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Risk management at JP Morgan

Today’s news that JP Morgan lost $2bn on trading credit derivatives looks like a particularly nasty story and is likely to go on for some time. According to some estimates JP Morgan has a position of $100 billion in credit derivatives, with what appears to be little or no risk management.

Given that this loss apparently has materialised over the last six weeks and that their own VAR (value at risk) estimate was $67m/day it looks to me like they’ve managed to max out the risk model every day over this six week period in order to lose $2bn. 67m/day x 30days = $2.01bn. This is extraordinary. Obviously JPM’s VAR model was wrong (and they are now changing it) as it should be the value of the maximum loss on a single day if the market really goes against them. How can you be so unlucky that you manage to lose the maximum amount every day for six weeks straight? Or in hedge fund speak a sigma 2 event every day for six weeks. What is the likelihood of that? Something else is wrong. Remember that this position is supposed to be a hedge. If I was Bruno Iksil, they guy who run this show at JPM, I’d take out a short position on the national lottery. Or to paraphrase Gordon Gekko “if this guy was an undertaker, no one would die”. Rest assured that JPM’s competitors and counterparties have now been showed JPM’s hand and will go after the rest of that $100bn position. To amount losses like this, JPM has clearly demonstrated that it hasn’t been unlucky but just extraordinarily incompetent. No one can be that unlucky.

For European markets this is likely to play out in three ways 1) through banks’ exposure to JPM, 2) increased regulation and 3) increased financial risk and market volatility. For the banks I would guess that the likes of Barclays, Deutsche Bank, SocGen have the biggest exposures, but I don’t have any data to back this up, so it’s just a guess. This story also plays into the hands of the lobby for increased regulation, which in turn will mean lower banking profitability and valuations. For the wider market we have to decide if this is the beginnings of a new Lehman event or not. Given the size of JPM (market cap $155bn or 1.5x Facebook and total assets of $2.3 trillion) the bank should be able to withstand further losses. After all, according to the statement, the $2bn loss only reduced JPM’s core capital from 8.4% to 8.2%. However, as we saw with Lehman Brothers, Bear Stern, Northern Rock, HBOS, et al, it’s not the actual balance sheet that matters but the market’s perception and confidence in the balance sheet that matters. If the market decides that JPM isn’t to be trusted this story could become a lot more volatile. JPM is currently off 9%. There should be more to come.

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