Explainer: How JPMorgan lost $2bn
JPMorgan invented credit default swaps in the 1990s, but practice proved bank's undoing in recent hedging loss.
Last Modified: 14 May 2012 10:22
Despite the $2bn loss on failed strategy for credit default swaps, JPMorgan is still expected to turn a profit [Reuters]

A London-based trader working for JPMorgan’s Chief Investment Office, identified in reports as Boris Iksil, whom wags have dubbed “the London Whale”, devised a complex strategy to make money on the credit default swap market.

But the strategy backfired, inflicting at least $2bn in losses and severe reputational damage on the New York-based bank. That figure could yet rise to over $3bn.

What are credit default swaps?

Credit default swaps are a type of derivative, or financial contract, originally created to “hedge”, or insure against, a company defaulting on its bonds. The buyer of a credit default swap on, say, a corporate bond issued by McDonald’s makes regular payments to a seller.

In return, the seller agrees to pay the buyer a prearranged amount of money if McDonald’s defaults on its bond payments.

JPMorgan financiers invented credit default swaps in the 1990s, and bets on the derivatives played a major role in the worldwide financial meltdown of 2008, although JPMorgan emerged relatively unscathed compared to other US banks.

In this case, the trader placed large wagers on the performance of an index (elegantly named “CDX NA IG Series 9”) that tracks credit default swaps on 121 North American corporations.

Why did JPMorgan lose so much money?

At one point, hedge funds discovered that JPMorgan was responsible for the big purchases, and began betting against JPMorgan’s positions.

Because of the limited liquidity in the credit default swap market - that is, because there were few buyers and sellers - it became very difficult for JPMorgan to unwind its positions once it became clear that its strategy was no longer profitable.

In a statement admitting the loss, Jamie Dimon, JPMorgan's chief executive, said: "The portfolio has proved to be riskier, more volatile and less effective as an economic hedge than we thought. There were many errors, sloppiness and bad judgment."

What does this mean for banking regulations?

Dimon has been a vocal opponent of the “Volcker Rule”, a regulation that, when it goes into effect this July, will place restrictions on banks from engaging in “proprietary trading”, or investing for the bank’s own gain, and not on behalf of customers.

Although the $2bn loss will probably not pose major problems for JPMorgan - Dimon says his bank will still turn a profit this quarter - it nevertheless would appear to undermine his criticism of more stringent financial regulation.

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