There is still little publicly available information about what exactly the trade involves, but we know the following:
1. they built up a huge long position on US corporate credit, and overpaid for it (due to the sheer size of the position distorting the market.)
2. they have already incurred a 2 billion dollar loss on it, despite the fact that it has largely not been unwound and/or hedged.
3. The further cost of unwinding it and/or hedging it and/or holding it to maturity can be estimated between three and eight billion dollars, and that is … if the credit quality of US corporates does not deteriorate.
4. The Whale’s London office managed to put on this massive trade without the added risk showing up in Morgan’s risk management models.
5.Regulators did not react until last week, despite Hedge Funds raising the alarm as early as February.
So what can we glean from these points?
JPMorgan can likely – hopefully – absorb these losses, thanks to its sheer size and Ben Bernanke’s generosity at the Fed discount window. But what if a somewhat smaller, less diversified, bank had put on a similar trade? Say, a Morgan Stanley or a Société Générale? A trade with a potential loss of 10 billion dollars would have caused larger downgrades, causing higher collateral calls from counterparties, causing more liquidation of assets at firesale prices, causing further losses, and would have raised their cost of funding in the interbank market and on the bond market, and would have harmed their brand and caused star traders in other units to move towards the exits as their prospective bonuses shrink measurably, thereby hurting the future earning prospects of the bank as a whole, in turn tanking their share price and credit quality with all the negative feedback loops that entails. I.e it would have caused a full-on bank run, on a systemically important institution in an already economically volatile environment. In short, it would have been a catastrophe.
The only reason the financial system has not collapsed is that this occurred at Morgan, and not somewhere else.
A second thing worth noting is that, unlike the massive UBS and Société Générale losses of the past few years, this one seems – so far – to have been completely above board and involved no outright fraud. And that should not be a source of comfort. On the contrary, it shows that traders can find ways to put on massive, systemically dangerous, trades without triggering the internal risk controls of even the best-run banks, by using complex next-to-impossible-to-model derivative products (in this case, tranched derivatives of credit derivatives). If a star trader’s position doesn’t make the in-house risk model budge, then he gets the go-ahead. And if he peppers his trade with enough impossible-to-model instruments, then he will find a way to smuggle it through the bank’s risk controls. The only thing stopping a smart trader is his … self-restraint.
A third point, and the most worrying point, concerns the reaction of the regulators. Faced with a clear massive distortion in the derivatives markets, and despite loud cries from Hedge funds, they did not react for three months, until last week, when – presumably subsequent to JPMorgan’s consent – the Fed convened a meeting of the big banks to establish the nature of their mutual exposure. In short, the regulators have not changed their policy of letting the big banks regulate themselves, limiting their own role to that of tax-payer funded mop-up crew after the party is over and the bankers are sleeping off their hang-overs. Moreover, it now transpires that nothing in Dodd-Frank is remotely relevant to stopping this kind of behavior.
Something has to change.




65 Comments

Here’s probably the best summary of the publically available information
http://ftalphaville.ft.com/blog/2012/04/30/975551/the-remarkable-resurgence-in-synthetic-credit-tranches/
Very helpful. Thanks, and recommended.
It would be helpful if you could explain the larger exposure as they try to unwind the position. We need a good laypersons take to put this in perspective, since the $2 billion number is now commonly used, as you noted in previous comments.
1. Crime pays, for Oligarchs.
2. Democrats and Republicans have aided and provided material support to financial terrorists.
3. It is just a Big Casino built on a fragile house of marked cards. When it all collapses try to get out of the way.
4. Something does have to change, but nothing will change when everything is Top Secret for Oligarchs.
Sure. I’ll give it a shot. Just for full disclosure, my understanding is based largely on discussions with friends trading corporate CDS for a couple of hedge funds here in Geneva who took the other side of the Whale’s bets, as well as what one can gather from the press reports. So its just trading room gossip, saturday night estimates, and educated guesses from the market distortions that are visible. But that’s all we have.
A rough analogy might be the following. Say Bruno bought up 100 billion worth of real-estate in a specific circumscribed market, a purchase so big it distorted the market and artificially raised prices. When he stops buying the ‘theoretical’ market-price drops to 98 billion. So he books a loss of 2 billion. That’s where we are now.
