The full story of why JPMorgan entered into the trades that cost it so much money may never become public. However, thanks to Jamie Dimon’s testimony on Wednesday, we can conjecture a little more about the motivations behind the synthetic credit trades entered into by the bank’s Chief Investment Office.
The story begins with surplus deposits. JPMorgan was perceived as safe thanks to its size and relatively good record during the 2008 crisis, so it attracted significant deposit inflows. Much of this money was lent out, but not all of it was, giving rise to the problem of what to invest it in. With government bonds paying record low rates, the bank decided, understandably, to invest some of the funds in corporate and asset-backed securities. The CIO bought over $380bn of these bonds, a very substantial position.
A diversified portfolio of this size generates good returns in ordinary markets, but it would have exposed the bank to large losses if (yet) another crisis were to hit. So, we think, JPMorgan decided to buy some protection against a crash by going to the synthetic credit market.
It is here that accounting rules start to make their life awkward. Both JPMorgan’s deposits and the bonds they were invested in are banking book items. These derivatives, however, are trading book items that attract fair value accounting.
If JPMorgan had just bought, say, senior tranche protection on a credit index, then while the bank’s position would indeed have been crash-hedged, it would have generated significant earnings volatility as the bonds would not have been marked-to-market but the derivatives would have been. In particular, in a tightening credit environment, such as we had earlier in the year as the ECB injected liquidity into the banking system, the derivatives would have lost money without a corresponding accounting gain on the bonds.
One way around this accounting mismatch is to restructure the derivatives position. The idea is still to be long crash protection — again, by buying protection on senior tranches, for example — but to offset this by also selling protection on the index. If done correctly this position will be indifferent to small moves in credit spreads (‘delta neutral’), but it will make money if there is a big increase in spreads.
This removes the fair value volatility from the position at the cost of introducing correlation risk: the amount of index you need to sell is a function of the correlation between the names in the index, so you have to readjust your hedge as the market price of correlation changes.
At this point, as Dimon’s testimony hints, regulation intervenes…
After the crisis, the Basel committee introduced some rules known as Basel 2.5 which change the capital treatment of many trading book positions — exactly where the synthetic credit positions are residing.
Prior to Basel 2.5, sophisticated banks like JPMorgan would have put correlation trading positions into their VaR models in order to calculate regulatory capital requirements. With the introduction of the new rules, these banks will have to use a new type of model for correlation trading, known as a Comprehensive Risk Model (‘CRM’).
CRMs are more sophisticated than VaR models, and are supposed to account for credit spread movements, correlation changes, defaults, and other factors. They are already being used in the EU and will one day be required in the US. Anticipating the changes, JPMorgan probably reviewed the capital consumed by various business lines in light of the new framework.
Banking book bonds ‘hedged’ with synthetic credit positions would have used a lot of capital. This is because there is again a mismatch; the bonds would not have gone into the CRM but synthetic credit positions would have, resulting in high capital requirement.
This regulatory mismatch provided another incentive to restructure the trade. What JPMorgan needed was a trade that didn’t have much accounting volatility, looked comparatively low risk in a CRM model, didn’t cost too much, and yet provided crash protection on its bond portfolio.
With these complex and conflicting requirements, it is perhaps no surprise that they ended up with something that was too complex to manage.
Perhaps the only reason why no other similar cases have come to light is that only JPMorgan had such large amounts of surplus liquidity that they had the problem of knowing what to do with it. In a way, the most interesting question in this whole saga is why they didn’t just lend those funds out.
David Murphy is a risk management and regulatory capital expert. He is the author of Unravelling the Credit Crunch and Understanding Risk; he runs rivast, a financial consulting firm; and he blogs at Deus Ex Macchiato.
He was formerly head of risk at ISDA, and has also held a number of senior roles in investment banking.
Understanding Jamie Dimon’s Testimony: the strange case of CRM – Deus Ex Macchiato
Whale precursors – FT Alphaville
Whale-watching series – FT Alphaville
These are the voyages of the JP Morgan CIO – FT Alphaville