Due to JPMorgan’s global presence, a significant portion of this debt was issued to European corporations. After the 2008 subprime-mortgage financial crisis blew over, the global economy was left in a poor state. Global markets were weakening and had experienced significant year-over-year declines. In order for JPMorgan to protect against the default of its vast amount of European loans, a hedging strategy was needed. One of the ways JPMorgan protected itself from the risk of corporations defaulting on their loans was through the use of Credit Default Swaps. JPMorgan’s European Chief Investment Office, led by Ina Drew, purchased billions of dollars worth of Credit Default Swaps backed by a basket of corporate bonds (Seligson, 2012). In theory this hedging strategy has the potential of protecting bondholders from sustaining the catastrophic losses associated with non-payment. Unfortunately for JPMorgan, the misuse of these derivatives combined with an adverse movement in their value can also lead to drastic losses. Credit Default Swaps and their Use
In its purest form, a credit default swap can be seen as a kind of insurance policy issued by banks and taken out by investors in order to protect against the failure of their investment (Clark, n.d.). CDSs may be used for both hedging and speculating purposes. From a hedging standpoint, (as JPMorgan entered into prior to the debacle) the buyer of the swap owns the underlying asset (such as a bond) in which the swap value is based upon. The buyer then pays the seller a semi-annual fee which is called the spread in return for coverage against a credit event. Defaulting on a payment or declaring bankruptcy are two common types of credit events. If a credit event were to occur, the seller is then required to pay the buyer the face value of the asset in exchange for the asset itself (or the difference can simply be settled in cash). Therefore from a hedging standpoint, we see that a bondholder may purchase a CDS in order to guarantee that they receive their quoted coupon payments and face value or a cash settlement from the swap if these payments were to suddenly be halted. From a speculating standpoint, a buyer would enter a CDS if they believe a credit event will occur while a seller would do so if they felt the opposite. In this scenario, the buyer does not own the asset being covered by the swap and the derivative is being used purely for predictive purposes.
Credit default swaps were developed in the early 90’s by Bankers Trust (currently owned by Deutsche Bank) and JPMorgan. They were created for banks to use in order protect themselves against exposure to the default risk of large corporate loans they made to their clients. This was a very important innovation because it now allowed banks to spread large risks amongst other banks in order to prevent catastrophic losses. Times have changed and although they are still used by some as a means of hedging, CDS are overwhelmingly used for speculative purposes because credit derivatives “often allow speculators to get the benefit of high leverage for very little initial outlay” (Koszeg, 2012). This phenomenon is one of the main reasons CDS usage (as measured by gross notional amount) has increased by nearly 150 times between 1998 and 2011 (ISDA CDS Marketplace, 2011).
Like most derivatives, credit default swaps have a great amount of risk associated with them. One issue that separates these ‘exotic’ derivatives from the typical futures contract is that they have very minimal regulation such as the fact that credit default swaps are not required to be purchased or settled through a clearinghouse. This lack of regulation is the reason for the great amount of “counterparty risk”, in other words, the risk that the “counterparty will not live up to its contractual obligations” (Investopedia, n.d.). Two investors may enter into a CDS agreement, however, there is always a chance that either the buyer will cease the spread payments or that the seller may not provide the insurance in the event of a trigger.
One reason for this is due to the fact that the CDS “remain highly concentrated in the hands of a small group of dealers” and if one of the dealers exits the market (ex. Lehman Brothers), a large number of the outstanding CDS may instantly be worthless due the absence of a clearinghouse (European Central Bank, 2009). Another risk that is quite unique to credit default swaps relative to other derivatives is the “jump-to-default risk” due to the “possibility of a credit quality deteriorating all of a sudden, actual market value can increase (or decrease) relatively rapidly”. (Deutsche Bank Research, 2009) In other words, a CDS seller may go from a steady stream of spread income to having a million or even billion dollar obligation in a very short amount of time. Although these are just two of the many risks involved with credit default swaps, it is clear that a combination of poor judgment and adverse market movement can cause even a company the size of JPMorgan to sustain crippling losses. Why did JPMorgan Lose Nearly $6 Billion?
