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Easy Street

What Did JP Morgan Get Itself Into?

Marketplace Contributor May 17, 2012

JP Morgan’s chief investment office earned $5 billion over the past three years. Today, the New York Times reports an estimated loss on the “London Whale” trade of $3 billion.

Does that mean that JP Morgan still has another $2 billion cushion for its losses? No. It means the bank has taken only four months to wipe out two-thirds of the CIO profits it earned in three years.

That’s scary enough. But if you really want Fright Night-type chills, consider this: no one knows how much JP Morgan could still lose, because no one knows how much JP Morgan has at stake.

The New York Times has a smart, incisive story with many good details this morning. But the most eye-catching detail – that the bank has lost $1 billion in just four trading days – is probably just a guess at the true paper loss, even if the source is very close to the trade. That’s reflective of the current state of confusion even among the experts right now. The Wall Street Journal reported on May 11 – the day after the loss was announced – that JP Morgan had lost not $2 billion, but $2.3 billion.

As a credit hedge fund manager noted to me this morning, no one in the market  knows the actual amounts JP Morgan has at stake. That makes it impossible to know, with even vague reliability, how deep the bank is in the hole.

Consider that in April, the first report, at Bloomberg, estimated the London Whale bet had $100 billion in face value, which is known as the “notional” amount. The notional amount is not the actual amount JP Morgan would be on the hook for; it’s not the amount of money JP Morgan has at stake. The Wall Street Journal also put the number at $100 billion “or more” in its May 11 story.

Now, $100 billion looks like child’s play.

Earlier this week, well-sourced ProPublica reporter and New York Times columnist Jesse Eisinger estimated it at $250 billion to $300 billion. The New York Times news story, using that uninvolved trader as an observer to work out an estimate, says the notional amount may be between $150 billion and $200 billion.

These are remarkable numbers. Just stop for a second. Contemplate this: a bet of $100 billion in notional amounts six weeks ago could have a notional value of $200 billion or even $150 billion now.

It may not hit home if you’re looking at numerals, but consider the real-world implication: that’s at least a $50 billion difference in notional amounts.

Imagine, if you will, the earnings conference call or board meeting where “give or take $50 billion” is a plausible comment. It doesn’t exist, unless you’re talking about a quarterly conference call in Narnia.

In the real world, $50 billion is not an acceptable margin of error. Yes, even on Wall Street, even in the world of derivatives, even in this universe of Monopoly money, $1 billion is real money, and $50 billion is an unimaginable fortune.

But that’s where we are right now: guessing to within $50 billion, or $100 billion, or $200 billion, because we have no better information to go on.

That’s not our fault. That’s JP Morgan’s fault. The bank hasn’t come clean about its original exposure – much less its future losses.

The rabbit hole becomes even deeper the more one delves into the various estimates of the bank’s potential future losses on the trade. Jamie Dimon estimated last week that the bank could take total losses of $3 billion – and he was sure to note that was a guess, based on vague “market volatility.” 

Today, Reuters noted an Oppenheimer & Co. estimate that JP Morgan could end up with a theoretical loss of $5.9 billion on the trade when all is tallied.  (For unknown reasons, the analysts undercut their estimate, saying they believe such a loss is “unlikely.”)

Others who have tried to replicate JP Morgan’s – or Oppenheimer’s – guesses have come up short. Reuters’ source told them the math is nearly impossible – and he’s one of the very brains who created the type of index that sunk JP Morgan.

“I’ve been through this exercise a few times, and I can’t make the numbers make sense,” said Michael Johnson, chief market strategist at brokerage M.S. Howells, who helped put together earlier versions of the credit derivatives index.

There are reasons to believe that JP Morgan itself may not have a clear understanding of what it’s gotten into. For one thing, the whole debacle was apparently caused only a little by the markets, and far more by the bank’s incorrect mathematical models of how much it could lose.

JP Morgan is also committed – or at least it was last week – to a strategy of “nobody move, nobody gets hurt.” On the conference call with analysts last week, Dimon explained his $1 billion estimate of losses by saying that the bank doesn’t intend to start selling its position any time soon: 

That is – I said the volatility could easily be that [$1 billion]. Obviously, it could be worse than that. We’re going to manage this for economics. Hopefully, by the end of the year, it’s the hope that this won’t be a significant item for us. We want to maximize the economic value of these positions and not panic to do anything stupid. Therefore, we’re willing to bear volatility.

There is, of course, a time stamp on that volatility: at least part of JP Morgan’s trade runs out in December of this year, when some of the contracts end. A significant chunk of the bank’s profitability for the trade hinges on that timing.

Another red flag: JP Morgan also appears to have moved the original trader, Bruno Iksil, off the trading desk. While that may answer the general thirst for blood, it’s Bad Finance 101. In a complicated trade, it’s always a bad idea to sideline or fire the one guy who knows how to unwind it. In the past, banks have racked up enormous losses – and even gone out of business – by getting rid of the Dungeon Master who holds the keys to their trading secrets, including Warren Spector at Bear Stearns and rogue trader Jerome Kerviel at Societe Generale.

The real reason for JP Morgan’s bet was, however, revealed in the excruciating conference call last week. An analyst on that call asked Dimon whether the firm’s Chief Investment Office – the source of the London Whale trade- was always designed to take big bets with JP Morgan’s money, or whether it’s become more aggressive lately.

Dimon’s response: “That is what we were supposed to do. We will manage that fixed income portfolio to maximize the returns to the shareholders and we’ve been very, very careful.”

Why is that scary? Read again that phrase, “we will manage to….maximize the returns to shareholders.”

Here’s the real-person translation: “JP Morgan’s policy is to do anything possible to raise its stock price – including, in this case, taking ‘poorly monitored, poorly reviewed’ risks that wipe out $3 billion of value in just a matter of weeks.”

That strategy – of maximizing shareholders returns – failed as miserably as the $2 billion bet on corporate bonds. On April 2, JP Morgan’s stock was near a year-long high, at $46.13. Six short weeks later – after the big trading debacle was announced, after the SEC and FBI investigations were reported – JP Morgan’s stock is trading at $34.43.

If you want to maximize shareholder returns, perhaps it’s best to try not to make poorly reasoned trading decisions that shave one-quarter of the value of the stock in just a few weeks.

But of course, that’s how you get there – being aggressive. As The Wall Street Journal‘s Deal Journal column (my old stomping grounds!) noted, “In 2006, that segment that houses the CIO lost $391 million and had negative revenue of $1.13 billion as its portfolio was equal to 6.1% of the bank’s assets.” Now the CIO has $350 billion in assets – or 15% of the bank’s total assets – and has earned $5 billion over the past three years.

The “anything goes” strategy of “maximizing shareholder returns” turned that sleepy little backwater CIO office into a major profit center. And that math about the growth of the CIO office in profits and size – not the estimated losses on the London Whale trade, not the notional amounts – tells us how JP Morgan got itself into this.

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