But when the hedge funds started buying protection on the index on the idea that prices would have to rise back up to levels suggested by the underlying market, they noticed that prices didn’t budge. Someone out in the market was selling what appeared to be an unlimited amount of protection on the index.
It’s important here to note that swaps don’t have a supply limit in the same way that many securities or physical assets have. You can run out of a certain bond or stock to sell, which can force up the price.
But a credit default swap is not limited by the supply available in the market. A swaps dealer can write new swaps to his hearts content—or until risk managers or regulators order you to stop.
We still lack many details on this trade. But what seems to have happened in the first few months of this year was that a trader at JPMorgan Chase, Bruno Iksil, was writing ever larger amounts of credit default swaps on an older index of investment grade credits. The price just kept falling—because Iksil was a bottomless pit of supply.
When prices on credit default swaps fall, a dealer can cover his earlier swaps by buying new ones from others at cheaper prices. The difference between the price of the swap you sold and the price of the swap you buy is your profit. But it’s not necessary for trading desks to actually cover to show a mark-to-market profit. If prices are falling, you show an unrealized, mark-to-market gain because you could theoretically cover your position with cheaper swaps.
It’s easy to see how a big player can manipulate this. If you can sell so many swaps that you push prices down, you are essentially writing your own profit. Of course, good risk management should pick up this kind of artificial profiteering.
A smart swaps dealer who noticed that prices on an index were out of whack with the underlying market might simply refuse to sell at that price. Customers demanding protection on the credits would be directed to prices based on the underlying credits in the index and offered protection based on those prices. Protection on the distorted price just simply wouldn’t be offered.
This may have been what happened at JPMorgan. The investment bank’s swaps dealing desk insisted on using prices that reconciled the skew between the underlying market and index, quite sensibly assuming that the two would eventually come back together. But Iskill may have been using the prices he was creating through his bottomless book.
Proper internal controls should have made this impossible. We don’t know how long the price discrepancy lasted. But at some point, it should have been caught and the traders at the dealer desk and at the CIO office forced to reconcile the prices.
Apparently, this didn’t happen. JPMorgan’s internal controls didn’t harpoon the London Whale. Instead, it learned of the trading from press reports and initially dismissed them as a “tempest in a teapot.”
One thing you can be confident about: there’s still a lot more we need to know about the London Whale’s trading before we can be confident how big a problem this is for JPMorgan.
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