Big Banks Misbehaving: Botched Hedging

September 30, 2012

Economist Bill Emmons provides a brief rundown of how hedging is supposed to work, and then dives into the case of the London whale (trader Bruno Iksil) and the investigations into the more than $6 billion in losses incurred by Iksil and JPMorgan Chase's Chief Investment Office in London.

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William Emmons: The second issue is what I'm calling botched hedging. So I'll speak briefly to watch hedging is, how it's supposed to work. What JP Morgan Chase did in one of their offices in London. How they were found out, and what's happening now.

So first, what is hedging? Well, hedging is taking an equal and opposition to offset an existing position, financial position. So a perfect hedge eliminates risk, but it also eliminates profit. JP Morgan Chase in its, what's termed its Chief Investment Office in London, sometimes employed imperfect hedges. And lots of other financial institutions do. Why? Well, because they thought that their traders might be able to identify imperfections or mis-pricings in certain asset markets or derivatives markets and actually collect some profit for accepting some minimal amount of risk, or at least that's the theory.

Now, of course, this raises the basic question, is this hedging or is this proprietary trading, that is trading for one's own account? And as I understand it, Steve or Julie or Mary may have information on this too, the so-called Volker Rule, which we'll talk about a little bit later, which is designed to eliminate proprietary trading, apparently would not have prohibited these trades. So it's not a perfect hedge, but it may still be allowed under the new Volker Rule, which is coming into force hopefully before too long.

How did this get out? Well, rumors were circulating in financial markets in early 2012 that a single trader, which somebody named the London Whale, was taking extremely large market moving positions in certain derivatives markets, corporate credit derivatives markets. The rumor was that it was JP Morgan, and it turned out to be true.

In March of this year, the CEO, Jamie Dimon, said that rumors that JP Morgan would lose a lot of money on these trades were a tempest in a teapot. That actually turns out to be a very important disclosure or statement. And that's the basis of some of the investigations going on now, as I'll say in just a second.

So in May of this year, JP Morgan reported about $2 billion of losses on those positions as they tried to exit those positions. The latest loss estimates are quite a bit higher, somewhere in the neighborhood of $6 billion. And importantly, JP Morgan restated their first quarter earnings, reflecting higher losses than they originally reported.

There have been many heads that rolled. One, Bruno Iksil, who was the London Whale, as well as the head of that office in London, Ina Drew, and some others. The Chairman and CEO of JP Morgan, Jamie Dimon, was called to testify before multiple committees in Congress. And there are currently investigations underway at federal and state agencies in the United States and in the United Kingdom targeting inadequate or misleading disclosures, going back to those statements in March, and then the initial reporting of earnings.

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