Jp Morgan Chase

JP Morgan Hedge Exposed the Bank to More Risk

The banking giant's experience with a $2 billion trading miscue provides a lesson in how not to protect against potential losses.

Vincent Ryan - CFO.com | US

May 16, 2012

• Email

• Print

• Reprints

• Single Page

• Comments

• Share

o LinkedIn

o Delicious

o Digg

o Facebook

o StumbleUpon

o Permalink

JP Morgan Chase's $2 billion mark-to-market trading loss stemmed from some fundamental mistakes by risk managers: particularly the notion that a hedge on credit exposures could reduce the bank's risk but at the same time earn billions of dollars. 

That's what experts are saying about a trading loss that has knocked billions off the bank's market share, sparked probes by the Justice Department and the Securities and Exchange Commission, forced credit-rating firms to issue negative outlooks for the bank, and turned the spotlight on a bank unit that was set up to invest excess deposits but also generate a sizable profit.

According to JP Morgan, the bank's chief investment office was investing in a benchmark for credit-default swaps designed to mitigate the bank's overall credit exposure, in particular the possibility of higher interest rates and inflation. But the hedge was risky itself and the positions in derivatives so large that they distorted the market, experts say. JP Morgan also may have failed to fully understand its exposure because it was relying too heavily on Value at Risk (VaR) - a common risk model that estimates the potential loss in value of a risky asset or portfolio over a certain number of trading days.

Last Friday JP Morgan stated that the trading positions, reportedly on a series of the 10-year Markit CDX North American Investment Grade index,  were "riskier, more volatile, and less effective as an economic hedge than the firm previously believed." JP Morgan CEO Jamie Dimon admitted that they were "flawed, complex, poorly...