Everything starts about six years ago, when “JPMorgan CEO Jamie Dimon changed the mandate of the CIO function to seek profit”, which means they are willing to take more risk than usual (Seligson, 2012). And high-risk-taking trader like Bruno Iksil and Achilles Macris were hired. As an international bank, JPMorgan made a lot of loans to European corporations and they forecast that the global economy is starting to deteriorated. Due to this, the bank became worried about its loan exposure and a solution to this risk is to hedge by buying credit default swaps. During the global recession, a lot companies had defaulted or went bankruptcy and JPMorgan’s hedge portfolio generated about $2 billion in gains from 2007 to 2010 by receiving par value from CDS’s seller (Shorter, Murphy, & Miller, 2012). Leading up to 2011, CIO had bought a CDS on an index called the IG 9 maturing in December 2012. This CDS included up to 121 various companies on the index (Fitzpatrick & Zuckerman, 2012). But by early 2011, European corporate credit recovered back from global recession and became healthier. The sudden improvement in European market reduced the value of owning CDS since default risk was reduced. As a result, JPMorgan rapidly lost over $1 billion on the hedge side of the trade (Seligson, 2012).
To offset this loss, the Chief Investment Office decided to change its position and start selling CDS contracts on a similar index maturing in December 2017 (Fitzpatrick & Zuckerman, 2012). As they forecast that global economy is doing well after the recession, Mr. Iksil and his group decided to become more bullish on corporate credit and Mr. Iksil began selling even more CDS on the same contract (Fitzpatrick & Zuckerman, 2012). This was an aggressive bet and risk-taking. JPMorgan was no longer hedging; they became speculator because of their power in the derivative market and its massive CDS’s sell. It became so huge in the spring of this year that made some hedge funds and others to take opposing positions Just after they sell credit default protection, the European economy did not continue to grow as they forecast but instead got back into another deep financial crisis. The bank starts to lose even more money. By the first week of May, JPMorgan announced it could lose up to $2 billion. The losses keep on increasing and the company found it hard to exit the trades because its positions were so big. Some experts predict the losses could top $9 billion (Seligson, 2012).
We observe three majors’ issues within CIO that lead to this huge loss. The first one is the massive sell of CDS. Second one, Mr. Macris has stopped using the risk-control caps, which had required traders to exit positions when their losses exceeded $20 millions (Shorter, Murphy, & Miller, 2012). And finally, CIO’s shifting they Value at Rick model to a more optimistic one during the first quarter of 2012 in order to hide awareness of the level of risk that they was taking on. They changed from a model showing the unit at risk of losing as much as $129 million a day to $67 million (Shorter, Murphy, & Miller, 2012). It made a big different since it’s nearly twice. What Did we Learn from this Debacle?
To sum up, the report started with a brief company overview, followed by an isolation of the crisis’ causes. Not all of JPMorgan’s system was at fault for their derivatives crisis. Certainly, not every department. Nor every employee. It is therefore important to pinpoint responsible individuals and departments for this crisis not to repeat itself. The report then developed to discuss credit default swaps and their use. Which in turn leaded to answer why the derivatives crisis occurred. Finally, the last part of this report examines vital lessons for JPMorgan and the financial industry as a whole. The Chief investment office should address a number of challenges for JPMorgan not to see big losses occur again. First of which, the CIO management has to set clear objectives and review them on a consistent basis. Managers have to be more involved in the daily trades that take place. Managers have to repeatedly survey JPMorgan positions and verify that objectives are being met. That is a crucial task for traders to follow specific instructions and execute them accurately. Another challenge for management is to “hire to right man for the job”. CIO traders proved to be underqualified for their jobs.