But Bruno is still owns all those houses, and he wants to reduce his exposure to further losses. Yet he can’t. If he tries to sell them off in short order, the price will drop to 90 billion because he will flood the market. So he would then lose 10 billion.
If he just holds on to them, and rakes in their cash flow (say, rents), they might be worth 95 billion to him. (that is the analogy to Iksil holding his CDS portfolio til maturity). So he would lose 5 billion.
Or he could try to hedge his losses by paying for an insurance policy against losses beyond such-and-such a number. (the analogous move to Iksil hedging by using other derivative instruments). But, given the size of his portfolio, and the small size of potential insurers, he’s going to have to pay between, say, 5 and 8 billion for insurance anyway.
So one way or another, Iksil is going to have to pay more than the 2 billion in losses he’s already booked.
Does that work for you? Not sure if you might have something better…
stealth rec’d for now. ;o) (busy day)
Yes, that is a helpful analogy. And thanks for the disclosure.
Thanks for the explanation and the discosure. I always want to know more about who was on the other side of the bet. After the crash not nearly enough was said about the winning bettors. All that money went somewhere. The only way it can actually be disapeared is through federal taxes.
Gosh, the Congress came up with a watered-down, ineffectual response to one of the biggest problems of our time? Who’da thunk?
Regrettably, this is apt rhetoric, and needs to be picked up and magnified until public pressure grows to the point where Congress will feel obliged to rein in the banksters.
the linked article says:
“Part of the Whale story involved asking whether a particular tradable credit index had become distorted relative to its underlying constituents. While we surmised that a fair amount of the pressure causing the distortion could be from curve trades put on as a bearish hedges, the resurgence in the trading of standardised tranches could also play a role.”
I don’t have any idea what that means.
Your explanation is much easier to understand, and more useful to the average person.’
Too bad cause, talking in riddles makes it easier for them to continue with what their doing.
There is absolutely no oversight.
It’s hard not to see the financial wizards producing another implosion.
Obey @ 5:
THANK YOU, THANK YOU for making that understandable to such as myself!
I hope JP Morgan doesn’t qualify for a bailout. The best way to treat compulsive gamblers is cut them off.
If that’s the case, he caused his own –very foreseeable — loss by distorting the market in the first place.
So, would it follow that market distorting positions themselves are a problem? That would appear to be something that you could regulate.
Thank you for this! I was sure it had to make sense somehow, but could never get through the jargon. Rec`d for sure.
I have to disagree that nothing in Dood Frank would stop that. The carve out from the Volker rule allows for hedging. Placing a huge market distorting casino bet is not hedging, it’s something you would want to hedge against.
Just b/c Dimon dishonestly called it “hedging” doesn’t make it a hedge. What was is hedgig against? Where it the counter position?
Actually, the answer is a return to Glass Steagall. If you want to bet in a casio, don’t do it with depositor (FDIC insured) money.
As you say, technically legal in other frames of reference is FRAUD.
Regarding your objection: a large market-distorting trade *can* be a hedge. In these very complex markets, and given the massive mixed portfolios the big banks have, a ‘hedge’ is anything for which the banks’ VaR (risk-management) model yields a result that lowers the bank’s theoretical risk profile. The problem is of course using these deficient risk models in the first place. Tho I don’t see any other way of implementing the Volcker rule. So there’s no way to make it work.
The only solution is what the Brits are trying with ‘firewalls’, by ensuring that investment banks can go down without the commercial bank under the same house taking a hit.
Oh, and those ‘firewalls’ are pretty much an updated version of Glass-Steagal.
Hey Wendy!! So you ARE around!! Hope you’re well. xoxo
Maybe this is a stupid question (I’m no economist) but with all this stuff ongoing and what we know took place in the slicing and dicing of mortgages, is that now going on with the slicing and dicing of student loan invasions on future (and maybe present) Social Security payouts? How are these people keeping the plates spinning when investors are getting somewhat jaundiced apparently? And is TPP part of the ongoing shell game/house of cards upbuilding?
