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JPM: Risk And Ego

Published 05/15/2012, 09:45 AM
Updated 07/09/2023, 06:31 AM
CASP
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How does one firm lose $2 billion…and likely more….in less than two months?

Well, it's doable if there's a massive market move. In the case of JP Morgan and the huge loss announced last week, though, the markets broadly speaking had not moved that significantly. Certainly nothing like we saw in the middle of 2011, let alone 2008. So the question begs, how does a firm lose that amount of money?

Risk concentration combined with another factor. What might that be? Let’s navigate.

JP Morgan supposedly had enormous exposure to one corporate credit index: the CDX NA IG 9 Index.CDX NA IG 9 Index
As JP Morgan sold protection -- read, insurance on the underlying corporate credits that make up this index -- it was betting that the premium paid for that protection would fall, generating a profit for the firm. As one can see in the graph, the premium went up.

Alarm Bells
Bloomberg broke this story in mid-April from sources within the market who talked about the massive size of the trades JPM put on this index. Based purely on the price action denoted by the graph of the index, it appears that JP Morgan was likely putting on -- or adding to -- its position in this index in the early part of the year, but stopped adding to the position in mid-February when the premium for the index started moving appreciably wider. One would imagine that, at that point, alarms were screaming inside JPM.

All of this seems to make sense but still doesn't explain how the bank lost so much so quickly. As industry insiders are now speculating, the size of JPM’s exposure to the index was somewhere in the vicinity of $100 billion. That fact is almost unfathomable. How does one trader/portfolio manager allow a position to get so large? First and foremost, it's a total breakdown in risk management. Any credible risk-management process would have certain position limits on a sector in general and an individual index in particular. Why is that?

The (Lack Of) Human Factor
Outsized risk concentration comes with a price of outsized liquidity risks. That is, how does JP Morgan methodically unwind its exposure to mitigate its risk and the potential for even greater losses. Having seen this occurrence more than once, the wizards who enter into these trades don't appreciate that liquidity is provided not by black boxes but by other human beings.

This breakdown in portfolio risk management is where street smarts will beat the book smarts of the quants engaged in this casino-like behavior everytime. What is typically the critical factor behind these situations? Ego. The traders/portfolio managers truly believe they are smarter than the market itself. They aren't.

This wasn't the first time something like this has happened, and I can assure you it'll happen many times again. Why? There's just no real hedge against ego, let alone for one with a massive portfolio and a suspect risk management process.

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