JPMorgan lost over $2 billion due to risky derivative trades meant to hedge risks from its corporate lending portfolio. The trades began as short-term insurance contracts but morphed into a massive long-term bet that the yield curve would flatten, leaving JPMorgan exposed when yields rose instead. The flawed strategy violated the bank's own aversion to "negative carry trades" that bleed money over time unless profits eventually outweigh costs.
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SCANDALOUS ACTS - J P Morgan Chase Bank
1. How JPMorgan made its multi-billion dollar blunder - The Term Sheet: Fortune's deals bl... Page 1 of 2
How JPMorgan made its multi-billion dollar blunder
By Stephen Gandel, senior editor May 15, 2012: 6:01 AM ET
At the heart of JPMorgan's $2 billion whale of a trading loss was a deeply flawed
belief.
FORTUNE -- If you want to understand the ill-fated trade that has cost JPMorgan Chase
(JPM) more than $2 billion and counting, all you really need to understand are three words:
Negative carry trade. And what you need to understand about those three words is that they
are dirty - really, really dirty.
In general, Wall Street hates negative carry trades. But it's likely that nowhere were negative
carry trades more loathed than at JPMorgan Chase. Ina Drew, the firm's former chief
investment officer, who left the firm on Monday amid the trading scandal, reportedly believed
that the bank could hedge against business losses and still make money at the same time.
That's very hard to do in general. But it's impossible to do with a negative carry trade. That's
because, until they payout, which not all do, negative carry trades cost more and more
money the longer you hold them. JPMorgan CEO Jamie
Dimon
Most negative carry trades involve buying insurance and paying a regular premium. But they
don't have to. If you rent, because you believe housing prices are going to drop and that you
will be able to buy a home cheaper later, in Wall Street speak that's a negative carry trade. The rent you shell out each
month, minus what you would have paid in interest (after-taxes) on your mortgage and property taxes, is your negative
carry. And the longer you rent, the more housing prices have to drop to make your choice to wait pay off.
That's not to say negative carry trades are always bad. Some have been spectacularly profitable. John Paulson's bet
against the housing market in 2006 and 2007, which reportedly netted $25 billion, was a negative carry trade. But if you are
running a trading operation at a big bank, and you are watching your P&L everyday, like Drew reportedly did, to make sure
your hedges are as profitable as they can be, you will do whatever possible to avoid negative carry trades, even if doing so
opens you up to massive losses down the road, which it appears is exactly what happened to Drew and JPMorgan.
MORE: Tossing blame for JP Morgan trade? Don't forget the Fed.
The bet that blew up in JPMorgan's face probably started mid-last year, but it could be even older than that. Banks,
especially large banks, are generally betting on the economy all the time. They give out money to people and businesses in
the hope that they will get paid back with interest. The problem is that in times of economic stress, the business of banking
is not always a good bet. But you can't close the doors. So, if you are big bank, what you do is hedge.
The easiest way to hedge your bets these days is to buy so called credit default swaps, which are essentially insurance
contracts that pay out if a loan goes sour. That's exactly what JPMorgan started doing in mid-to-late 2011 as the economy
started to slow, Washington gridlocked and the problems in Europe grew. JPMorgan appears to have bought insurance
against a number of large U.S. corporations, protecting the bank against the possibility that if the economy did fall into a
double dip, as more and more people were predicting, the bank would be covered against the chance that some of its
largest corporate customers would default for the next 18 months. The contracts were short-term and expired in December.
And even if they didn't, just the rising threat of higher defaults would likely cause short-term corporate bond prices to fall,
and yields to rise, and make the insurance contracts they were purchasing increase in value.
But while that hedged the bank, the trade, like all negative carries, was also costly. Drew's chief investment office lost $100
million in the second half of 2011, ending the year up just $800 million, compared to a profit of $1.3 billion the year before,
and a gain of $3 billion in 2009. What's more, the economy didn't fall off a cliff, instead it started to improve and by February
again looked well on the path to recovery. At this point, what JPMorgan should have done was close out its insurance bets,
and take the loss. Or at least left them on and just swallowed the CDS premiums as a cost of doing business. Afterall, even
with the costly trades JPMorgan was still able to turn in an overall profit of nearly $19 billion last year. The bank could afford
to have some insurance.
MORE: Corporate America's double standard on the deficit
http://finance.fortune.cnn.com/2012/05/15/jpmorgan-london-whale-blunder/ 5/15/2012