Friday, June 1, 2012

JP Morgan’s Synthetic Credit Portfolio Losses


On March 10, 2012, JP Morgan has announced a 2 BUSD trading loss on credit derivatives trading. Since then, JP Morgan’s top management in its Chief Investment Office (CIO) has changed and speculation is ongoing about the “real losses” incurred by JP Morgan’s investment.

Unfortunately, I have not yet found the explanation of what these positions are specifically about. The official information as of today is as follows:

JP Morgan's 10-Q filing dated 10 Mai 2012

Let’s first stick to JP Morgan’s 10-Q filing for the first quarter 2012. On page 9 of this filing we learn that

  • the loss has occurred in JP Morgan’s Corporate / Private Equity segment;
  • the loss has occurred as a consequence of marking to market a synthetic credit portfolio that was intended to work as an economic hedge for the firm.

The relevant passage reads as follows:


In Corporate, within the Corporate/Private Equity segment, net income (excluding Private Equity results and litigation expense) for the second quarter is currently estimated to be a loss of approximately $800 million. (Prior guidance for Corporate quarterly net income (excluding Private Equity results, litigation expense and nonrecurring significant items) was approximately $200 million.) Actual second quarter results could be substantially different from the current estimate and will depend on market levels and portfolio actions related to investments held by the Chief Investment Office (CIO), as well as other activities in Corporate during the remainder of the quarter.

Since March 31, 2012, CIO has had significant mark-to-market losses in its synthetic credit portfolio, and this portfolio has proven to be riskier, more volatile and less effective as an economic hedge than the Firm previously believed. The losses in CIO's synthetic credit portfolio have been partially offset by realized gains from sales, predominantly of credit-related positions, in CIO's AFS securities portfolio. As of March 31, 2012, the value of CIO's total AFS securities portfolio exceeded its cost by approximately $8 billion. Since then, this portfolio (inclusive of the realized gains in the second quarter to date) has appreciated in value.

The Firm is currently repositioning CIO's synthetic credit portfolio. Accordingly, net income in Corporate likely will be more volatile in future periods than it has been in the past.”


As regards CIO's average VaR, its value has more than doubled in Q1 2012 (129 MUSD) as compared to Q1 2011 (60 MUSD). On March 31, 2012, CIO's VaR is 186 MUSD compared to 55 MUSD on March 31, 2011. (See JP Morgan's 10Q filing, pages 73 et seq.)

In plain English, this means that, on March 31, 2012, CIO's portfolio had a 5 % chance to devalue by 186 MUSD or, in other words, during 100 trading days, CIO's portfolio would loose at least 186 MUSD on 5 trading days. However, such VaR, first, does not correspond to an actual mark-to-market loss on a specific trading day and, second, does still not tell us anything about the type of positions taken by JP Morgan.


Business Update Call dated May 10, 2102

Second, we could analyze the business update call given to investors by Jamie Dimon on Mai 10, 2012:

The only passages where JP Morgan's CEO talks about the investment loss are the following:


Regarding what happened, the synthetic credit portfolio was a strategy to hedge the Firm's overall credit exposure, which is our largest risk overall in its trust credit environment. We're reducing that hedge. But in hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored. The portfolio has proven to be riskier, more volatile and less effective than economic hedge than we thought.

What have we done? We've had teams from audit, legal, risk and various control functions all from corporate involved in an extensive review of what happened. We have more work to do, but it's obvious at this point that there are many errors, sloppiness and bad judgment. I do remind you that none of this has anything to do with clients.”


The original premise of the synthetic credit exposure was to hedge the company in a stress credit environment. Our largest exposure is credit across all forms of credit. So we do look at the fat tails that would affect this company. That was the original proposition for this portfolio.

In re-hedging the portfolio, I've already said, it was a bad strategy. It was badly executed. It became more complex. It was poorly monitored. We don't – obviously, we don't have to do anything like this at all, if we don't want.”


The rest of the conference call consisted of general announcements and slogans which did not help understanding the actual investments carried out by JP Morgan. As an example, the hedge was described as follows:


This was a unique thing we did and obviously it had a lot of problems and we are changing appropriately as we are getting our hands around it, but we are going to have a CIO who is going to have talented people there, continue to do what they've always done.”


We are obviously not more intelligent after reading this. As Jamie Dimon said, JP Morgan will explain any details later on:


We will discuss all these matter and more and in fulsome detail on our second quarter analyst call and we are going to take some questions on this call. I do want to tell you now we are not going to take questions about specific risk positions, strategies or specific people.”


Let's wait for the next quarterly report then.


Resources:

  • JP Morgan's 10-Q report dated May 10, 2012
  • Transcript of JP Morgan's business update call dated May 10, 2012