Understand how Jp Morgan Ended up Finance Essay

The infamous Jamie Dimon joined the darling financial institution in 2005 as CEO and also joined the New York Federal Reserve bank board in 2008. 4 Notorious for his squeaky clean reputation relative to many of his contemporaries, his myriad successes in the big banking world landed him four times on Time magazine's 100 Most Influential People list. While the whale tale that plays out in the remainder of the paper threatened to tarnish his sterling leadership (and that of the firm's), his navigation surrounding the event is one of the reasons JP Morgan surfaced, ultimately, intact.

The Set Up

Usually, a story of this nature would trigger thoughts of the rogue trader phenomena at UBS or Societe General. However, this story has a twist. What is lurking beneath the infamous London Whale trader, Bruno Iksil, is a whole department enabling the beast. That department was the firm's Chief Investment Office (CIO).

The major responsibility of CIO was to manage the firm's excess cash reserves through investments that would meet their future liquidity needs and hedge their $350 billion balance sheet. This was primarily done by investing in a diverse portfolio of high credit quality, fixed income securities that had maintained an average rating of AA+.

At its helm was Ina Drew, appointed by Dimon in 2005. The following year her team was able to lift the $20 million trading loss limit for their department. In 2007, they started the Synthetic Credit Portfolio to hedge the inherent credit risk in the firm's main business lines. (This portfolio is a key character in the story and will be discussed further in the following section.) By 2010, CIO had brought in 25% of JP Morgan's annual profits of $20 billion.

At this point, with loss limit barriers removed, exotic new products in the mix, and record profits, one might think that more transparent and thorough department reporting would be required. However, according to JP Morgan's task force, CIO actually lost its alertness and became less concentrated on the trading details. Focused more on top line risk measurement numbers that, ironically, masked their ever-growing risk exposure; one might say they lost the trees for the forest.

In fact, some commentators thought CIO had deflected from its original purpose and become the world's biggest proprietary trading counter. In other words, it had become a profit center not a risk management center. Because CIO was so actively increasing its exposure to high yield bonds and various over-the-counter derivative products, the risk of its trades became nearly equal to that of the entire investment banking department at JP Morgan. Since the fund-raising cost for CIO was lower than that for the investment banking arm, the regulations were less, and there was a history of successes, Dimon was moving more and more trading business to CIO.

It was this sense from the rest of the trading community, of a growing whale, that partially fueled the pressure and cornering felt inside CIO.

The Methodology

The positions in the Synthetic Credit Portfolio consisted of standardized indices based on a number of credit default swaps (CDS) on debt issuers.[footnote: JP Morgan Report on Trading Loss] A credit default swap is a financial swap agreement in which the seller of the CDS will pay the buyer if a loan defaults. A CDS is a derivative contract, but acts very much like an insurance contract. The riskier a bond is, the higher the price of the insurance will be. There are different prices for different bonds to be "insured" from defaults. Also, issuers can choose to insure either the buyer or the seller of the bond.

The trader language is intuitively a little backwards in the banking world for CDS. Being long a CDS is buying protection and is effectively a short risk position. Conversely, shorting a CDS is selling insurance and creating a long risk exposure. A firm like JP Morgan is in the business of being long on financial risk by way of their principal banking service functions. Hence, the objective of CIO was to have a net long CDS position to mitigate these risks.

CIO added a layer of complexity in its Synthetic Credit Portfolio by choosing to trade the Credit Default Swap Index (CDX) which serves as a benchmark for protecting bondholders against default similar to equity value indices.

This is what the CDS index of investment grade firms looked like on Apr.18th, 2012. Notice that it doesn't show the price changing over time like stock indexes do. Rather, it shows prices of the swap depending on the period of time the swap covers, more like the yield curve of a bond.

Typically, an upward sloping CDX curve means that it is healthy. That is, the riskier a bond is, the higher the price of the insurance will be. Because, as the time period becomes longer, the more opportunity there is for unexpected events to happen, the riskier it is. So, swaps with longer time intervals cost more than those with shorter ones

Iskil went on to implement a flattener strategy on the CDX curve, basically, betting the front end (left) of the CDX curve would go up relative to the back (right.) Although there are several ways to do this, CIO chose to do so by buying short term CDS and selling long term CDS. If the CDX curve really flattens, meaning that short-term swap prices rise faster than long-term swaps, investors will make a profit. If the market moves on a small scale, the short/long positions will cancel each other out, making the total position "market neutral."

With the move by the U.S. Federal Reserve, announced in the third quarter of 2011, to implement a massive "Operation Twist" agenda, it's easy to see why CIO initially adopted their strategy. The aim of the Fed's objective was to, indeed, flatten the U.S. Treasury yield curve and CIO seemed to be going with the flow. So, where did they go wrong?

