Tuesday, May 15, 2012

A Hedge Fund by Another Name

J.P. Morgan, and its gifted, somewhat overly confident CEO, Jamie Dimon, plowed through the Great Recession of 2008-09 relatively unscathed. With news, however, that Morgan lost $2 billion over the last number of weeks on a spectacular trade gone awry, Dimon’s sterling reputation for risk management has taken a beating. The stock, too, has been hammered, resulting in a market cap that is $25 billion lower than it was on Thursday evening. But despite the huge loss (and analysts are speculating that the final tally on the loss will be double what was reported), the bank, with a reported profit of $20 billion last year, is in no real peril.

So how did this happen? The bank hasn’t revealed the exact circumstances that led to this crisis - and with good reason. As the bank attempts to unwind its positions, it is keen to avoid letting the market know about the bets it has taken in the past, for fear that speculators will bet against it as it is exiting those positions. The big trades they have been making, however, haven’t exactly been going unnoticed. Rumors have been circulating for months about the outsize trades that a London investor, now nicknamed the whale, has been taking. The bets have been so big that they have been distorting the derivatives market for corporate debt. Those outsize bets in London are only part of the story, however. In order to understand what happened at J.P. Morgan, you have to understand what has happened to the bank’s structure and the economy more generally. J.P. Morgan, is, at its core, an old-fashioned corporate lender. When the financial crisis hit, it wade into riskier territory, snapping up Bear Stearns in a fire sale and then, later, taking over Washington Mutual. Those acquisitions, while bringing opportunity, also brought risk. The consumer deposits that came along with Washington Mutual posed a particular dilemma. With the mortgage market cratering, it would have been unprofitable for the bank to loan that money out to regular Americans. At the same time, corporate demand for loans was also weak. Enter the CIO. Ostensibly set up to hedge risks, the Chief Investment Office (CIO), based in London, became a huge profit center for the bank as it used excess cash to trade stocks, bonds, and derivatives. Consisting of only a few dozen people, the office produced 25% of the bank’s profit in 2010. Of course, huge rewards also bring huge risks.

J.P Morgan holds large amounts of long-term corporate debt. In 2011, as the world economic outlook looked grim, the CIO took positions to hedge against potential losses in the corporate debt market. Those positions, which are extremely expensive, turned out to not be needed: the European debt crises seemed to pass and the U.S. economy picked up some steam late in the year. The CIO, used only to dealing with profits, tried to offset those hedging “expenses” by selling up to $100 billion in derivatives, betting that Europe and America would continue the upward economic trend in 2011. Over the last few weeks, however, reports have indicated that the United States is on a slower growth trajectory than what economists had hoped, and the sovereign debt storm in Europe is starting to brew again. Altogether, this means that J.P Morgan is going to have a hard time explaining to shareholders what went wrong and the steps the bank is taking to make sure this doesn’t happen again. There is probably a lot about this debacle that we don't yet know.
- Read more about it here: Reuters and NYTimes