If you are the CEO of a major global bank and you have to announce a $2.0 billion trading loss, you will no doubt feel that the shareholders, regulators, and reporters are all against you. But if you announce that the loss occurred in a portfolio that just six weeks earlier was the subject of criticism in the press, and which you described as nothing more than “a tempest in a teapot”, you are entitled to feel that the gods are against you.
The gods definitely have it in for Jaime Dimon, CEO of JP Morgan Chase, the legendary “fortress balance sheet” bank that prides itself on having avoided problems during the housing bust and credit crisis of 2007-2008. Someone inside the bank blew a large cannonball through the bank’s fortress walls, and it seems likely to have been “the Whale” of the credit derivatives market, JP Morgan’s Bruno Michel Iksil.
Messr. Iksil was identified in The Wall Street Journal as the trader whose transactions were so large he was moving an entire market (hence his earned sobriquet as the Whale). According to the press reports of early April, he was selling credit default swaps on a portfolio of corporate bonds. Credit default swaps are derivatives that act like insurance products – the buyer of the swap receives a cash payment from the seller if the corporation that is the subject of the swap enters into a credit default. Messr. Iksil was betting that the credit condition of the corporations involved in his portfolio would improve over time. The buyers of this credit protection were betting the opposite – that these corporations over time would worsen in terms of credit quality, and likely be subject to credit rating downgrades. The buyers of this credit default swap index were large hedge funds, and the press implied that they were buying precisely because they wanted to be on the opposite side of Messr. Iksil’s trade. If true, this is in market terms a damning statement, because it says the professionals smelled an opportunity to gang up on the Whale and force him to disgorge his position at a large loss.
There is nothing disreputable or illegal for hedge funds to do this, though this doesn’t happen very frequently, because it is unusual for any one trader to take on so much risk that prices for all instruments in the market are affected by his trades. It is even more unusual for JP Morgan to be caught in such a situation, but this isn’t the conservative, Aaa rated JP Morgan of old. This is Jamie Dimon’s bank, a point he made clear in the press conference today when he was asked whether this trading violated what is known as the Volcker Rule, which severely limits the ability of Too Big To Fail Banks to take on market risks for their own account. “No,” said Mr. Dimon, “but it violated the Dimon Rule.” When an institution of 250,000 employees depends on one person, the chairman, to keep it out of trouble with rules he invented, too much risk is riding on the shoulders of that one person.
This is Jamie Dimon’s Baby
There is no doubt that Mr. Dimon’s hands are all over this loss, in the sense that he built up the London-based unit (the Chief Investment Office, or CIO), which is responsible for the loss. In 2005 he appointed a Chase executive, Ina R. Drew, as head of the CIO, and instructed her to become more aggressive in taking on risk. Ms. Drew is no stranger to taking on large market risks, so this was an invitation to open the floodgates, which she certainly did. Mr. Dimon admitted that in recent years the amount of investment money Ms. Drew had to play with doubled, to $360 billion (according to former employees).
Jamie Dimon was also forcefully asserting that what the Chief Investment Office was doing was not trading, but hedging. This is largely a distinction without a difference, because both activities involve taking on market risk – the risk that losses might arise from price changes affecting financial assets like stocks, bonds, commodities, foreign exchange, and derivatives associated with any of these instruments. The difference between what Ms. Drew does and what a trader does is that Ms. Drew manages the market risk that arises from JP Morgan’s balance sheet, while traders manage the off-balance-sheet risk from assets bought and sold with the bank’s customers.
In Ms. Drew’s long history as a balance sheet risk manager, which dates to her days in Chemical Bank before it merged with Chase Manhattan (which later merged with JP Morgan, all of which merged with Bank One bringing Jamie Dimon as CEO), Ms. Drew toiled quietly but effectively, hedging what were already substantial risks because of the huge balance sheets the top US banks had even in the 1980s, when she started her career.
Back then, the biggest risk to manage was interest rate risk, which was an inevitable outcome of any bank’s operations, because banks “short fund” their assets. This means if the bank has a portfolio of loans earning 5%, it is going to finance this with short term liabilities (deposits and trading instruments including derivatives) costing about 3%. The difference in earnings is known as the “interest rate spread”, and going back even decades ago, these earnings were much, much bigger than anything reported by the trading room of the bank.
What if, however, the Fed starts aggressively raising interest rates in response to an overheated economy? This has happened before in the US and many other countries, especially in response to dangerous inflationary outbreaks. If the cost of liabilities goes up to 6%, the bank cannot avoid this cost because it is short funding, meaning it rolls over its liabilities every month or so on average and its rate of borrowing quickly ratchets up to 6%. Its assets, meanwhile, are long term in nature and cannot be easily changed, so the loans still earn 5%. The interest rate spread has gone negative, which is going to cause enormous losses – again, much larger than a trading room would experience.
This is the risk Ina Drew has been paid during her career to manage. She is what is known as an asset and liability manager, and these people toil anonymously in bank treasury departments, working for the Chief Financial Officer, and not for the trading department. Typically they have not earned the enormous bonuses traders get, ironically because the size of the risks they manage – the entire balance sheet of the bank – could make them billionaires if the same bonus formula was applied to their profit-making potential as has been applied to trading activity.
Changes Come to the Asset/Liability Management World
Beginning in the late 1990s, the world of asset and liability management changed dramatically for the big banks, and Ms. Drew is a beautiful example of how the job became much more powerful.
1) With all the mergers that had been occurring, JP Morgan Chase as the surviving entity has a balance sheet in excess of $2 trillion, which is a risk to the entire US economy considering the GDP of the US is $15 trillion.