The key point is that, to maintain the flattener strategy, you have to keep your long and short positions balanced. As these products continually either shift in value or expire, a trader has to frequently enter into new trades. Also, in order to keep the balance between products that does not move step-in-step, an accurate ratio must be established. As shorter term products are less volatile than longer term products, a one-to-one ratio on rate curves is insufficient. Traders will need a greater amount of the near term product to offset the longer dated maturities. Disrupting this ration degrades the hedge into an outright long or short position on the index, leaving it enormous exposure to the market. 6

Worlds Collide

At the Harbor Investment Conference that took place in February 2012, leading hedge fund managers came together and were subjected to the sales pitch for one particular off-the-run CDX, the Series9 IG 10-year Index (where IG is short for Investment Grade.) The product's appeal was the existence of several of its bond components that had subsequently been downgraded since the index's inception in 2007.13

Given the lack of a department Treasurer since October 2011, the introduction of competing top line objectives at the start of 2012 (discussed below,) and the initial losses beginning to occur in January, CIO must have thought they had found the Holy Grail. But, prudence was out the door. Iskil built up $12 billion of shorter term maturities matched up with $20 billion of longer term maturities in the Series 9. Anyone active in calendar spreads would recognize this as an outright directional trade. In addition, Iksil's portion of the overall CDS market was so large that he was quickly running out of counterparties to his accumulating positions.12

As soon as JP Morgan couldn't hide its positions any more, due to their overwhelming presence in this niche market (and whatever leaked out at the Harbor conference), hedge fund traders started to collectively move against them. Ultimately, the other market participants were able to alter the price for what JP Morgan was looking for and caused their extraordinary losses. And, it would take CIO several months of mounting losses to accept this truth. 12

A Game of Poker

At times, it seems that CIO was infected with many elements of the gamblers' psychology including overconfidence and belief perseverance. Up until that point, it appears they had attributed their significant successes to themselves rather than other market factors. In tandem, they anchored their values of the portfolio and preserved their belief of this value by refusing to accept price movements as real and citing leaks of their positions as the source of divergence.16 While CIO was right that there were outside forces putting pressure on prices unrelated to typical market conditions, they were wrong in believing that it wasn't real or sustainable. If CIO had disclosed the position and loss every step of the way, the situation may have been reversible.

What was At Risk? 12

On top of all this, they had a major problem with their Value-at-Risk (VaR) model, a statistical risk measure used to base how much a trader might lose in one day. A precise VaR model is important and the one that CIO used was different from the rest of banks. It developed the VaR model on its own and the weight setting was lower.

CIO had been petitioning to implement a new model throughout this key period, late in 2011 and early 2012. The VaR number decreased dramatically to $67 million per day from $129 million. Iksil's VaR alone was often $30 million to $40 million, sometimes reaching $60 million. That's almost equal to level for the firm's entire investment bank. A minor adjustment in the mathematical calculations (incorrectly omitting a division symbol to create an average rather than a sum), significantly altered the output of the model. 12

In the report released by JP Morgan, there were some risk protocol breakdowns in the model's development, approval and implementation process. For instance, back testing was not rigidly required by the firm's management as only two months' worth was done to gain the model's approval. So, it became operational with many technical problems embedded in the system including the increased potential for error by requiring manual data entry. Further, the developer and the operator were the same person which breaches the separation of duties best practice. This combination left CIO depending on a highly inaccurate model.

Observations

An influential company, like JP Morgan, who prided themselves on being a leader in managing financial risk, took a wrong turn and lost sight of core fundamentals. A In a report released by the Task Force of JP Morgan, there are a few areas where they feel that the CIO failed to do their job in terms of judgment and acting on their concerns. A 

One such area was how upper management established inconsistent priorities for the Synthetic Credit Portfolio that proved near impossible to follow simultaneously. The priorities included keeping the risk balanced while managing both VaR, gains/losses, and reducing the Risk Weighted Assets (RWA). When trying to achieve these all at once, varying priorities created conflict and fostered a platform to develop their unusual strategies in an effort to meet multiple objectives. A If CIO management had listed these priorities in order of true importance while also developing a way to act on them, there would have been a stronger framework to reconcile front line strategies against top line goals. In addition, a type of fire sale, exit strategy needed to be outlined in advance of the trading positions going awry. A 

It is no wonder that from this complicated profile of priorities there come even more complex trading strategies. When theyA were conceived, the CIO managers, as well as their personnel, did not fully understand how to use these products in a way that managed the risk they were creating. These strategies should have undergone extensive analysis on their impact to the RWA, especially, given their notional amounts prior to trading.

Ultimately, upper management was responsible for taking more time to develop comprehensive trading strategies that required the whole department had extensive product knowledge under numerous scenarios. The CIO didn't obtain or even ask for detailed reports on specifically the Synthetic Credit Portfolio. By not having reports generated in real time, the Chief Investment Officer had little knowledge on what the trading activity looked like on a day to day basis. A Instead, she just simply checked the portfolio's profits and losses.

