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In JPMorgan Chase Trading Bet, Its Confidence Yields to Loss

When reports emerged in the first week of April that a JPMorgan Chase trader in London was making bets so big they were distorting a little-known market in credit derivatives, an embedded regulator approached executives.

Jamie Dimon
Scott Eells | Bloomberg | Getty Images
Jamie Dimon

The senior supervisor of the Federal Reserve Bank of New York, one of roughly 40 Fed officials who work inside the bank, was told that senior management was not overly concerned about the reports, according to a person briefed on the matter.

The executives had been assured that things were fine by Ina Drew, the bank’s overall chief investment officer, and Bruno Iksil, the so-called London Whale leading the trade. Jamie Dimon, the chief executive, who had been traveling in Dallas and Atlanta that week, returned to tell analysts that the reports were “a complete tempest in a teapot.”

That would soon change. A week and a half later, top executives in a conference room on the 48th floor of the bank’s Park Avenue headquarters realized they had a problem.

Losses were mounting on the trade as hedge funds’ bets against the bank turned profitable. Conference calls between New York and London were not producing satisfactory answers. A team of risk officers now referred to as the Navy Seals began meeting twice a day, at 8 a.m. and 4 p.m., with Mr. Dimon frequently in attendance.

The trading unit, called the chief investment office, was a star performer within the bank, producing profits even while intended to mitigate risk. But questions were being raised about what the trading unit was telling top executives in New York. Concerned risk executives began producing an analysis of the “Whale” trade every day and updating the New York Fed.

JPMorgan also contacted the Office of the Comptroller of the Currency, the national banking regulator, and Securities and Exchange Commission officials.

People inside the firm say that Ms. Drew campaigned vigorously to keep the trade on initially. These same people now say she and some of her colleagues are likely to be fired or forced to resign; however, no decisions have been made.

The mistakes “were self-inflicted, and this is not how we want to run a business,” Mr. Dimon said on Thursday evening when the bank disclosed that it had at least $2 billion of trading losses as a result of the strategy. The bank warned that the losses could grow, and further market turmoil on Friday threatened to add to the tally.

While the loss is not a huge threat to a bank as large and powerful as JPMorgan, whose shares tumbled 9.3 percent on Friday, it is a stark reminder that the banking system remains vulnerable to market shocks more than three years after the financial crisis. It has heightened concerns that big banks continue to make risky financial bets that could threaten the economy.

And additional fallout potentially awaits JPMorgan. The Securities and Exchange Commission recently opened a preliminary investigation into JPMorgan’s accounting practices and public disclosures about the trades, according to people briefed on the matter, who spoke on the condition of anonymity because the case is not public.

The inquiry, which is being run out of New York, will probably examine the bank’s past regulatory filings about the internal unit that placed the trades, as well as recent statements from the firm’s top executives.

The surprise loss and the regulatory scrutiny has now swung a harsh spotlight on a unit of JPMorgan that few people outside Wall Street knew existed.

The unit, which employs fewer than 40 people across the bank’s international offices, was created to manage the bank’s exposure to complicated global financial transactions, like interest rate changes and currency movements.

And unlike JPMorgan’s deal-making investment banking unit, the chief investment office was supposed to keep its head down, carrying out trades that protected the bank from the volatility caused by the recent financial crisis, according to two people with direct knowledge of the matter, who spoke on the condition of anonymity because they were not authorized to speak publicly.

Yet what began as a way to hedge against risk has turned into a major liability. Many of the problems can be traced to the aftermath of the financial crisis.

In 2007, the bank hired Achilles Macris of Greece, who previously was the head of global capital markets at Dresdner Kleinwort Wasserstein. He was charged with running the unit’s European operations on the sixth floor of JPMorgan’s offices near St. Paul’s Cathedral in London’s financial district.

As part of an expansion, Mr. Macris turned to a number of former hedge fund and investment banking experts to bulk up the European team.

Under the leadership of Mr. Macris in London and Ms. Drew in New York, the group’s exposure to financial markets ballooned. Ms. Drew — one of the highest-ranking women and one of the highest-paid executives at the bank, making $15.5 million last year — is widely viewed as a natural trader with an eye for unusual opportunities to strike a profit.

The business’s investment securities portfolio more than tripled to $356 billion in 2011, compared with $76.5 billion in 2007, according to company filings. The rise was in part a result of the extra exposure related to JPMorgan’s acquisitions of Bear Stearns and Washington Mutual in 2008.

The unit’s exposure to risk also rose sharply. The group’s average “value at risk,” or the amount the unit could potentially lose on any given day, stood at $57 million in 2011, according to company filings. That is just shy of the $58 million of average value at risk at JPMorgan’s much larger investment banking business, which includes the firm’s trading units.

Mr. Dimon knew about the expansion of the unit, whose increasing risks didn’t raise concerns presumably because its profits were rising.

