- All I know is that everyone's really mad about this JP Morgan mess. What on earth happened?
A JP Morgan trader, Bruno Iksil, has been accumulating a giant bet on U.S. corporate bonds. He used derivatives to do it, and he messed up the bet and lost $2 billion for the bank. He could end up losing $1 billion more if the market doesn't cooperate.
Iksil was so powerful - and his bet was so large - that other traders nicknamed him the London Whale.
- Is this one of those "rogue traders" I keep hearing about?
No, Iksil worked for JP Morgan and had the full support of the bank and did all his trades with the full knowledge of these four Very Important People at the top.
- How did no one know about this?
Oh, they did. Everyone knew. Thousands of people. Iksil's bets have been well known ever since Bloomberg's Stephanie Ruhle broke the news in early April. A trader at rival bank Bank of America Merrill Lynch wrote to clients back then, saying that Iksil's huge bet was attracting attention and hedge funds believed him to be too optimistic and were betting against him, waiting for Iksil to crash. The Wall Street Journal reported that the Merrill Lynch trader wrote, "Fast money has smelt blood."
When the media, analysts and other traders raised concerns on JP Morgan's earnings conference call last month, JP Morgan CEO Jamie Dimon dismissed their worries as "a tempest in a teapot."
- So why is this in the news again now?
JP Morgan finally put a stop to the bet and admitted the size of the loss. The bank filed the information as part of its usual report to the SEC late on the night of May 10 and then held a hasty, awkward conference call with analysts yesterday.
- Yikes. Details, please?
Okay, you really want to know? Tighten your seatbelt and take an aspirin. If you're already pretty sophisticated about finance, you might want to check out Lisa Pollack's excellent piece at FT Alphaville in April.
For the rest of us: You heard that Iksil was bullish, or enthusiastic, about corporate bonds that were "investment grade," or strong. The corporate bonds were probably already owned by JP Morgan as part of its trade with corporate clients. JP Morgan also owns a lot of "high-yield," or junk bonds. Those are low-rated bonds from companies that are close to default. If JP Morgan owns a lot of high-yield bonds, the best way to balance that risk is to bet on investment-grade corporate bonds.
Iksil wanted to find a way to bet that those investment-grade bonds were totally secure, that they would never default.
He noticed that most of those bonds were probably already included in an index. In this case, the index was the Markit CDX North America Investment Grade Index. The Index rolls out a new version every 6 months, and the one that Iksil focused on, #9, actually started trading five years ago, back in 2007. (Although Iksil's bet is far more recent.) Iksil reportedly accumulated a huge bet on this Index worth $100 billion - according to Bloomberg, which first broke the story of the London Whale in early April.
- Hold on. Do we know which corporate bonds?
There were over 120 of them in the Index. Here's the full list, which Lisa Pollack at FT Alphaville tracked down. It includes everything from the railroad Burlington Northern Santa Fe to CBS to Fannie Mae and Freddie Mac. The common connection among them is that they're "investment-grade," meaning that they are among the stronger corporate bonds out there.
- Okay, go on. You were saying something about protection?
Yes. "Protection," on Wall Street, usually means one thing: credit default swaps. Credit-default swaps, or CDS, are contracts that pay you money if the credit (like, a bond) goes ahead and defaults.
Iksil didn't think these companies were going to default. He thought they would do great. So he didn't buy credit-default swaps; he sold them. He was so confident, in fact, that the value of his bet approached $100 billion back in early April.
Other people in the markets - like hedge funds and other traders - thought Iksil was being ridiculously overconfident. Waiting for the giant Iksil's to fail, the anti-Iksil team took the other side of the bet. The rival traders bought credit-default swaps on the Index. They also bought protection on the underlying corporate bonds to influence the value of those as well. Their hope was that Iksil's bet would go down in value; then he would have to run to them to buy credit-default swaps to cover his rear and keep his bet even. They outsmarted Iksil. As he kept digging himself deeper into his position, he got backed into a corner and couldn't cover his losses.