Even more concerning is the lack of efficient communication between traders and senior members and officers of the department. Reports show that multiple warnings were given by traders to different senior members expressing concern regarding the riskiness and volatility of this portfolio. A catalyst for this breakdown was the significant changeup in managers within a short period of time beginning in late 2011 through early 2012. However, a company of JP Morgan's size and history should be able to easily withstand routine shakeups of this nature.

Consistent communication, seamless management transitions, and intimate knowledge of shifting valuations are not areas to be lacking in especially when it comes to the scale of assets JP Morgan possesses. Despite numerous attempts to voice concerns during the first few months of 2012, CIO management did not disclose any problems or losses for the portfolio to the board.

The Aftermath

Internal Impact

While the firm's share price took a huge plunge immediately following the height of the losses, a year later the stock has more than recovered. Its overall ranking as a world company has dropped, however, from 36 in 2011 to 51 in 2012.1

Many members of the Synthetic Credit Portfolio team, including Messrs. Goldman, Wilmot and Weiland departed the company along with Drew. Dimon took a 50% pay cut for 2012 and the firm was seeking claw backs from various other employees as well.

Several additional steps have been implemented to better manage CIO since then. With new faces in CIO's leadership team, such as CIO Matthew Zames and CFO Marie Nourie, the department has upgraded its reporting and modeling. Reports now include detailed trading and positions data and VaR models have automated control features. A CIO Investment Committee meeting is now held weekly and Business Control Committee meetings are held monthly with a cross-reference team with the Risk Committee. New departments to supplement CIO, called Deputy CRO/Head of Firm-wide Market Risk to monitor market risk and Wholesale Chief Credit Officer ("WCCO") to assess the wholesale credit risk, were also created.

Actions to strengthen the model review group are focused on selecting the most significant models, testing and reviewing risk exposure precisely, specifying different models to different products, and updating the database. CIO also enhanced the limit structure, such as "53 new country exposure limits, also applicable to both CIO and Treasury, as a subset to the Firm-wide Country Exposure Limits" (From: JPMorgan Report on Trading Loss). These new risk policies offer specified rules to CIO and require them to limit the risk onto a transparent and controllable scale.

Social Impact

According to OCC's quarterly report on bank derivatives activities, in the fourth quarter of 2011, the big five banks (JPMorgan Chase, Bank of America, Citigroup, Goldman Sachs and HSBC) held 95.7% of the U.S. $ 230.8 trillion derivatives in the outstanding balance. After JPMorgan's announcement of the huge loss, major banks' stock price acted as: Citigroup fell 2.4 percent, BoA fell 1.7%, Morgan Stanley fell 3.2% and Goldman Sachs fell 2.7%. As the Butterfly Storm presents, a small abnormal fluctuation will bring a disaster to the worldwide financial industry. And the amount at stake is powerful enough to destroy it.

Standard & Poor's and Moody's both downgraded the rating of JPMorgan after the firm disclosed its initial trading loss of $2 billion. As we can see from the chart, the last credit rating was lowered and future rating downgrades are possible reflecting increased concerns about the bank's hedging capabilities.

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The next graph shows Moody's rating downgrade in response to JPMorgan's London branch problems. It was downgraded from Aa2 to Aa3 since 21 Jun 2012.

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The following chart shows the rating for JPMorgan Chase financial strength declining from B to C in the middle of 2012.

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What's more, the rating on long-term debt was lowered from Aa3 to A2, which means Moody's regards JPMorgan's debt as riskier making it more costly for them to raise funds in the future. In addition, it has altered the risk profile for existing bondholders' portfolios.

Regulatory Impact

Dimon was requested to appear in congressional hearings regarding the loss. The Federal Reserve and OCC called for JPMorgan to improve its risk management team and rebuild the CIO department structure. In addition, federal regulators commanded JPMorgan to improve its money-laundering prevention.

Conclusion

As Mr.Dimon said to Meet the Press:" we have a huge security portfolio, we are a big bank. In fact this security portfolio has unrealized gain of $80 billion, but in how we manage that portfolio we did lose $2 billion. We took far too much risk, the strategy we had built is badly verified and badly monitor. It should never happen. "

Certainly, Jamie Dimon's long-standing reputation and willingness to cooperate in various sentence hearings displays a role model case for handling such crises. Weathering this storm required the collaborative effort of many of the firm's top talent. From assessing the damage, to outlining more than a band aid fix.

Dimon, speaking as a panelist at the 2013 Davos convention, pointed out that these losses were sustained in an area protected from clients' accounts. However, this was a major malfunction in the company, that consults other international firms to avoid this.

When a huge $6 billion loss occurs in a department aimed at reducing risk rather than taking it, it comes as no surprise that business leaders began taking notes.

The trades and risks were in such great magnitude that it is crucial with true risk management for the officers to have been monitoring this activity closely, accurately and often.

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