In 2009, the unit’s net income peaked at $3.7 billion, up from $1.5 billion the previous year. The jump in earnings in 2009 resulted from large purchases of mortgage-backed securities guaranteed by the United States government, according to a company filing. Net income for last year totaled $411 million.

Last summer the chief investment office began calling brokers at several Wall Street banks, the brokers say. The office was offering to sell insurance on an index of big American corporations like General Mills, Alcoa and McDonald’s — known as CDX IG Series 9. If the companies in the index went bankrupt, JPMorgan would have to pay out, but if the companies continued to do well JPMorgan could rake in the fees from financial firms that bought the insurance.

The strategy initially made money for JPMorgan and its position began to grow, as did an appetite for it among a tight-knit segment of hedge fundsfocused on credit opportunities. The large scale of the trade was permitted as a result of an expansion in the limits placed on the size and the scope of securities the unit could trade in that were adopted after JPMorgan acquired Washington Mutual in the financial crisis. Those limits have now been scaled back.

By January, these hedge funds were getting calls nearly every day from brokers representing the chief investment office, according to hedge fund managers and brokers on the calls.

The seller’s identity was not supposed to be known, but the sheer volume of the trade made it hard to hide, and soon enough all fingers in the “small, clubby world” of credit hedge funds pointed to Mr. Iksil’s desk at JPMorgan, according to one fund manager.

“A bunch of us started looking at it and talking about it a lot,” the manager said. “There was agreement that Bruno was selling.”

There were two ways that JPMorgan could win this bet. If the companies in the index did well, the bank’s cost of insuring the index would continue to fall. JPMorgan could also artificially drive the price lower by continuing to issue more and more insurance — a distinct possibility thanks to JPMorgan’s size and stature.

In January and February, as the price of the insurance continued to drop, lunch meetings and casual conversations between hedge fund managers swirled around the ability of JPMorgan to continue financing this bet.

“A lot of people told me it was a foolish trade,” said an official with a hedge fund that bet against JPMorgan. “The naysayers on this trade said, ‘Look, this guy has unlimited firepower, he can just keep selling and selling and make your life miserable.’ ”

Among the hedge funds that began taking positions against JPMorgan were Blue Mountain, a New York fund; Lucidus Capital Partners, a London fund; Hutchin Hill, a New York fund; and Bluecrest, a giant London hedge fund founded by two former traders on JPMorgan’s proprietary trading desk.

The trade did not at first make money for the hedge funds. In the improving economy early in the year, the hedge funds had to make regular insurance payments. But in late March, doubts about the economy began to swirl, and the index jumped.

JPMorgan began seeing losses by the end of the first quarter, on March 31, but they were not enormous, allowing bank executives to shrug off the early criticisms of the trade. But the trade drew increasing attention as the index continued to spike, multiplying JPMorgan’s potential losses if it had to pay out on the insurance.

Soon United States and British regulators were talking daily with bank executives. (The New York Fed has been following the chief investment office practically since its inception, as part of its regular supervision of the firm.)

The Securities and Exchange Commission investigation is at an early stage. No one at JPMorgan has been accused of any wrongdoing.

An important avenue for the S.E.C. investigation, people briefed on the matter said, is the firm’s accounting methods relating to the trades. Investigators could take a close look at how the bank reported risk for the chief investment office and whether changes it made to that measure were adequately disclosed.

In the first quarter, JPMorgan changed its risk measurement to one it felt was more in line with recent regulatory changes involving capital requirements. Yet the bank had issues with the model, and Mr. Dimon said on Thursday that it was later deemed “inadequate.”

JPMorgan, said a person briefed on the matter but not authorized to speak on the record, did not need regulatory approval to change its risk model, but eventually would have to. Other firms said they tended to work in concert with regulators when altering this model.

The change clearly masked the risk of the trades now under the microscope. Mr. Dimon disclosed that the daily value at risk for the trading unit had almost doubled, from an average of $67 million for the first quarter, to $129 million, after the bank scrapped the new model and revised the figures.

One senior Wall Street executive speculated the change might have assigned a lower risk weighting to big trades, allowing the bank to take more risk than it should have in recent months.

In the case of the trade that generated the huge loss, the insurance on the contract does not come due until 2017, so JPMorgan could potentially hold off any actual losses until then. If the economy improves, the cost of insuring American companies could drop again. But now that the London Whale’s trade is public, hedge funds could force the cost of this specific insurance contract up, and with it JPMorgan’s paper losses. This is what appears to be happening now.

On Friday, the insurance index spiked sharply, bringing it up 32 percent from its low in March.

“There are no buyers or sellers in the market right now. Because of that, it is impossible for JPMorgan to get out of this trade,” said Gennaro Pucci, who oversees the PVE Macro Credit Fund in London. “These positions, which made sense for them to put on, just become impossible to manage when liquidity dries up.”

A senior Wall Street executive said on Friday: “JPMorgan violated the cardinal rule of risk: Don’t become the market.”

Reporting was contributed by Azam Ahmed, Susanne Craig, Michael J. de la Merced, Julie Creswell and Nelson D. Schwartz.

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