The revelation by JPMorgan
Chase last week that it lost US$2 billion in its
hedging operations was duly followed by an apology
of sorts by chief executive Jamie Dimon. "This
should never have happened. I can't justify it.
Unfortunately, these mistakes are self-inflicted,"
he told the bank's annual meeting. His subsequent
claim to reporters that "the buck always stops
with me" was followed by resignation of Ina Drew,
chief investment officer and in charge of the unit
responsible for the losses.
According to a
New York Times "overly simplistic primer" on "how
JPMorgan got in this mess in the first place",
chief investment office originally made a series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.
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 a lot. 
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 atomic dimension.
The [US] 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 & 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
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
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. 
That is how hedge
funds squeezed JPMorgan for a $2 billion loss.
JPMorgan paid up because even with the $2 billion
loss, it still makes $4 billion in the same
quarter, much of it from CDS-insured CDO deals
that could then bypass international banking rules
on capital. With all the noise about the Volker
Rule restricting bank proprietary trading,
JPMorgan still has the last laugh.
friend Dar Maanavi, former head of corporate
derivatives at Merrill Lynch, thinks the reason
JPMorgan has not come completely clean on this is
that from a regulatory perspective, if it is so
simple to coordinate risk taking between the bank
and the trading 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, JP chose to make the loss look as
if there was some unauthorized dumb trading going
on versus admitting that the bank and proprietary
trading are highly integrated activities, in the
face of Volcker rule debates on restricting such