After the market close last Thursday, JP Morgan Chase (JPM) announced that it had incurred a large loss in a “hedge” position.  The loss is rumored to be approximately $2.3 billion.  If it was truly a hedge position then there presumably is a gain on the item being hedged.  I did not see any mention of that in the initial press coverage.  So what can we conclude from that?  One possibility is that the accounting for the item being hedged is not marked to market.  In that case, there is an accounting loss but maybe there is zero or at least a smaller “economic” loss.  Another possibility is that there is no offsetting gain.  In that case the “hedge” was poorly designed or really was not a hedge at all.

Market speculation is that the losses stem from a London based trading unit that supposedly was selling protection on a portfolio of corporate credits.  The seller of credit protection is taking on credit risk, which is a natural position for a commercial bank. So, maybe the bank believed it was underexposed to corporate credit and assigned the London unit the task of increasing the bank’s exposure to the desired level. 

Like other banks, JPM produces each day an estimate of the maximum loss that it would expect to incur on trading positions 95% of the time.  This number is called the 95% value at risk (VAR).  It is also the minimum loss that one would expect 5% of the time.  That is, we should expect a daily loss greater than the VAR five percent of the days.  One weakness of the VAR is that it does not tell you anything about how large the loss is likely to be on the one in one hundred days that the VAR is exceeded.  JPM’s VAR during the first quarter was reported to be in the neighborhood of $60-70 million.  Thus, the actual loss has turned out to be more than 30 times the VAR.  While this loss did not transpire all within one day, the huge size of the loss relative to the VAR supports the argument that capital requirements set at a modest multiple of daily VAR is too low, probably much too low (I made the same argument back in October – http://www.clucerf.org/blog/2011/10/24/value-at-risk-and-extreme-scenarios/).

On Friday, the JPM stock price fell ten percent, shaving $15 billion off the value of the company.  This is seven times the reported loss.  On the face of it, it appears that the equity market reaction is overblown.  Or maybe stock market investors have downgraded their formerly high assessment of JPM risk controls. 

In a former life I was responsible for the interest rate hedging operation at a fortune 100 financial services company.  I used to say, only partly in jest, that my personal performance metric was to never show up on the front page of the Wall Street Journal in an article on hedge debacles.  There have been many such debacles over the past two decades.  Each time there is some lesson to be learned, for example separating trading and controls (Barings), recognizing that loss distributions tend to have fat tails (LTCM), the need to alter compensation schemes for senior executives and traders (Bear Stearns and Lehman Brothers).  The good news is that with all these lessons, management teams are no doubt getting smarter and more cognizant of the various things that can go wrong.  Even so, boards and management teams are probably still not smart enough to avoid future debacles.  The overriding lesson is that we should insist on more transparency and greater capital cushions for the giant banks.  If this makes them less competitive, and thereby encourages reductions in size, so be it.