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The JP Morgan debacle – guess who’ll pay the bill

May 27, 2012

Published in ‘New Europe’, May 27-June 2, 2012, page 36

The JP Morgan debacleWhen Nassim Taleb wrote his best seller “The Black Swan,” he tried to describe outliers, that is: very rare and highly improbable events, that carry extreme impact on the social, political, or financial system. What we see nowadays is that those black swans are not as rare as Taleb thought and, over the last three years, they tend to happen more and more often, to the point that we have become accustomed to them, especially in the financial sphere. The last “bird” of this sort carries the name JP Morgan Chase–the largest financial firm in the United States.

Without getting into too much detail, in 2011, the bank made profit by betting that credit conditions would worsen; in early 2012, London traders of JP Morgan changed their view and took opposite positions. As a result, the bank now has a losing portfolio of long and short positions with a face value of roughly $100 billion in a derivative index tracking the health of corporate debt, the Markit CDX North America Investment Grade Index. Things got more complicated by the fact that JP Morgan itself controls a large part of the trading in this index; thus, unwinding its own positions might influence the index negatively, and further hurting its own results. So far, the estimated loss is between $2 and $5 billion, but none can exclude it might shoot higher. Total loss in stockholder value is over $30 billion, and growing…

To make the story more exciting, one must note that JP Morgan’s Chairman and CEO James Dimon was considered as the best risk manager of the banking industry; that the trade was approved by him personally, although he was not aware of its execution details; and, finally, the position was handled by a London trader nick-named as “the whale” due to the size of his trades. And of course, all this happened under the wise supervision of roughly 70 (yes, seventy) people assigned by the relevant market watchdog, the Office of the Comptroller of the Currency, which proudly carries the logo “Ensuing a Sound National Banking System for all Americans.”

Now, on the serious side, all this debacle raises two important remarks.

First, JP Morgan is not exactly a bank, but the result of the merger of four large financial institutions, namely: JP Morgan, Chase Manhattan, Manufacturers Hanover, and Chemical Bank. Those institutions were large enough in their own right to carry significant risk by their operation as separate entities; their combination has created a monstrous structure that is not only too-large-to-fail, but also too-complex-to manage. It seems that the message of the 2008 crisis didn’t get through, and financial institutions kept growing, both in terms of assets and of trading books.

Then, comes (again) the question of financial modelling and its use and abuse by the financial industry in evaluating risks. Most banks use the now famous VaR or Value-at-Risk model as their main tool for evaluating the total risk of their portfolios. The objective is to have a single metric capable of capturing all the risks of a portfolio, after netting the long and short positions. The problem is that this metric systematically underestimates the total risk. The funny thing is that the VaR model was largely developed and promoted by JP Morgan itself. And the troubling point is that the model’s flaws have been widely known for a long time, to the point that a US House of Representatives’ “Subcommittee on Investigations and Oversight” was convened on September 10, 2009, a year after the crash, to examine “Risk models and specifically a method of risk measurement known as Value-at-Risk… [an important factor to] risk-taking that has led to a global recession with trillions of dollars in direct and indirect costs imposed on US taxpayers and working families.”

Three years later, the case of JP Morgan shows that the lessons from the 2008 crisis have not been learnt, and the taxpayers and working families will be called again to pay the bill, through the massive transfer of income that constitutes the zero percent lending policy of the Fed to the banks.

Christos Kissas, PhD

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