In early May JPMorgan Chase (JPM) reported $2 billion in trading losses on bets gone awry in the bank's Chief Investment Office. The losses were odd given that (i) the Wall Street Journal had reported a month earlier that a JP Morgan trader nicknamed the "London Whale" had made large bets in the debt markets and (ii) during the financial crisis, JP Morgan avoided the missteps of Goldman Sachs ("Goldman (GS)"), Morgan Stanley (MS), and AIG (AIG) from bets on real estate, mortgage-backed securities and credit default swaps. The Whale made bets on a continued economic recovery with complex trades that moved in relation to the value of corporate bonds. Though the Whale lost billions as prices moved against him, a pack of opportunistic hedge fund traders, led by the "Monster," made millions from credit-default swaps designed to take advantage of mispriced credit derivatives held by the Whale. Other casualties of the trading loss were Ina Drew, JP Morgan's Chief Investment Officer, who retired less than a week after the loss was revealed and Irvin Goldman, who was stripped of his duties as oversight of risk in the Chief Investment Office.
From Predator to Wall Street Prey?
The initial $2 billion loss was a bitter comeuppance for JP Morgan's CEO, Jamie Dimon, whose pristine balance sheet allowed JP Morgan to acquire Bear Stearns ("Bear") in a sweetheart deal in the first quarter of 2008. Dimon has also been a vocal critic of any potential Wall Street financial reform. JP Morgan enjoyed its "predator" role after Bear experienced a run on the bank when (i) clients and short-term lenders pulled out over $18 billion of capital from the firm in a one week period in March 2008 and, (ii) it could not liquidate its $90 billion proprietary trading portfolio quick enough to meet its margin calls. The Federal Reserve stepped in to help facilitate an emergency sale to JP Morgan for $2/share; months prior, Bear had traded as high as $131/share. Pursuant to the transaction, the Fed provided a $29 billion loan to a new corporation, Maiden Lane, to acquire real estate-related assets and securities that JP Morgan did not want. As early as June 2010, those assets had declined by over $5 billion.
The ugly side of a run on the bank that firms like Bear and hedge fund, Long-Term Capital Management ("LTCM"), experienced is once their trading positions are divulged, competitors become mercenary. Legend has it that after LTCM faced liquidity issues from failed sovereign debt investments, it attempted to sell itself to Goldman. Once Goldman learned of LTCM's trading positions during due diligence, it liquidated its own holdings of the same securities and offered to buy them back from LTCM at a lower price. According to Shock Exchange … How Inner City Kids From Brooklyn Predicted The Great Recession And The Pain Ahead due out in July 2012, Ralph Baker, Executive Director of the New York Shock Exchange , explains how Goldman again turned mercenary towards Bear and AIG amid the financial crisis:
The Bear hedge funds valued their MBS assets on prices obtained from investment banks like Goldman Sachs which underwrote them. One of the hedge fund managers implied that of all its counterparties, Goldman offered valuations for securities held by the fund that were starkly lower than competitors, causing the net asset value ("NAV") of the funds to decline further. This allegation against Goldman became a prevailing theme during the financial crisis as AIG made similar claims. Some Bear executives implied that Goldman had an incentive to give the securities a lower mark because Goldman had also "sold short" the securities, i.e. made bets that they would decline in value. Goldman shot back that "the value of the mortgage securities underwritten by Goldman and owned by Bear weren't large enough to cause the overall decline in net asset value that sank the hedge funds … The steepest markdowns of Bear's holdings were triggered by other securities firms."
JPMorgan now finds itself in the unenviable position of Wall Street prey. As the firm has attempted to unwind the Whale's trading positions, the red ink has mounted; according to unnamed traders and executives at the firm, losses could total as much as $9 billion. However, regulators who think the most volatile tranches of JP Morgan's trading positions have been sold, place the ultimate losses in the range of $6 billion to $7 billion. Not debatable is that once JP Morgan's holdings are a fully divulged, hedge fund managers and Wall Street competitors will turn predatory and pound its trading positions. At stake is more than $9 billion of losses. The future of Wall Street financial reform and the stock market hang in the balance as JP Morgan's aura of invincibility and best in class internal controls, the economy and Wall Street's ethics after the Facebook (FB) IPO fiasco are now in question.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.