Ina Drew — the JPMorgan (JPM) executive who famously “loves crises” — is out; it seems the buck for the $2 billion trading loss in her unit has stopped with her. And slowly, a few shapes are beginning to emerge from the fog of what exactly happened here.
For one thing, it’s becoming increasingly obvious that Drew got paid her eight-figure salary in return for being able to pull off a very neat trick: turning hedging operations into a profit center.
Drew’s Chief Investment Office quadrupled in size between 2006 and 2011, reaching $356 billion in total, and it’s easy to see how that happened. On the one hand, it was incredibly profitable, with the London team alone, which oversaw some $200 billion, making $5 billion of profit in 2010, more than 25% of JPMorgan’s net income for the year. At the same time JPMorgan accumulated enormous new deposits in the wake of the financial crisis, both by acquiring banks and by attracting big new clients wanting the safety of a too-big-to-fail bank. Historically, JPMorgan has served big corporations by lending them money, but nowadays, as the cash balances on corporate balance sheets get ever more enormous, the main thing these companies want from JP Morgan is a simple checking account — one where they can be sure that their money is safe.
With lots of deposits coming in, and little corporate demand for loans, it was easy for all that money to find its way to the Chief Investment Office, which could take any amount of liabilities (deposits are liabilities, for a bank) and turn them into assets generating billions of dollars in profits.
But the CIO does much more than just provide profits for JPMorgan. In contrast to the bank’s lending book, the CIO is nimble. Loans, as a rule, have to be held to maturity: that’s the essence of relationship banking. Investments, by contrast, can be sold at any time. Of course, an investment which can be sold at any time has another name: it’s a trade. Thus did the CIO become home to big traders, making huge bets and huge bonuses.
In the past couple of years, of course, that raised its own set of problems: how could this group of traders possibly be Volcker-compliant? The answer lay in Drew’s love of crises: her incredibly valuable ability to prevent losses and even make profits when the world is falling apart. In that sense, the CIO was one big hedge, and in a narrower sense the CIO was the go-to office whenever JPMorgan saw a risk which needed hedging.
Mark Dow has an intriguing thesis this morning:
We know that over the last 2-3 quarters of 2011 we were gripped by the fear of a European financial meltdown and a second recession in the US.
We know that that the Fed’s swap lines and the ECB’s LTRO reversed this market view and crushed credit spreads lower, hurting those who had been buying protection in the previous months.
Against this backdrop, it seems likely to me that the aggressive selling of protection we heard about in April 2012 was actually the unwinding of the hedge that had been accumulated in 2011 and was by then deeply underwater.
In other words, Jamie Dimon, like everybody else, was worried about a Europe-induced financial crisis at the end of 2011, and so he told Drew to put on positions which would protect against such a crisis. She did so — only this time around, the crisis never happened, and Drew’s positions had to be unwound.
That’s where things seem to have gone very, very wrong. Drew prided herself on turning every hedge into a profit center — having her cake and eating it too, basically. We’re deep in the realm of speculation, here, but it’s entirely possible that Drew positioned the CIO, at the end of 2011, to profit from a European meltdown. When that meltdown didn’t happen, simply selling those positions would involve realizing a substantial loss. And so rather than selling the positions, Drew decided to put on new, profitable positions which would offset the old hedge. Enter Bruno Iksil, the London Whale, and his enormous trade.
Iksil’s trade was fundamentally bullish, which would make sense for a trade designed to offset a fundamentally bearish hedge. Of course it wasn’t a perfect offset — there’s no such thing as a perfect hedge. Traders making multi-million-dollar bonuses don’t get paid to design perfect hedges, in any case. Iksil was being paid to put on a trade which would make money for the CIO, even as it was also hedging existing positions.
As with all imperfect hedges, however, especially when they’re big and public, the market can always move against you in exactly the way you don’t want. We don’t know the details of Iksil’s trade, but let’s say that the big underlying position was a bearish position in cash bonds, while Iksil’s trade involved a bullish position in the CDS market. In April, the cash and CDS markets stopped mirroring each other, and started behaving very oddly — you’d see bullish moves in cash bonds, combined with bearish moves in the CDS market. That combination, it seems, turned out to be the one thing that JPMorgan wasn’t hedged against, and the losses in the CIO started mounting rapidly.
How did Iksil’s trade go so horribly, massively, wrong? Partly it’s because his position was so big and so public. When hedge funds worked out what he was doing, they managed to get the word out, using stories in Bloomberg and the WSJ. And then it was just a matter of watching the market do what it always does, when it smells blood: I’m told that Boaz Weinstein’s Saba, for one, made a lot of money taking the other side of Iksil’s trade.
Taking a much bigger-picture view, however, what was really going on here was that JPMorgan had hundreds of billions of dollars in excess deposits, thanks to its too-big-to-fail status. And rather than lending out that money and boosting the economy, Jamie Dimon decided to simply play with it in financial markets, just as a hedge fund would. Here’s Bloomberg:
Dimon pushed Drew’s unit, which invests deposits the bank hasn’t loaned, to seek profit by speculating on higher-yielding assets such as credit derivatives, according to five former executives. The CEO suggested positions, a current executive said.
It’s always dangerous when a CEO suggests positions for an internal hedge fund to take, because the CEO by definition has no risk manager with enough authority to effectively constrain him. Dimon is powerful and secure enough that he’s not going to lose his job over this. But he probably should. Partly because the bank’s risk-management procedures were so weak that a $2 billion loss could suddenly appear out of nowhere. Partly because Dimon became too cocky, and started thinking that his job was to trade the bank’s billions for profit. But mainly because he’s lost sight of what JPMorgan has to be, in a post-crisis world.
Those excess deposits weren’t gifted to Dimon on a plate so that he could gamble them on the CDX NA IG 9. Rather, Dimon’s job is to take those deposits and lend them productively into the real economy. Every extra dollar in the CIO is a sign of his failure to do that. And the $2 billion loss is really just a symptom of what happens when banks get too much money, and don’t really know what to do with it all.