James Dimon. (AP Photo/Mark Lennihan)
J.P. Morgan’s CEO Jamie Dimon once sarcastically complained that all his traders would need to talk to a psychiatrist in order to comply with regulations. Now, in the absence of strict regulations, every trader on the street is psychoanalyzing Dimon’s every word in order to try to make money off J.P. Morgan’s very large mistake.
Back in February, Dimon famously told Fox Business that because of the Volcker Rule for “every trader, we are going to have to have a lawyer, a compliance officer, a doctor to see what their testosterone levels are, and a shrink, ‘what is your intent?’ ” But now it is J.P. Morgan’s intent in a $100 billion bet that has sent the financial media abuzz with questions. The $2 billion loss that J.P. Morgan has incurred related to this position has only further fueled the speculations about what, exactly, J.P. Morgan was trying to do with this trade.
Bloomberg reported in April  that a J.P. Morgan trader dubbed by the media as “the London Whale” had a $100 billion trade that was so large it was distorting the market. Specifically, this trader is said to have sold $100 billion worth of credit default swaps on a group of high-grade North American companies (the NA IG CDX Index). What that means is that J.P. Morgan made a $100 billion bet that investment-grade corporate debt would remain strong or get stronger and that the companies would be free from defaults.
This position is huge for the market in which it trades. Lisa Pollack at FT Alphaville  pointed out that the total outstanding notional across the entire market for this index for March was nearly $150 billion. This is interesting because back in February, Dimon said that at J.P. Morgan, “we don’t make huge bets.”
It remains unclear whether or not Jamie Dimon was lying back in February; whether this $100 billion trade is a bet, or if it would be considered a hedge. Hedges are offsetting trades that are placed to reduce your overall risk. Quite clearly, J.P. Morgan has failed to reduce its risk and admitted as much this past Thursday when Dimon held an after-hours conference call. He explained that this trade was part of “a strategy to hedge the firm’s overall credit exposure,” but that instead, it was “riskier, more volatile and less effective.” Hence, the $2 billion loss, with potential for more to come.
In the quest to figure out what this trade is all about, many hypotheses have been raised, including one idea that this is a curve trade  and another that this was a way to reduce the cost of a different hedge . The problem here is that neither of these hypotheses are describing hedges—they are describing bets. Or in Wall Street parlance: proprietary trades.
Proprietary trading is exactly what the Volcker Rule is trying to prohibit at loan-making and deposit-taking institutions. The logic is that if you enjoy cheap financing from the Federal Reserve and the cushion of customer deposits that traditional banks enjoy, you don’t get to act like a hedge fund. To put it another way, the Volcker Rule doesn’t prevent FDIC-insured banks from taking risk, it just prevents them from the financial equivalent of BASE jumping with the taxpayer strapped to their front as a cushion against a fall. You want to continue to proprietary trade? Fine. But do it with your own padding and your own parachute.
When Dimon lambasted the Volcker Rule back in February, he was decrying the efforts it would take to distinguish market making—which is buying and selling on behalf of clients and is permitted by the rule—from proprietary trading. That is why it is so interesting that in Dimon’s opening statement he stated, “I do remind you that none of this has anything to do with clients.”
Nothing to do with clients? Now, I’m not a psychiatrist, but I don’t know that you need to be one to be suspicious of Dimon’s assertion here. If this doesn’t have “anything to do with clients,” that seems like a Freudian admission that this was a proprietary trade. If it is not a proprietary trade, but rather the failure to adequately hedge exposures from their client business, then this would have something to do with clients.
If we psychoanalyze Dimon’s own words from the conference call, more questions arise. Dimon claimed the “original premise…was to hedge the company in a stress credit environment,” but the way you hedge against a stressed credit environment is to go short credit by, for example, selling bonds or buying CDS protection. The London Whale allegedly did precisely the opposite and went long on $100 billion worth of credit—hardly a hedge for a stressed credit environment.
We are beginning to see the fallout from this immense loss at J.P. Morgan. Interestingly, when Dimon complained about the Volcker Rule, he bemoaned that a doctor would have to see what his traders’ “testosterone levels” were. Yet it is a woman, J.P. Morgan’s Chief Investment Officer Ina Drew, who is the first to see the fallout, having announced her retirement on Monday .
J.P. Morgan is regularly touted as having the best risk managers on Wall Street. It invented the gold standard of firm-wide risk measurement known as VaR—Value at Risk. This is the very same metric whose model it just updated, and on the conference call, Dimon noted that “in the first quarter, we implemented a new VaR model, which we now deemed inadequate. And we went back to the old one.” If the kings of risk-taking no longer have their house in order, surely this raises the question, Are the banks not only too big to fail, but too big to manage?
J.P. Morgan’s comment letter on the Volcker Rule offers the criticism that “the proposed rule appears to presume that banking entities will camouflage prohibited proprietary trading to evade the rule, and that extraordinary efforts are necessary to prevent this behavior.” One has to question, in light of the suspicious nature of J.P. Morgan’s latest bets, whether this defensiveness warrants further analysis.