Loved your old post resurrected on the side, by the way.
(I know, don’t try to fit puzzle pieces in that are apples and oranges, but that doesn’t seem to matter now that everything is tradeable – oops I meant gambleable.)
Obviously they were too busy because Obama had assigned them to the robosigning investigation after the SOTU.
The winners were mainly hedge funds, as far as I can gather. Here in Geneva and in London. As soon as they saw the market distortions, they put on opposing trades and just waited for the prices to start reverting to normal. They’re still cashing in, and will continue to do so as Iksil tries to hedge his positions and keeps distorting the various different derivatives markets.
This is for wendy plus all mothers out there, not unrelated to what we struggle towards:
She is as in a field a silken tent
At midday when a sunny summer breeze
Has dried the dew and all its ropes relent,
So that in guys it gently sways at ease;
And its supporting central cedar pole,
That is its pinnacle to heavenward
And signifies the sureness of the soul,
Seems to owe naught to any single cord,
But strictly held by none, is loosely bound
By countless silken ties of love and thought
To everything on earth the compass round,
And only by one’s going slightly taut
In the capriciousness of summer air
Is of the slightest bondage made aware.
Robert Frost
And that, my friends, says OWS to me. We are the 99%.
Good question. I don’t have anything too insightful to say about the big big picture. I’m sure that if financial asset prices start falling the Fed will jump in with QE3 to give the markets another sugar rush. But I’m not sure this can go on for much longer.
Iceland and Alexis Tsipras of Greece show the way: focus your campaign on the central issue of economic survival in the face of hostile foreign banks, and when you gain power from elections, you use it to hurt the foreign banks.
It helps to have actual democracy (aka proportional representation).
If only folks in the US were as up in arms about constitutional reform as they are about “social issues”, we would have both good government and progress on “social issues”.
Glad you liked it mafr.
This bit:
“Too bad cause, talking in riddles makes it easier for them to continue with what their doing. ”
- is dead right!
The sad thing is that there are people at JPM who should have been challenging the assumptions upon which the derivatives were being marked. But they were probably more focused on making the traders happy… hoping that someday they’d get to trade their own make-believe products that would make them rich too.
And for those who were concerned about bogus pricing, they were probably overworked and unable to get their hands around the issues quickly enough.
Who is Iksil? The American taxpayer?
Bruno Iksil is the name of the trader otherwise known as the ‘whale’ or ‘voldemort’. Sorry if that wasn’t clear.
“The sad thing is that there are people at JPM who should have been challenging the assumptions upon which the derivatives were being marked.”
Well, apparently the SEC has subpoenaed emails and whatnot to find out what, if anything, anyone in London or higher up knew. I guess we’ll find out…
Haha… I was guessing it was an actual person. And thanks for explaining. But I think my second — and rhetorical — question is still an important point!
“When the houses of the mighty collapse, the pieces fall on the weak.”
If the SEC finds anything, I’m guessing it’ll be more related to ignorance than bad intent.
A major problem with this stuff is that the traders create new products that are highly complex. And the new products should be challenged by fellow JPM employees, but the employees either:
1) don’t want to ask the questions because they’re more interested in making the money than understanding the product; or
2) ask the questions, but don’t get answers as the traders say they’re too busy to explain it… then may tell that person’s boss that s/he is too slow and probably needs to be let go so that a “better” employee can be found.
A smoking gun email may exist, but I doubt it.
Indeed!
;0)
And Thanks to whoever added that whale illustration. It’s perfect! Whoever runs the FDL art department has a gift!
I have been out of this world for years, but I appreciate your source of knowledge being discussions with friends on the inside of this world, after work insider gossip, Saturday night conversations and educated individual/group estimates of where things are and where they are going – as these are the same ways I am informed about many of the lies in the media like the “Bill Clinton was about to push private account Social Security” back when my friends were working on developing an additional benefit to add to SS – not any take down/privitization of SS (a FDL book salon fellow fell into the trap of “officials with agenda sources feeding him partial truth” making the “gossip/insider info/educated opinion” seem the only reliable way to truth these days of bad media). So in my opinion you are well sourced.