2) Ms. Drew came into her job as head of the Chief Investment Office in 2005, and a few years later after the credit crisis of 2007-2008, she was handed an asset and liability manager’s wet dream: the Fed set interest rates for banks at 0%, and more important, has now promised to keep them there until at least 2014. This has been the mother of all short funding opportunities, because there is no risk involved. The bank can keep borrowing month after month at 0% and earn the entire return on its assets as the spread. This is a back-handed bailout of the big banks engineered by the Fed, with no say from Congress or anyone else. Jamie Dimon in his press conference said the CIO has unrealized profit in its portfolio of $8 billion, and it took $1 billion of that into income to offset its $2 billion trading loss.
3) The Federal Reserve has provided yet another back-door bailout to the banks besides zero percent interest rates. With all of its Quantitative Easing programs, and its new Operation Twist program, the Fed has flooded the banks with free money, in the form of Federal Funds paid when banks sell the Fed their riskier assets. The banks are supposed to lend these reserves back into the economy, but they haven’t done so because the credit risks are too high. Corporations which have sound credit ratings don’t borrow from the banks anymore, and the consumer is already overloaded with debt that has caused big losses for these banks. So banks merely invest these reserves in financial assets, like stocks, bonds, commodities and derivatives. This is why Ms. Drew’s investment portfolio could double almost overnight to $360 billion when the bank has barely increased its lending portfolio at all.
4) Because of these developments, Ms. Drew’s unit has taken on a vital role in the bank’s fortunes. Her unit alone in some quarters has generated 25% of all of the revenue of the bank. Ms. Drew personally took home $14 million in salary and bonuses last year, and the people under her like Messr. Iksil are millionaires as well.
5) When interest rates went to zero, and when the role of the risk manager became simply that of managing the return on assets (since liabilities no longer cost anything), it is no surprise that Jamie Dimon ordered Ms. Drew and her unit to maximize this return – to find assets earning as much as possible, even if it meant taking on assets with greater credit risk.
6) The reason the bank could do this is because around 2000, banks discovered they had tools that could be used to manage credit risk, and not just market risk. The tools were derivatives known as credit default swaps and credit default options, the very tools which were used to manage mortgage risk and which blew up spectacularly when the housing bubble burst. This is where Messr. Iksil comes into the picture – he has been managing the credit derivatives portfolio, and in a sense the credit risk of the whole bank, for Ina Drew. Considering how enormous the balance sheet of JP Morgan Chase now is, if Messr. Iksil merely hedged a portion of that balance sheet, he would still be known as the Whale.
This is Why We Need the Volcker Rule
All of this sets the stage for today’s announcement of a $2 billion loss in the CIO unit. It reminds everyone of the press reports six weeks ago describing outsized trading done by Bruno Iksil. Mr. Dimon would not identify the culprit by name, and there are some indications that the problem is bigger than just Messr. Iksil – the whole CIO unit is under review. Mr. Dimon would only say that “In hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored.”
There is an awful lot of crow-eating in that one statement, and Mr. Dimon did some noticeable self-flagellation in today’s conference call. It is part of Mr. Dimon’s charm and why the analysts love him – he owns up to his mistakes. And these were, ultimately, his mistakes. He set the unit up; he charged it with increasing its risks in a big way, including using credit derivatives; he runs the bank like it’s a personal fiefdom, meaning a lot rides on his judgments about risk and return. If the strategy was poorly monitored, it is partly because the market risk oversight function of these big banks does not extend to looking carefully at what asset and liability managers do. Remember, they are “hedgers”, not traders, and the banks get caught up enough in this arbitrary distinction that they allow their hedgers to avoid the more rigorous controls imposed on trading. Which is also why Jamie Dimon has been spending months now in Washington working with the Federal Reserve to water down the Volcker Rule, which is part of the Frank-Dodd Act of bank reforms meant to prevent a replay of the credit crisis. This would also explain why the strategy at the bank was poorly monitored; in a one-person show like JP Morgan Chase, the CEO was too busy to monitor it.
Mr. Dimon did admit that this fiasco is going to revive the debate about the Volcker Rule, and perhaps undermine his careful work of exempting the CIO unit from the Rule because it is a hedging and not a trading unit. Mr. Dimon was purposely vague about exactly what the positions were, but if the press reports from April were correct, Messr. Iksil was selling credit default swaps. If he were hedging the loan portfolio and the risk that credit would deteriorate, he would be buying credit default swaps. So what was Messr. Iksil really up to? To the outsider observer, it sure sounds like speculation.
This is what Sen. Carl Levin thought, as evidenced by his statement today. “Today’s announcement is a stark reminder of the need for regulators to establish tough, effective standards… to protect taxpayers from having to cover such high-risk bets.” Sen. Levin is dead right; if a trading or hedging loss is big enough in a bank Too Big To Fail, the taxpayers must cover the loss. Good luck, however, on getting the regulators to do anything about this. The Fed will set up an investigation and tut-tut for awhile, maybe even placing Jamie Dimon in a public doghouse of shame, but it will all blow over and be forgotten, The Fed exists to carry water for these big banks, which is exactly why it was watering down the Volcker Rule in the first place.
The only outside chance something might change is if this loss gets much larger. Jamie Dimon said that is a possibility, since they are going to hold on to the credit default swap position for some time. Remember, on the opposite side of these trades are major hedge funds, and in their shark-eat-shark world, they smell wounded prey. They are going to do their best to push rates further against JP Morgan and force them to cough up even more blood. Some observers estimate the loss in that situation could reach $20 billion, and if that happens taxpayers better hold on to their wallets.
At that point Jamie Dimon would probably regret touting his bank’s fortress balance sheet and excellent risk management skills. Maybe he does already. Since his family is of Greek background, he probably understands better than most other bank CEOs that the gods inevitably punish hubris.