The JPMorgan Whale’s regulatory motive

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. Read more

Accounting for credit risk before the crisis – a case of a gateway drug?

“The question is,” said Alice, “whether you can make words mean so many different things.”

In a recent Alphaville post, I made the claim that if the monolines had been required to mark the credit risk that they had taken to market, they would not have played such a prominent role in the financial crisis. Here I want to provide some support for that claim. Read more

Pass the margin on the left hand side

If you read some of the regulations written recently, you may be forgiven for thinking that central clearing is the solution to all the risks in the over-the-counter (OTC) derivatives market. Some rules mandate clearing for certain market participants and trades, while others impose higher capital requirements for staying outside of the system. There is, of course, an implicit assumption in all of this that central clearing is an unequivocally good thing.

If only it were that easy. In fact, there are lots of issues with OTC derivatives clearing. Today, we’ll just look at one aspect: that of margin. Read more

How much is that swap in the window?

Before the crisis, it wasn’t too hard for a corporate client to trade over-the-counter derivatives. They just had to find a bank willing to sign them up, agree some documentation, and they were good to go. For most corporates, banks were eager to help, so the client could probably find someone willing to meet their needs both in terms of what they want to trade and how they wanted to trade it.

If they didn’t want to post collateral, then that was fine. Certain trading arrangements had a cost, sure, but derivatives sales people are known for being accommodating (especially given that they get paid based on the deals that they close). No collateral? No problem, sir! Read more

The doom loop in sovereign exposures

The Basel III capital rules for credit valuation adjustments (CVA) create new, large capital requirements for over-the-counter derivatives trading with counterparties who don’t post daily cash collateral. Yesterday we saw how these rules were inspired by CVA losses on credit protection written by monolines like MBIA and Ambac. Today we’ll examine the unintended consequences of the new rules.

First we have to get a bit technical about how the CVA capital charges work. Sophisticated banks will be required to put their CVAs and eligible hedges into a value-at-risk (VaR) model.  That model will use historical credit spread movements to estimate possible losses for the current CVA and its hedges.  The capital charge is based on the one-in-a-hundred loss. Read more

A tragedy the monolines hath wrought

Yesterday we saw how bank credit risk management imposed credit valuation adjustments (CVA) on over-the-counter derivatives trading to charge for the credit risk being taken. CVA is biggest where the counterparty does not post collateral, is not a good credit, and owes a lot of money under the derivative contract in question.

Act 1 Read more

Revenge of the loan officer

In the first post of his series for FT Alphaville, Deux Ex Macchiato writer David Murphy introduces us to credit valuation adjustments (CVA) by providing some historical perspective. More on David and his background beneath the post.

Whenever you are promised cash in the future by someone who might not pay you back, you have credit risk. In derivatives trading, situations often arise where someone might owe you money in the future, perhaps because you have purchased an option from them, or because a coupon on a swap goes your way rather than theirs. This means that derivatives trading often includes taking some credit risk, along with the more obvious market risks. Read more