I like your clear explanation of the market distortion cost ($2 billion – now 2.3 billion) of the big CDS (on an index of 129 corporate bonds) buy. On its face as long as this was a hedge of assets owned, the drop in value of the hedge will be offset by the rise in the value of the underlying credits.
And if that is the case Dodd Frank would not stop it unless there were bright line maximum size of hedge purchased relative to market for that hedge rules. As noted earlier “a huge market distorting casino bet is not hedging”.
Dodd-Frank must review the VaR (risk-management) model and come up with its rules for getting to the bank’s theoretical risk profile. As long as that model meets the sanity test of a hedge going down in value as the other assets go up in value, there is no problem.
Dodd-Frank risk management rules need only outlaw the casino bets – and that is possible if Obama chooses to ignore Dimon and the other bankers and order Treasury to produce tough regulations.
So far, here in the US our US based banks are acting like foreign banks, working against the interests of the general population and businesses.
Maybe some foreign banks contributed, but our Big Banksters were the instigators and promoters of the mortgage CDS games.
And we and other nations have paid for them, to great pain.
As you pointed out, this one is an example of behavior that while legal, is immensely damaging to the larger financial system. The obvious question is what would motivate a trader to put together this kind of market-distorting and damaging deal.
The obvious answer is that the trader expected to share in any rewards from the trade and be insulated from any loss. That is a situation that is engraved invitation to every sort of bad and damaging behavior. If the trader(s) who did this knew they had to eat a personally significant percentage of any losses, they’d have much less motivation for this sort of risky behavior.
I just can’t help think that concentration on each of these separate frauds is like trying to cure cancer with a box of bandaids.
The whole system is flawed and needs a complete make over.
The Frontline piece on Wall Street brought a few things to light for me:
That there were folks hired expressly to engage in financial arbitrage as they created complex derivatives, often to attract ignorant customers that had revenue steams that could be…tapped.
That some of those employees were making ungodly amounts of money AND either believed, or pretended to believe that they were helping Their Banks (often it was JP Morgan employees’ interviews) balance sheets they were given the go-ahead to sell the crap not only by the Banks, but by the Fed expressly.
And recently, when Gensler, et.al., came out with their final approval for the regs on derivatives, it took about one whole week for the banking lobbyists to increase the original bar of notional assets requiring regulation: by 6,999%.
And if that weren’t enough to increase yer cynicism, I saw a Real News video the other day that not only did the OMB say that almost 85% of the investment banks would be exempt from capital requirements v. risk, but that The Ben Bernank said: Hold it; we need to look into the rules for two more years befooe they’re finalized.
His reason? Again: the rules are sooo complex, we need to take time to…yada, yada.
Volcker said that The Volcker Rule could have been written on three pages had it been meant to be effective.
So if the Value at Risk model they’re using is meaningless or worse (Yves mentioned JP MOrgan had been bailed out 2005, never checked into that story), leads us to ask:
Isn’t the broader point even more worrisome, that they don’t WANT there to be meaningful regulations that protect taxpayers and purchasers, even of houses, cars, and student loans?
“On its face as long as this was a hedge of assets owned, the drop in value of the hedge will be offset by the rise in the value of the underlying credits.”
- you would think so, right? But that was apparently not what they were doing. The most charitable view of Iksil’s actions that I have seen say that he was working with a faulty model, that *told* him the bank was net short corporate credit, and so his long trade constituted a ‘hedge’ of that position. And then the model blew up in his face and their VaR doubled overnight. In short, he thought he was hedging, but in actual fact he was exposing the bank to a massive downside.
So I’m not sure, given the kinds of complicated indirect and dynamic hedging strategies the banks are playing with, that there is a way of implementing a Volcker rule that protects retail deposits in any real way. Like I said above, the british idea of ‘firewalls’ looks more promising. But, sure, THAT is the discussion we should be having now…
“If the trader(s) who did this knew they had to eat a personally significant percentage of any losses, they’d have much less motivation for this sort of risky behavior.”
