How Bank Handles Bad Bet Is Fraught With Peril
“If I go there will be trouble, and if I stay it will be double.”
That dilemma, grittily framed by the British rock band the Clash, could serve as a warning to JPMorgan Chase as it considers what to do with the soured bet that has already produced $2 billion of losses.
When a trade goes bad on Wall Street, the advice is typically to sell the holdings and bear the short-term pain. After all, the situation may only get worse if the bank maintains the position.
But the “cut your losses” approach may seem unappealing if the trade is too large. A bank that is forced to dump an outsize position could drive prices lower, increasing the size of its eventual losses.
Either way, a financial firm must weigh the unpredictable nature of the markets. Even a somewhat stable trade can later show large losses under adverse conditions.
“We’re going to be prudent about any of our moves,” said Matthew E. Zames, the JPMorgan executive who was tapped Monday to replace Ina Drew as the leader of the chief investment office, the trading group responsible for the losses.
JPMorgan’s response may depend on the makeup of the trade, and the bank is being extremely guarded about the details of the position. The bank’s chief executive, Jamie Dimon, wants the public to believe that the situation is under control. On a conference call last week, he suggested the bank was going to try to ride out the trade, even though it could produce losses of at least an additional $1 billion this quarter.
“We’re going to manage it to maximize economic value for shareholders,” Mr. Dimon said. “We’re willing to hold as long as necessary.”
Selling out of a bad trade is possible. In early 2008, the French bank Société Générale announced that the rogue trader Jérôme Kerviel had lost $7.2 billion after he made several unauthorized transactions. The bank got out of all of Mr. Kerviel’s positions before announcing the losses.
But there are indications that the JPMorgan trade has become too big to sell without piling up even more losses.
“The position may not be simple to liquidate,” Guy Moszkowski, an analyst at Bank of America Merrill Lynch, wrote in a note after the conference call.
The JPMorgan trade focuses attention on an opaque market for credit derivatives, which are financial instruments whose value is tied to the price of corporate bonds. Investors buy such derivatives as insurance against corporate defaults.
"This trade, although large, is certainly not substantial enough to cause a problem in the context of our capital. "
The chief investment office was making both bullish and bearish bets on corporate debt, using an index of credit derivatives called the CDX IG Series 9. It appears the bullish betstarted to prompt big losses toward the end of April. At the time, the CDX index showed that the cost of insuring against company defaults was rising, a bearish signal. Given the size of the losses, people involved in the market surmise that JPMorgan’s bullish bet is substantially bigger than its bearish bet.
It is unclear just how large JPMorgan’s position is, but people involved in the market figure the bank dominates this part of the credit market. So even small moves in the index can prove costly to JPMorgan.
In addition, some analysts said they think JPMorgan focused its bearish bets on CDX indexes that mature within the next 12 months, while its bullish bets were on indexes that do not mature for a number of years. That mismatch could leave JPMorgan more exposed if the corporate market deteriorates.
Numbers buried in JPMorgan regulatory filings may provide some support for these theories. At the end of the first quarter, JPMorgan had a $149 billion net bullish position in credit protection, a figure that subtracts the bank’s bearish positions from its bullish ones. That is up from $66 billion at the end of 2011, a 126 percent increase. Most of the increase came from credit insurance that matures in five years or more. This suggests that the bank made an unusually large bet in the first quarter. JPMorgan did not comment on the numbers.
Other JPMorgan filings are flashing danger signs, too. The bank uses a metric known as value at risk as an early warning indicator for potential trading losses. In the first quarter, the chief investment office reported its maximum value at risk was $187 million, which represents the estimated daily loss in a highly stressed case. That was up from $80 million in 2011. The first-quarter figure also dwarfs the value at risk readings elsewhere in the bank.
It is hardly a fail-safe measure. The metric greatly underestimated losses in the financial crisis.
JPMorgan’s next move depends on what happens in the credit markets. If investors become fearful about companies’ prospects — not unlikely given the sovereign debt crisis in Europe — JPMorgan’s bet could face even bigger losses.
For now, Mr. Dimon is not panicking. “Clearly, markets and our decisions will be a critical factor here,” he said last Thursday. “Hopefully, this will not be an issue by the end of the year.”
Mr. Zames repeated his sentiments Monday. He has faced a crisis before. He was a trader at Long-Term Capital Management, the hedge fund that nearly collapsed and had to be bailed out by banks in 1998.
“I’ve never forgotten the lessons of 1998,” he said. “This is not all that similar to Long-Term, frankly.”
“This trade, although large, is certainly not substantial enough to cause a problem in the context of our capital,” Mr. Zames added.
JPMorgan may be proved right. But at the moment, the bank’s trade is at the mercy of the markets.
Kevin Roose and Susanne Craig contributed reporting.