by Peter Tchir, TF Market Advisors
I wish we could go into just the facts, but frankly we don’t know the facts, so here is my best guess at piecing together what happened and what some of the consequences might be. I hope it is mostly correct, which means it is balanced and not sensationalized like so much else that is out there on this subject.
Short High Yield Market
Last year, I think they went short the high yield market globally, primarily through CDS. They generally wanted to buy cheap jump to default (“JTD”) risk, so they focused on the short end of the curve, and on first loss tranches. This created trades in a variety of series of XOVER and HY.
The trade worked well, and defaults in names like Eastman Kodak and American Airlines came quickly and helped make a lot of money. Some other distressed names saw a flattening or even inversion of their curve on the back of that, generating yet more money.
Too Short
With the ECB announcing LTRO and data in the U.S. looking okay, and overall policy response in Europe improving, they were worried about being too short. At this point they could have cut their short. That was clearly a choice, but a choice they decided not to make by the looks of it.
Why not? Maybe they still needed the high yield short against core positions? Maybe they needed it for the Fed stress tests which were very punitive for the high yield market. Maybe they just thought this trade was the best short by far out there and wanted to see if there was a good way to keep the short, and all the benefits for stress test purposes, without as much risk of loss in a spread tightening environment?
It looks like they decided, primarily that JTD, while cheap in high yield, was priced too high in investment grade and sold that protection. Maybe they thought names like MBIA which drive the pricing of the lower tranches of IG9 had curves that should have been steeper. So in various forms they took the other side of the HY trades.
They likely added new traded, by the end, this trade likely had at least 20 significant line items, spread across indices, tranches and straight indices, and points along the curve.
The trade, as far as I can tell should do well in a stressed market. It had a fair degree of idiosyncratic risk which in the near term could cause some problems, but in a stressful environment it should have delivered good returns, and certainly would have looked great on the Fed Stress test results.
If we had a significant tightening, the trade would probably lose some money, but nothing like an outright short, even a smaller outright short would have lost, and it would ideally be offset by gains in the bond and loan positions held by JPM.
So What Went Wrong?
Something did go wrong, the trade lost money. But it didn’t go “horribly” wrong. To me, “horribly” would mean a money losing quarter for the firm. They did something so big and so stupid they wiped out the entire firm’s earnings for the quarter. That did not happen. In fact, the loss seems in the right order of magnitude when you look at gains that group has delivered. This isn’t even a case where one big loss wipes out 5 years of small gains. This group is still up over time and had JPM monetized some more AFS gains held by that group, he could have shown a $5 billion profit for the CIO office.
The only thing that we can safely say is that this trade, ignoring other positions held against it was down about $2 billion this quarter, as of sometime last week. We don’t know when the $2 billion was calculated, we just know that is what we were told on last Thursday. It is impossible to know what has happened since then, and it could even be a gain now because of the hedges of hedges put in place prior to and after the call.
The trade was large, and small moves against each of the legs could easily cause the losses seen so far. That is the key here. The decision wasn’t horribly wrong. It’s not like they bought something that dropped 30 points. They have lots of longs, some of which moved several points against them, while some large shorts also moved against them. It sucks, but there isn’t a single long/short trader in any market who hasn’t had this happen at least once.
Key Issues and Questions?
The trade was too large. In spite of the effort to spread the trade around the globe and across so many indices and tranches, it just got too big. The off the run indices that suited the view best, were too small and illiquid relative to the size they needed. Their trading also stuck out like a sore thumb so the market was over time able to figure out what trade they had on. Why did they let it get so large? That is a question that needs to be answered and is a reason the group is being shifted. This was bad risk management, but it is possible they believed they had spread the trade across so many line items that it wasn’t as outsized and it now appears it was.
Marks and Growing the Position to control the price. One concern would be if they were growing the position in an effort to influence the price. I do not like the fact that the indices they were allegedly doing trades on were trading very rich. Even if selling the tranches, there should have been a concern about selling tranches on an index that is trading rich. Maybe there was and maybe they thought the tranches were so mispriced that it was worth doing. That is reasonable. If on the other hand, they continued to grow their position in an attempt to control the marks and their losses that is another issue. I’ve never understood why the market is so happy about “window dressing” since the difference between trying to influence a mark and “window dressing” seems to be a very fine distinction. If the trading was really being done to aggressively control the marks, then there are bigger issues for the traders concerned. While just getting too large, but with approval is not smart, this is much worse. No idea if it happened, but that angle does need to be investigated internally at the very least.