- knowing traders, I actually doubt it. You need to be a bit of an adrenaline junkie to be a trader, and they feed off high-risk high-reward situations. The only really serious risk-management I have seen in finance is in full-liability partnerships. There, managers freak out at any sign of risk. Goldman and the rest of the investment banks should be forced to go private. Letting them go public, and thereby freeing management from any share in losses, was a huge mistake.
If that’s the case, we could criminalize the creation of any new product that has not been pre-approved. For example, if Phrma started selling drugs that had not been approved — and someone died — there’d probably be some sort of punishment.
Or we could move toward sound money (via competing currencies) and full-reserve banking (via increased capital requirements). But that’s too simple.
Banking and much of the FIRE sector has turned into nothing but outright fraud and corruption. The JP Morgan whale, the MF Global collapse, The massive continued support of the TBTF banks and Wall St by the Fed and the Treasury, these are just the visible part of a large submerged iceberg of terrorist banking.
Where are the regulators?
Where is the government?
I know these problems were largely created by Republicans, but the Democratic party lead by Obama has done nothing to stop them.
That’s why I cannot vote for Obama.
As Durbin admitted while explaining the relationship between the banks and Congress:
“They own the place.”
Haven’t seen the frontline piece. As for the new regs on derivatives, when I see the massive manic expansion that the hedge funds here have planned for their derivatives desks, that pretty much tells me the regs are a joke. Any remotely serious derivatives rules would have seriously shrunk the market.
And happy momma’s day, Wendy!
;0)
Thank you for those beautiful verses, juliania; it’s just perfect for the Mothers within us all, and for the over-arching principles of OWS (even anchored a diary with it), as is this sweet song I found awhile back after this self-same Obey had given me another by the same artist.
For you, too, this one. In one of my dreams last night, I left some gathering of people at which we solved a few things in contention, and I walked down a rutted, snowy road singing this song, occasionally picking up bits of rough snow to hold in my hands.
My love to you, juliania; so glad to see you this morning,
wd
“If that’s the case, we could criminalize the creation of any new product that has not been pre-approved.”
Yes, that could be part of a solution. Ban any derivative that is hard to model.
But then Dimon and Blankfein will complain that all new jobs will be outsourced to other countries with a less stringent regulatory regime… and that means any pol who supports the idea also “hates jobs!”
So absurd.
Who was on the other side of the trade? i.e. who gets the $2+Billion that our “savvy businessmen” lost? Someone has to be a very happy camper right now…
And a mere (estimated) $7.7 of them are already circling the globe, lol!
And derivative sales have *increased* since the meltdown. Implying that they know they’ll be bailed out; moral hazard; gotta love the term, eh?
And happy momma’s day to you, too, dear Pug.
p.s.
Rumor has it that the Prodigal kgb may be Home one day in the near future. I continue to hold my breath. ;o)
Oopsie; forgot to say congratulations on gettin’ front-paged; nice passin’, baby. ;o)
Yeah, did you see that? Pretty sweet, eh! It must be my rugged good looks…
;0)
Good to hear that the KGB returneth. Tell him to fix that damn front page of his…
This was a blast. Thanks to everyone for dropping by with comments, thoughts, reactions, and objections. Much appreciated all round!
Well…I reckon it was your rugged good looks AND the Eames chair, but it’s a great combo.
And hell’s bells, that young whippersnapper doesn’t listen to me (big mistake, eh?) Just web-cammed with with A.’s kids. Pure cacophony, and I loved every minute of it. Tried to teach their new dog to talk; cracked the kids up. Think Grammy’s gonna warp ‘em? I certainly hope so….
Glad ya had a fun thread, dear. ;o)
“indirect hedging” was what blew up Long Term Capital in the late 90′s
Perhaps “indirect hedging” should be outlawed for any bank with access in any way to Fed help. including non-US banks that have not 100% firewalled the US operation’s capital from their capital account activities outside the US?
“Perhaps “indirect hedging” should be outlawed for any bank with access in any way to Fed help.”
- Well that, or hedging tout court.
Let them manage their risk the old-fashioned way, good underwriting, ample loan-loss provisions.
