||How Hedge Funds Squeezed JPMorgan
Henry C.K. Liu
This article appear in AToL as JPMorgan
Not So Dumb on MAy 18, 2012.
According to the NY Times:
How JPMorgan got in this ($2 billion) mess in the first place. Here's
overly simplistic primer, but you'll probably get the idea: The
company's chief investment office originally made a series of trades
intended to protect the firm from a possible global slowdown. JPMorgan
owns billions of dollars in corporate bonds, so if a slowdown were to
occur and corporations couldn't pay back their debt, those bonds would
have lost value.
To mitigate that possibility, JPMorgan bought insurance — credit-default
swaps — that would go up in value if the bonds fell in value.
But sometime last year, with the economy doing better than expected,
the bank decided it had bought too much insurance. Rather than simply
selling the insurance, the bank set up a second “hedge” to bet that the
economy would continue to improve — and this time, traders overshot, by
I wrote in May 2009 on how hedge funds could
squeeze a bank:
There were two dimensions to the cause of the
current credit crisis. The first was that unit risk was not eliminated,
merely transferred to a larger pool to make it invisible statistically.
The second, and more ominous, was that regulatory risks were defined by
credit ratings, and the two fed on each other inversely. As credit
rating rose, risk exposure fell to create an under-pricing of risk. But
as risk exposure rose, credit rating fell to exacerbate further rise of
risk exposure in a chain reaction that detonated a debt explosion of
The Office of the Comptroller of the Currency and the Federal Reserve
jointly allowed banks with credit default swaps (CDS) insurance to keep
super-senior risk assets on their books without adding capital because
the risk was insured. Normally, if the banks held the super-senior risk
on their books, they would need to post capital at 8% of the liability.
But capital could be reduced to one-fifth the normal amount (20% of 8%,
meaning $160 for every $10,000 of risk on the books) if banks could
prove to the regulators that the risk of default on the super-senior
portion of the deals was truly negligible, and if the securities being
issued via a collateral debt obligation (CDO) structure carried a
Triple-A credit rating from a “nationally recognized credit rating
agency”, such as Standard and Poor’s rating on AIG.
With CDS insurance, banks then could cut the normal $800 million
capital for every $10 billion of corporate loans on their books to just
$160 million, meaning banks with CDS insurance can loan up to five
times more on the same capital. The CDS-insured CDO deals could then
bypass international banking rules on capital. To correct this
bypass is a key reason why the government wanted to conduct stress
tests on banks in 2009 to see if banks need to raise new capital in a
Downward Loss Given Default.
CDS contracts are generally subject to mark-to-market accounting that
introduces regular periodic income statements to show balance sheet
volatility that would not be present in a regulated insurance contract.
Further, the buyer of a CDS does not even need to own the underlying
security or other form of credit exposure. In fact, the buyer does not
even have to suffer an actual loss from the default event, only a
virtual loss would suffice for collection of the insured notional
amount. So, at 0.02 cents to a dollar (1 to 10,000 odd), speculators
could place bets to collect astronomical payouts in billions with
affordable losses. A $10, 000 bet on a CDS default could stand to win
$100,000,000 within a year. That was exactly what many hedge funds did
because they could recoup all their lost bets even if they only won
once in 10,000 years. As
it turns out, many only had to wait a a couple of years before winning
a huge windfall. But until AIG was bailed out by the Fed, these hedge
funds were not sure they could collect their winnings.
May 25, 2009
how hedge funds squeezed JPMorgan for a $2 billion loss. JPMorgan paid
up because even with the $2 billion loss, it still made $4 billion in
the same quarter, much of it from CDS-insured CDO
deals that could bypass international banking rules on capital. With all the noise about the
Volcker Rule restricting bank proprietary trading, IPMorgan still has
the last laugh.
news is that the $2 billion did not evaporate into thin air. It went
into the balance sheet of hedge funds and stayed in the financial
My friend Dar Maanavi, former head of corporate
derivatives at Merrill Lynch, thinks the reason JPMorgan has not come
completely clean on its $2 billion loss is that from a regulatory
perspective, if it
is so simple to coordinate risk taking between the banking and
businesses, then it must be just also possible to take speculative
positions for the trading businesses on the banking side. Maanavi
thinks that in such an environment, JPMorgan chose to make the loss
if there was some unauthorized dumb trading going on versus admitting
that banking and proprietary trading are highly integrated activities,
in the face of Volcker rule debates on restricting such integration.