“It’s exactly the kind of bet that is very difficult for board directors to understand. It reinforces concerns we have that a major financial institution doesn’t seem to have learned the right lessons from the financial crisis.”
These are the words of Richard Clayton, research director at CtW Investment Group. CtW advises a collection of US labour pension funds who, it claims, hold 6 million shares in JP Morgan.
The remark, of course, concerns JP Morgan’s highly publicized $2 billion trading loss announced this month. The loss, as far as it is understood, centres around a trade on credit default swap indices—a portfolio of credit default swaps.
How this happened is still being sought—the US bank is choosing not to offer much light on the subject—but the hit was taken in the firm’s Chief Investment Office business.
The Chief Investment Office’s purpose appears to be relatively straight forward. The bank has more liabilities (deposits) than assets (loans). It takes the difference between the two, a tidy $360 billion, and invests it in high-grade, liquid fixed-income securities.
But this is where it gets trickier. By doing so, JP Morgan would have created a series of subsequent risk exposures for itself: counterparty risk and market exposure.
Using CDS would be a typical way of hedging out the counterparty risk. But hedging it out security by security (i.e. buying CDS for every issuer you are exposed to) could be an expensive process, and one not necessary under the Volker Rule. Banks can hedge their exposures on an aggregated portfolio basis.
It is very possible then JP Morgan ended up putting on a portfolio hedge by purchasing a CDS index that did not perfectly track the underlying exposures it had.
This is not surprising. A credit default swap index contains a set list of names not designed to replicate the exposure of JP Morgan or any financial institution. Its advantage is that it is more liquid and typically trades at a smaller bid-offer spread to that of a single-name CDS. That’s the trade off.
This is what is known as basis risk. JP Morgan’s traders would have been fully aware of this. It is very possible the temptation was to buy a cheaper hedge that roughly squared off the credit exposure the bank had. This may have suited its needs and its view on the economy.
Of course, this is just an educated guess. Until the bank comes completely clean we are left to speculate. Meanwhile derivatives have been dragged through the mud once again. As Richard Clayton rightly observes, this level of complexity is hard for investors to understand.
The attitude from many treasury teams in Asia is still one of mistrust towards derivatives and the banks who sell them. Many were burnt during the credit crunch having bought products that didn’t fully hedge their market exposure. But they have to accept some degree of the blame. They did it for the sake of keeping the trade cheap. When the markets went against them, they lost money.
As I have said on a number of occasions, the cost of fully hedging your risks is not cheap and there’s no reason why it should be. A lot of companies therefore are happy to buy cheaper products that present some basis risk. They do so at their own risk.
Many are suggesting derivatives should now be even more tightly regulated. This is not helpful. The cost of doing bilateral trades will increase dramatically as it is under Basel III and it will be the corporations—the end users—that will suffer most.
Will they pay for that risk mitigation? No. More likely, they will choose either not to put on any hedges or will move to the exchanges where the products are cheaper, more liquid but are standardized and not tailor-made to suit a specific risk-profile. In other words, where there is basis risk.
Understanding exactly how JP Morgan lost its money is therefore extremely important. If it was a directional bet on the market gone wrong, then the bank needs to shamed for failing to act with due care and attention. But hopefully it won’t compel regulators to tighten the screws further as to force the innocent bystanders further away from using derivatives to hedge their exposures.
Surely that’s in the interests of all concerned, including JP Morgan.