- I read somewhere that this is about "mark-to-market." What does that mean?
Imagine you buy a car for $10,000. Two years later, that car has a market value of only $2,000. That $8,000 difference is the "loss" you take when you mark down the value of what you owned to what other people are willing to pay for it.
That's what banks do, too. JP Morgan's position was so big that even a slight change in market value- a little dip down- would create billions in losses in the trade.
- Derivatives? Derivatives? Again with the derivatives!
We know, we know.
- Also, the London Whale? We all know London doesn't have whales.
Actually, once it did get a misguided one that swam into the Thames. But the London Whale we're talking about is Bruno Iksil, the most powerful trader at JP Morgan. (You could argue he also got lost while swimming in the wrong waters.) Iksil works in JP Morgan's Chief Investment Office, or CIO, which has $350 billion of the firm's money to play with to make money. The CIO sits in the firm's Treasury office, and it's nearly as big as the entire JP Morgan investment bank. Just to put it in perspective, $350 billion is 15%, or one-sixth, of all of JP Morgan's assets.
- Gosh. Why does he get so much money to play with?
Iksil's job is technically to make sure that whenever JP Morgan takes risk as a firm, that it's protecting itself. On Wall Street, that's called a "hedge." (We use the same idea in real life all the time: "hedging your bets.") JP Morgan holds all sorts of securities, including corporate bonds, on its own books as part of the deals it strikes with customers. Iksil and his team exist to make sure that even if JP Morgan's customers lose money, the bank itself is still covered.
But hedges are supposed to be mere protection, not outsized bets of their own. The actual corporate bond market - and the index that Iksil bet on - haven't moved too much. So Iksil's huge bet, the level of risk he took on, and the complicated derivatives he used all walk and talk like proprietary trading. As my former colleague - and current Huffington Post business writer - Mark Gongloff commented today on Twitter -"poorly constructed hedges sure quack like a prop bet."
- Proprietary trading? Refresh my memory.
Proprietary trading is the part of an investment bank that makes money for its own account. Most people think of banks as middlemen - they match up buyers and sellers - but banks got sick of watching other people make huge profits on trades. Over the past 10 years banks have committed more and more of their own money to playing in the market on their own behalf, for proprietary purposes. Thus, "proprietary trading."
A lot of big banks came out of the financial crisis stronger than ever, with bigger profit than ever, but over the past year those banks have seen their profits from regular businesses falling. Every big bank has made major layoffs. So taking these risky bets could have been seen as a way to make money.
- Isn't proprietary trading illegal now? I heard about the Volcker Rule that was supposed to stop this kind of thing.
The Volcker Rule is something that's been talked about a lot but - this may surprise you - it hasn't actually even been written yet. It's currently a legislative whale, at 300 pages, and banks like JP Morgan are still fighting it.
- What is the Volcker Rule again?
It's an idea that's part of the Dodd-Frank legislative reforms. Paul Volcker, the former Federal Reserve chairman, said banks should go back to being middlemen for clients. So they should stop any kind of investment activity on their own behalf: no more putting money in hedge funds, investing in companies, or taking big, stupid bets in the market.
- But haven't banks always taken bets with their own money?
Yes. But the landscape has changed. In the distant past, when investment banks were partnerships, this kind of betting was no problem: the partners bet, and lost, with their own money. They were kept separate from real banks, which take your deposits and make loans.
But over the past 15 years, investment banks became giant, publicly traded (and government bailed-out) institutions. They also merged with the plain old banks. So now, when they take bets, guess what money they're using? Not their own, and not even their shareholders'. They're using your deposits. And they're more likely to require a bailout from the government if things get really bad.
- So at least JP Morgan is sorry, right? At least they get that this was stupid and feel all sorts of compunction?
No. They acknowledge it was stupid, but the bank has not indicated that it will stop this kind of activity in the future.