I have written several articles recently wherein I attempt to explain further the mechanics of the trade that some estimate will ultimately cost JPMorgan (JPM) $9 billion. There are many reasons why it is absolutely critical to develop as complete an understanding of what happened at the firm's London CIO desk as possible. If you intend to own a part of a company--and that is after all, what you are doing when you buy a stock--you must not only understand the numbers, you must also understand the organizational culture you are buying into. While valuation is important, it is not the sole consideration. No discount to tangible book is sufficient to compensate investors for the risk of going into business with a firm who willingly throws caution to the wind.
Before proceeding let me say that no one knows for sure exactly what the trade involved but by now there are some very educated guesses. Having said that, allow me to explain yet another intricacy of the now infamous trade. As I have explained before, Bruno Iksil was likely trading against hedge funds executing skew trades. In an effort to hedge against mounting losses on a CDX super senior tranche bet placed in 2011, Iksil began selling protection on the IG9 index--this is a portfolio of CDS on North American investment grade (IG) companies. The size of Iksil's position caused the index to become disconnected from its fair value. Noticing the discrepancy, hedge funds attempted to play the skew; that is, they tried to bet that the gap between the index and its fair value would tighten. Because Iksil was willing to sell an unlimited amount of protection, the gap stubbornly refused to close, setting off the alarm bells that led to his detection. The previous articles cited above go into more detail and provide cites to many relevant sources.
The purpose of this article is to present yet another wrinkle in the story and to draw conclusions from it about the firm's culture. Here is the wrinkle: in addition to the purchase of the CDX super senior tranche and the selling of protection on the IG9 index, some contend Iksil was simultaneously buying protection on high-yield (HY) CDX. If we assume that the super senior tranche was the original hedge, any protection bought on HY represents an attempt by Iksil to hedge the hedge of the hedge (adding a third level of abstraction to the whole mess). In other words, having placed a long bet on investment grade debt (via sold protection) to offset losses on a short credit position placed in 2011 (via the super senior tranche), Iksil then took a second short position, this time in high yield credit in an apparent attempt to profit from the fact that, in the event of an economic downturn, high yield would suffer first, creating a wider spread between IG and HY.
The size of Iksil's trades caused the correlation between IG and HY to break down. Of course, JPMorgan's VAR models are largely based on historical correlation. In effect then, the firm blew apart their VAR models with their own trades, which eliminated their ability to detect how risky the position was becoming.
This is where we come full circle to an organizational culture defined by arrogance. The CIO desk was so convinced that it was capable of handling a position the size of Iksil's that it failed to realize that the size of the position was bound to change the correlation upon which their risk models were predicated...
"Once positions become too large and liquidity declines, even the most effective VAR models break down. And once others learn about your concentrated positions, no risk model stands a chance."
If Iksil's trades had not been so large as to displace the market, the firm's models might have had a fighting chance of picking-up on the impending disaster and other market participants might have had a harder time determining what Iksil was up to.
The other disturbing thing about the second short position (purchased HY protection) is that it represents a fundamental unwillingness on the part of the firm to simply be happy with hedging their hedge. Having already suffered substantial losses on the original super senior tranche bet after the ECB eliminated systemic risk with its LTRO, one would think the firm would simply be happy hedging that risk and being done with the matter.
Here's where the arrogance comes in. The firm was so convinced that credit couldn't possibly rally any further in 2012 (remember the original hedge was a short credit position) that they bought protection on HY to try to profit from a projected deterioration. In other words, being wrong once wasn't enough. They got burned on the senior tranche bet, hedged it by selling IG9 protection, then turned around and made another short credit bet paid for by profits from the hedge of the original short credit bet. That's right: so convinced was the firm that short credit was the way to go, they completely ignored the irony inherent in the fact that they were paying for the second short credit bet with profits from a long credit position which they were forced to take because their first short credit position was a loser.
In conclusion then, I implore JPMorgan shareholders or anyone considering purchasing the shares to consider that this is the kind of organizational culture into which you are buying. The firm would like you to believe that the reshuffling of the CIO office will eliminate this sort of recklessness. This seems highly suspect. In order to believe that, you have to accept that the CIO office operated on its own and top management back in New York was ignorant to what was going on. By that logic Jamie Dimon operates with incomplete information about some of the firm's most important trades. That is less than desirable. The other, more plausible alternative, is that top management knew of this trade early-on and hoped, like Ina Drew and like Bruno Iksil, that eventually the market would turn in their favor and no one would have to know. This alternative is less than desirable as well. Short JPM or long JPM puts.