In fact, “An internal review found that some of the CIO traders appear to have deliberately ignored the massive size of their trades — and the difficulty in liquidating them — when valuing their positions. The result was not reporting the full declines in the value of positions” (Horowitz, 2012). This passage, taken from an article written by David Henry and Jed Horowitz from Reuters, also demonstrates that CIO traders need to report adequate information to upper management. Moving on to the Risk management committee. The smaller risk committees and the head risk committee should meet more to resolve issues. Why bother raising such an issue? Well here is how the system works at JP Morgan: you have on one hand the Head risk committee which is located in JPMorgan’s headquarters in New York, and on the other hand you have the smaller risk committees which are distributed around a number of branches. To figure out a way where risk committees distributed across the world report with no trouble to the head risk committee is not easy. Members of the risk management committee should be hired based on their experience in the derivatives field.
According to a recent report, when Iksil, also known as the London Whale, searched for approval for his speculative strategies, managers “were happy to sign off on the trades” (Martin, 2012). In fact, three directors that oversee risk at JPMorgan were “a museum head who sat on American International Group Inc.’s governance committee in 2008, the grandson of a billionaire and the chief executive officer of a company that makes flight controls and work boots.” (Abelson, 2012), according to an article from Bloomberg. The only member with credible Wall Street experience was James Crown who was out of the industry for 25 years. JPMorgan made poor judgment when using Credit Default Swaps.
Traders bought CDS when the market was doing well and sold them when the market was doing badly. In other words, it was accumulating losses from both activities. JPMorgan brought it on itself. The CEO, Jamie Dimon, said: the trades going through the Chief Investment Office were “flawed, complex, poorly reviewed, poorly executed and poorly monitored.” (Ehrenberg, 2012). JPMorgan sought a speculative strategy because when buying the CDS, JP Morgan actually did not own the asset. Last but not least, JPMorgan has to reinstate risk-caps for traders not to go “wild” on trades. JPMorgan is one of the biggest banks in the world. For some traders to actually trade in such amateurish manners is not characteristic of JPMorgan or for management to poorly review and monitor its strategies.
Abelson, D. K. (2012, May 25). JPMorgan Gave Risk Oversight to Museum Head With AIG Role. Retrieved from Bloomberg: http://www.bloomberg.com/news/2012-05-25/jpmorgan-gave-risk-oversight-to-museum-head-who-sat-on-aig-board.html Clark, J. (n.d.). What are Credit Default Swaps? Retrieved November 26, 2012, from How Stuff Works: http://money.howstuffworks.com/credit-default-swap2.htm Deutsche Bank Research. (2009, December 31). Credit Default Swaps – Heading to a More Stable System. Retrieved November 25, 2012, from Deutsche Bank Research: http://www.dbresearch.com/PROD/DBR_INTERNET_EN-PROD/PROD0000000000252032.pdf Ehrenberg, R. (2012, May 11). Jamie Dimon Failed Crisis Management 101. Retrieved from CNN Money: http://finance.fortune.cnn.com/2012/05/11/jamie-dimon-jpmorgan/. European Central Bank. (2009, August). Credit Default Swaps and Counterparty Risk. Retrieved November 25, 2012, from European Central Bank – Eurosystem: http://www.ecb.int/pub/pdf/other/creditdefaultswapsandcounterpartyrisk2009en.pdf Fitzpatrick, D., & Zuckerman, G. (2012, May 14). Three to Exit J.P. Morgan. Retrieved November 24, 2012, from The Wall Street Journal: http://online.wsj.com/article/SB10001424052702304192704577402500885560924.html Henry, D., & Viswanatha, A. (2012, July 13). U.S. Investigates Whether JPMorgan Traders Hid Losses. Retrieved November 24, 2012, from Reuters: http://www.reuters.com/article/2012/07/13/us-jpmorgan-earnings-idUSBRE86C0G420120713 Horowitz, D. H. (2012, Jul 13). JPMorgan traders may have hidden derivatives losses. Retrieved from Reuters: http://in.reuters.com/article/2012/07/13/jpmorgan-loss-restatement-idINDEE86C07R20120713 Investopedia. (n.d.). Counterparty Risk. Retrieved November 25,