Running ‘risk-management’ through opaque models no one understands or cares to understand is just an excuse not to take risks seriously. It’s like letting an elephant trash a china shop and then saying, okay, next time lets give the elephant a better map of the layout of the store…
But the “hedge” still has to be offsetting “something”. The issue is not the market distortion, though I would say that any bet that is so big it distorts the market should be vetted to see if its casino gambling in hedge’s clothing.
The issue is simpply calling soemthing a hedge, doesn’t make so. ANd that brings us back to garden variety plain vanilla fraud.
Years ago, when NYC required only US made steel pipes for its sewers, a guy committed fraud by bribing NYC personnel at the pipe yards to accept Korean made steel pipe and sign off that it was US pipe.
Was it all steel pipe? yes. Did it meet the requirement of being US made, no.
We took a guilty plea in federal court from that guy. Plain vanilla fraud my friends. You don’t need complicated theories fo the case, you really don’t. SEC and DOJ have been making their own jobs harder than they need to be.
Thank you for this diary! Please, post more!
Indeed the whole system needs a makeover
That’s a post in itself.
Goldman used to have a wonderful reputation. That was back when it was a partnership. The wheels began comingo ff the bus of their institutional culture almost immediately after they went public.
The financial regulations of the 1930′s really showed an good understanding of human nature. So far, the financial regulations of the aughts and teens seem to be more focused on understanding computer programs, but not the impulses of the people sitting in front of those computers.
Thanks Cynthia. All good points.
Regarding your first pt “So, would it follow that market distorting positions themselves are a problem? That would appear to be something that you could regulate.” – that is what is behind my third remark in the OP. The huge and persistent price differential between the cash market and the secondary index-derivative market should have set off alarm bells with the regulators. Someone out there was writing over 100 bn notional in CDS contracts in a highly volatile market, when US corporates could have (and still can) suddenly go over a cliff if the Euro crisis worsens and the EuroBanks pull their huge stakes in US corporate debt. It wasn’t clear who it was, but if it was anyone other than JPM, it would have been a serious threat to the system. Yet they did nothing. It’s not so much a lack of regulatory tools or rules, it’s just a corrupt regulatory culture. I don’t know what to do about that. Maybe strengthen the regulators who aren’t totally captured – i.e. the FDIC.
Your other point regarding hedging, “The issue is simpply calling soemthing a hedge, doesn’t make so. ANd that brings us back to garden variety plain vanilla fraud.” – Right, But. Like I said somewhere above, the way risk-mitigation departments like Iksil’s work is by using models. And his *excuse* is that his model was telling him this trade was shrinking the bank’s VaR. I.e. his model was telling him the bank, in the aggregate, was short US corporate debt, and that he was then just offsetting that net position. Of course, the model then turned out to be wrong. “Oops”.
I naturally think that story is horseshit, to the extent that no one who’s dealt with Iksil takes remotely seriously the idea that he intended to ‘hedge’ anything. Any ‘risk-mitigation’ trading desk that is posting five billion in annual winnings is not in the business of mitigating risk. It’s laughable. But the VaR model provided him with the legal cover – i.e. he has deniability (depending, now, on whether there is something incriminating in the internal emails that the SEC is demanding). In other words, grossly simplified, Iksil used supercharged levered derivatives of derivatives for which the model failed to pick up on the tail risk in order to place a large bullish bet. When the trade goes south and the model blows up, he comes out and says … ‘whocoodanode?’ and walks away with his golden parachute.
And that is how these VaR models are used in general. They provide legal cover for the banks. No person in their right mind would use a VaR model relying on fragile historical correlations between diverse products and asset classes to manage their own money. It’s literally financial russian roulette – one out of six years, the correlations will break down, and you’ll go bankrupt. But who in the trading rooms stays in the same bank for six whole years, eh? Hell, just spin the chamber…
I think the VaR models provide legal cover to the banks as long as the SEC buys that idea. I’m not so sure a jury would buy it.
Juries in the Southern District of New York have proven themselves to be pretty good at understandig financial fraud.
SO, I “get” why the banks claim that VaR provides cover, I just think that cover could be pierced on a case by case basis.
BTW, I hope you will continue posting, you have a gift for explaining the arcanea of the financial world in terms lay persons can understand
Thanks for the kind words.
;0)