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May 12, 2012, 04.29 PM IST
JPMorgan Chase & Co's shock trading loss of at least USD 2 billion from a failed hedging strategy knocked financial stocks across the globe on Friday, as well as the reputation of the biggest US bank by assets and its CEO Jamie Dimon.
For a bank lauded for navigating the fallout from the 2008 financial crisis without reporting a loss, the errors are embarrassing, especially given Dimon's criticism of the so-called Volcker rule to ban proprietary trading by big banks.
The debacle knocked 8% off JPMorgan's share price and prompted Dallas Federal Reserve Bank President Richard Fisher, who has called for the breakup of the top five US banks, to say he is worried the biggest banks do not have adequate risk management.
"What concerns me is risk management, size, scope," he said in answer to a question about JPMorgan's trading loss. "At what point do you get to the point that you don't know what's going on underneath you? That's the point where you've got too big."
Dimon conceded the losses, which could rise by a further USD 1 billion, were linked to a Wall Street Journal report last month about London-based credit trader Bruno Iksil, nicknamed the 'London Whale', who, the paper said, amassed an outsized position which hedge funds bet against.
Iksil, who graduated in engineering from the Ecole Centrale in Paris in 1991, was not available for comment. The Frenchman, and the Chief Investment Office (CIO) where he works, are known by rival credit traders for taking extremely large positions.
A friend and former JPMorgan colleague said Iksil and his team were not carrying out so-called prop trading, where a bank makes bets with its own money, in disguise and its activities were known about at the highest levels.
"The CIO does not do prop trading, let's be clear on that. It involves taking positions in the form of investments, trades, credit-default swaps, or other, with the aim of rebalancing the risks of JPMorgan's balance sheet.
"The information comes from the very top of the bank and I do not even think that the CIO team members at Bruno's level are given the full picture," the ex-colleague said.
The CIO is run by New York-based Ina Drew, who is Chief Investment Officer.
Iksil was brought into the CIO unit to head its credit desk, an asset class it had not previously covered, a person who worked in the unit said. It built up large credit positions over several years through trades which were vetted by management and the losses now likely resulted from a combination of these trades going wrong, the person said.
The CIO desk had grown rapidly in the past five years and was given free range to trade in a whole range of financial products, the only exception being commodities, they added.
Credit market traders said other banks have comparable functions to JPMorgan's CIO. The French banks, Citigroup, Deutsche Bank and UBS were all cited as examples of large treasury functions that hedge credit exposures in similar ways.
Jobs at risk
JPMorgan reported that since the end of March, the CIO had made significant mark-to-market losses in its synthetic credit portfolio. Although other gains partially offset the trading loss, the bank estimates the business unit will post a loss of USD 800 million in the current quarter. The bank previously forecast the unit would make a profit of about USD 200 million.
Dimon said the problem was with the way the hedging strategy had been carried out, describing it as "ineffective, poorly monitored, poorly constructed".
"It is risky and it will be for a couple quarters," said Dimon, who admitted to having egg on his face due to the loss. He indicated that some people may lose their jobs.
JPMorgan had informed the UK's Financial Services Authority (FSA) of the situation, but this was a regulatory requirement and there was no indication that the regulator would take any action, a source familiar with the situation said.
The loss is a blow to Dimon and the reputation of a bank strong enough to take over investment bank Bear Stearns and consumer bank Washington Mutual when they failed in 2008.
"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."
The bank's position remains strong. It has been earning more than USD 4 billion each quarter, on average, for the past two years and had USD 2.32 trillion of assets supported by USD 190 billion of shareholder equity at the end of March - a ratio of almost 13%. That is four times the industry mean and ahead of 10-11% at Citigroup
JPMorgan shares had fallen by 7% by 1540 GMT on Friday to USD 37.88 and dragged other financial shares lower. Bank of America fell initially before recovering and Citigroup by 2.8%. European banking stocks also recouped some of their earlier losses to close down 0.85%.
In disclosing the loss, Dimon was forced into a major volte face. During an earnings call last month he dismissed reports that Iksil had amassed a huge position that prompted hedge funds to bet against him as "a complete tempest in a teapot".
But on Thursday, Dimon 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."
Questions over precisely what trades had gone wrong for JPMorgan bounced around London's credit markets on Friday, with the focus on credit derivatives. These financial instruments have been targeted by regulators who say their development played a central role in the financial crisis.
But Dimon and leaders of other large banks have recently pushed back. Last week they met Federal Reserve Governor Daniel Tarullo in New York to question the way regulators run tests to see if banks have enough capital to withstand possible losses.
"The argument that financial institutions do not need the new rules to help them avoid the irresponsible actions that led to the crisis of 2008 is at least USD 2 billion harder to make today," Representative Barney Frank said in a statement.
The Democrat co-authored the 2010 Dodd-Frank financial reform law designed to avoid a repeat of the recent credit crisis.
Allegations that traders at the banks take outsized risks with bank capital to earn big bonuses have been among the drivers of government regulations since the financial crisis.
JPMorgan says it uses pay formulas to reduce the chance of that happening throughout the bank.
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.
Dimon said he remained opposed to the Volcker rule.
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