JPMorgan Chase & Co, the biggest U.S. bank by assets, said it suffered a trading loss of at least $2 billion from a failed hedging strategy, a shock disclosure that hit financial stocks and the reputation of the bank and its CEO, Jamie Dimon.
For a bank viewed as a strong risk manager that went through the financial crisis without reporting a loss, the errors are embarrassing, especially given Dimon's public criticism of the so-called Volcker rule to ban proprietary trading by big banks.
"This puts egg on our face," Dimon said, apologizing on a hastily called conference call with stock analysts. He conceded the losses were linked to a Wall Street Journal report last month about a trader, nicknamed the 'London Whale,' who, the report said, amassed an outsized position which hedge funds bet against.
JPMorgan said in a filing with the Securities and Exchange Commission that since end-March, its Chief Investment Office has had significant mark-to-market losses in its synthetic credit portfolio — these typically include derivatives in a way intended to mimic the performance of securities. While other gains partially offset the trading loss, the bank estimates the business unit with the portfolio will post a loss of $800 million in the current quarter, excluding private equity results and litigation expenses. The bank previously forecast the unit would make a profit of about $200 million.
"It could cost us as much as $1 billion or more," in addition to the loss estimated so far, Dimon said. "It is risky and it will be for a couple quarters."
The dollar loss, though, could be less significant than the hit to Dimon and the reputation of a bank which was strong enough to take over investment bank Bear Stearns and consumer bank Washington Mutual when they collapsed in 2008.
JPMorgan had $2.32 trillion of assets supported by $190 billion of shareholder equity at the end of March — an equity ratio of almost 13 percent, four times the industry mean and ahead of 10-11 percent at Citigroup and Bank of America Corp. — and has been earning more than $4 billion each quarter, on average, for the past two years.
"Jamie has always styled himself as one of the kings of Wall Street," said Nancy Bush, a longtime bank analyst and contributing editor at SNL Financial. "I don't know how this went so bad so quickly with his knowledge and aversion to risk."
JPMorgan shares fell almost 7 percent after the closing bell and dragged other financial shares lower, with Citigroup down 3.6 percent and Bank of America down 2.6 percent. FBR Capital Markets analyst Paul Miller cut his target for the stock to $37 from $50 in response to the disclosures. The shares were at $40.74 before the news.
Dimon said he still believes in his arguments against the Volcker rule. The problem at JPMorgan, he said, was with the execution of the hedging strategy, which "morphed over time" and was "ineffective, poorly monitored, poorly constructed and all of that."
On the call, Dimon said he wouldn't take questions about specific people or their specific trading strategies. But he indicated that some people may lose their jobs as executives sort out what when wrong. "All appropriate corrective action will be taken as necessary in the future," he said.
WHALE OF A LOSS
The April Wall Street Journal report said Bruno Iksil, a London-based trader in JPMorgan's Chief Investment Office, nicknamed the 'London Whale,' had amassed an outsized position that prompted hedge funds to bet against it. On an earnings conference call last month, Dimon called the concern "a complete tempest in a teapot." On Thursday, however, he said the bank's loss had "a bit to do with the article in the press." He added: "I also think we acted a little too defensively to that."
The Chief Investment Office is an arm of the bank that JPMorgan has said is used to make broad bets to hedge its portfolios of individual holdings, such as loans to speculative-grade companies.
The failed hedge likely involved a bet on the flattening of a credit derivative curve, part of the CDX family of investment grade credit indices, said two sources with knowledge of the industry, but not directly involved in the matter. JPMorgan was then caught by sharp moves at the long end of the bet, they said. The CDX index gives traders exposure to credit risk across a range of assets, and gets its value from a basket of individual credit derivatives.
Two financial industry sources in Asia said they heard the JPMorgan trader took a position that a credit derivative curve, part of the CDX family of investment grade credit indices, would flatten, but was caught out by sharp moves at the long end. The CDX index gives traders exposure to credit risk across a range of assets, and gets its value from a basket of individual credit derivatives.
"It's a pretty stunning admission for a company that prides itself on its risk management systems and the strength of its balance sheet," said Sterne Agee analyst Todd Hagerman. "The timing couldn't be worse for the industry. It will have ramifications across the broker-dealer community."
Just last week Dimon and leaders of other large banks met Federal Reserve Governor Daniel Tarullo in New York to question the way the regulators conduct stress tests to see if banks have enough capital to withstand possible losses. They also made arguments over trading restrictions.
Allegations that traders at the banks take outsized risks with bank capital to earn big bonuses have been among the drivers of government regulations adopted, and pending, since the financial crisis.
JPMorgan spokesman Joseph Evangelisti said the company uses pay formulas to reduce the chance of that happening in the Chief Investment Office and throughout the bank. Except for people handling the bank's private equity investments, "no one at JPMorgan is paid on their profits and losses," he said.
PUSHING FOR DETAIL
Regulators and lawmakers are now likely to push Dimon for more details about the trades. Those details will guide how regulators now view the issue and its impact on the Volcker rule, said Karen Petrou, managing partner of Washington-based Federal Financial Analytics.
If the trades were meant to hedge against specific risks as opposed to clearly being done as a proprietary bet on the markets, it may not play as clearly into the Volcker rule debate as supporters of the crackdown want it to, she said.
"The question is whether this in fact was a hedge and I think that's to be determined," she said. "That's really the heart of the matter."
But some in Washington quickly expressed views on the lessons from the episode. Senator Carl Levin, in a statement issued two hours after the news broke, said, "The enormous loss JPMorgan announced today is just the latest evidence that what banks call 'hedges' are often risky bets that so-called 'too big to fail' banks have no business making."
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