Risk Management and the VAR jump. I assume these positions all fell within their limits or were appropriately approved. If they were somehow hiding the scale of the trade, then there are issues, both with them for attempting to do that, and with JPM for not having limit controls that picked up this level of activity. I would be shocked if these positions were being done covertly, and assume from the press conference that wasn’t the case, or else the tone would have been much worse, and the so far reasonably amicable changes to the CIO office wouldn’t be occurring.
That leaves us to figure out why the VAR may have jumped. There are a couple of reasons that I can think of that make some sense, though it is a bit of a stretch. If HY spreads were modeled as being highly correlated with investment grade spreads, and that correlation was then reduced, we would have a spike in VAR. On the portfolio, with a high correlation between IG and HY, the trades would have largely offset each other in a VAR calculation. As the correlation was reduced, there were be a greater risk that the trades don’t offset and VAR would increase.
Tranches are strange in that they have a “leveraged” exposure. Did the new model underestimate the VAR on IG tranches or overestimate it on HY tranches? Did they not use enough leverage? Did they not account for the change in leverage as price moved? Something strange happened to VAR, and assuming it wasn’t purposeful mis-booking (which would be a massive issue for those involved), this “new” model was doing something incorrect. Although no answer is ever likely to be forthcoming to mere investors and owners of the company, at least the Fed should be able to find out why the VAR jumped.
What now for JPM?
I think the market has already started to overcome the initial fear of the trade. Investors are able to put it into the correct context – $2 billion just isn’t that big or meaningful at JPM. It is bad and changes need to be made, but it isn’t even a disaster for the quarter. So the market is digesting this. Will there be more questions and problems with this trade? Possibly, but I truly believe it is contained.
Things I cannot understand or what is Jamie’s real intent?
For a man who typically comes across as so “confident” he has been very contrite about this. Is “Contrite Jamie” scared of the Fed? Is he that embarrassed by the loss? Something about his language and behavior and the entire press conference just don’t ring entirely true. Maybe he was simply so stunned by the loss, but I can’t help think he has some agenda that just isn’t obvious yet.
Which leads to the other big question, why take a loss at all and why not monetized unrecognized profits in the AFS book? The AFS book seems like it has over $7 billion of gains just waiting in accounting limbo to be harvested. Why not take more, have no loss and not need to have a conference call? It is almost like he wanted to have this conference call, that he went out of his way to ensure he had to discuss this. Had he booked more profits, they wouldn’t have had to change their guidance. Weird that they chose to go this route, and again makes me wonder if there isn’t a bigger plan in place here.
That leads to my final question. Does the market really believe that Jamie Dimon and his advisors had no clue how the market might perceive the call? That some “investors” would take a run at driving the positions even further against him? It seems like a no brainer that he would anticipate that potential reaction. Read the transcript very closely. He seems to go out of his way to highlight they could have more losses, but throws in the possibility of it turning into a gain, that they won’t necessarily take it all off, and that some other “economic” hedges would or were in place. If your goal was to spook the market and profit from it, those all seem like nice little caveats that your lawyer would want you to include. This is getting a little more out there, but his almost naïve sheep being led to the slaughter attitude about the position just doesn’t feel right either.
Was it a Hedge?
That is another question and in reality is the wrong question. When did everyone get so focused on what is a prop trade or a hedge or a position. Every loan is a prop trade. It is a bet that you will get paid back. On a portfolio level it is that you will make few enough individual mistakes that the interest earned covers your costs and losses and leaves you with a profit.
The only way to ensure that you don’t lose money on a loan and never have any potential P&L issues from it during the lifetime, is not to own it. Otherwise any hedge creates basis. The more “perfect” the hedge, the higher the cost. In the end, we don’t really care if banks lose some money, we just don’t want them to lose LOTS of money.
Banks need to hedge the stress scenario. That is when too big to fail becomes an issue for all of us. So let’s keep ensuring that banks can’t fail, and let the relatively small losses occur if they need to.
What is Mr Dimon’s Job?
And the next person who says Mr. Dimon’s job is to lend money to make the economy better, should really just stop, step away from the keyboard or microphone and think about what his real job is. That is to maximize shareholder value over the long run. To take actions that give the share price the best chance at appreciating over the long run. That is his job. He is supposed to work for the shareholders and no one else. If you don’t like the risks he is taking, don’t invest in his bank, but he, nor the bank are tools for public policy. And in spite of the stock price decline on the back of this announcement, it is hard to find any other bank that is close to its 2007 prices.
