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25 Aug 2013 10:28
Banks globally have been hogging headlines for the wrong reasons, most of them complex financial scandals.
Barclays, Deutsche Bank and as yet 20 unnamed others are embroiled in the London interbank offered rate (Libor) scandal. HSBC has been accused of enabling drug lords to launder money in Mexico.
Then there is JP Morgan and its chief executive, Jamie Dimon, a walk-on-water banker who came through the subprime crisis unscathed and even managed to produce a profit while his competitors were standing cap in hand in the bailout queues.
This was thanks to a bet its chief investment office made against subprime mortgage loans in 2007.
The chief investment office is no small thing within JP Morgan. It has assets under management of $360-billion, up from $75.6-billion in 2007. This is more than a chunk of change for JP Morgan, which has assets of $2.3-trillion.
But the office has recently chalked up losses of $5.8-billion associated with the activities of a single trader, Bruno Iksil, also known as the London Whale, because of the size of his bets. The tale of this whale and how he came to ratchet up these eye-watering losses is worth examining in depth because it appears to speak to the core problem – at the heart of which is a rotten system.
Little is known about Iksil. He lives in Paris but works in London, does not like working on Fridays, wears black jeans and does not like ties. And he is no longer in the employ of JP Morgan; he left the bank last month. Iksil often fell back on complex mathematical equations, throwing about jargon to confuse superiors when questioned about his trades, website Zerohedge reported.
At one time Iksil was earning $100-million a year as JP Morgan's top trader. In 2010 his work helped to contribute $5-billion in profit to the $17.4-billion that JP Morgan reported overall. But in May this year the chief investment office posted a loss of more than $5.8-billion as the result of Iksil's aggressive exposure in the market.
Sometimes referred to as Voldemort, the evil character in the Harry Potter series, Iksil gained a dark reputation for the massive bet he took, creating buzz in the hedge fund industry on both sides of the Atlantic.
Iksil took massive positions, perhaps as much as $100-billion, in an obscure security known as IG9 10-year, the Investment Grade 9, 10-year credit default swap index, to give it its full name.
Investors use credit default swaps to insure against default by corporate and sovereign bonds. Basically, you buy insurance to cover the investment made in the bond against default. The credit default swap is then traded on the secondary markets as an investment in its own right. If a swap price is high, it signals a higher risk of default. The lower its cost, the lower the risk of a default.
Buyers and sellers
The IG9 10-year is a highly traded index tied to the creditworthiness of the more than 120 companies it bundles together. Constituents include Alcoa, General Mills and McDonald's. Created in 2007, this credit default swap matures on December 20 2017. Originally there were 125 companies in the index, but there have been four defaults since its inception: mortgage providers Fannie Mae and Freddie Mac, savings bank Washington Mutual and loan provider CIT.
According to Bloomberg, the size of the Iksil whale trade is not known, but as much as $100-billion could have been linked to this index.
In this market, as with any other, there are buyers and sellers. Both sides of the trade depended on the volatile and unpredictable European debt crisis. Iksil's position was that debt insurance costs would go down, whereas his adversaries were betting that euro worries would increase debt insurance costs. His bet was that the index would fall, basically betting that the cost of insuring against default would decrease.
Iksil sold credit default swaps at such a rapid pace that the index dropped 6.7 basis points in just two days from January 25 to January 27 this year. Although traders were excited by the extraordinary volume passing through the credit derivative market, hedge fund managers were astonished at the moves on the IG9 10-year.
Traders in the United States were baffled by this outsize position and speculated about how many banks and traders were behind the multibillion dollar position.
But a single trader was behind the trade: Iksil. He was in effect the market and was winning his own bet, his trade working in his favour.
It takes a whale trader to spot a whale trader and a competitor was soon to spoil his play. Boaz Weinstein, chief executive of the $5.5-billion Saba Capital hedge fund, took up the challenge of counteracting the outsized trade.
Weinstein recognised the traits of a risky trade and set up for a kill, including convincing traders at an investor conference in New York that the London Whale was significantly exposed. He recommended traders buy IG9 10-year when it was trading at 120 basis points. This was in February this year.
A basis point equals $1 000 annually on a contract protecting $10-million of debt, so 120 points would mean that it would cost $120 000 a year to protect $10-million.
The index hit a low of 105 basis points on March 21. Weinstein and his traders were losing ground but remained relentless in their bets.
As Iksil continued to short IG9 10-year, Weinstein's Saba Capital and other traders took long positions. His position was so big that Saba and other hedge funds that were his allies worked for months to buy up the oversupply of Iksil's sell orders.
But they chipped away at his position, eventually leaving him exposed when the trade as a whole turned against him. Given the size of his bet, he was hopelessly exposed because he could not easily liquidate his position. The whale was beached. He lost while Weinstein and his allies started raking in the profit.
According to the Wall Street Journal, for every $1000 increase in the annual cost of protection for the IG9 10-year index, JP Morgan would have lost as much as $490000 per $1-billion of net credit default swaps it sold.
Dimon said last month that by July 13 JP Morgan cut its IG9 positions by 70%, but warned losses could increase by another $1.7-billion from the present $5.8-billion.
Chief executive's baby 'could do no wrong'
How could JP Morgan not notice such a large bet? Bloomberg, in a detailed analysis, reported that chief executive Jamie Dimon had come under fire for not having tighter control over the chief investment office, which has had five executives in the past six years.
Bloomberg reported that Dimon created the office in 2005 to increase profit and invest in government-backed securities and other high-yielding assets, and the office soon started to increase the limits on trades. Former JP Morgan's executives have said that limits were often ignored.
Dimon testified to the US Senate banking committee last month that JP Morgan "embarked on a complex strategy that entailed adding positions that it believed would offset the existing ones".
In 2005, Dimon moved Ina Drew from the bank's global treasury into the position of chief investment officer. Drew, who was reporting directly to Dimon, was allegedly encouraged to invest in higher-yielding assets such as credit default swaps, said Bloomberg.
Although the London Whale's initial losses hit $2-billion, JP Morgan had to start unwinding the large position on IG9 10-year to limit future losses. Dimon warned that total losses could hit $8-billion.
Drew resigned in May, after the losses were announced, and agreed to return two years of her compensation.
With Achilles Macris as chief executive of the chief investment office in London, the new strategy started working well for JP Morgan. Bloomberg reported that Macris's team created a portfolio of $200-billion, posting a profit of $5-billion in 2010, more than a quarter of JP Morgan's net income that year.
Macris left JP Morgan with Drew.
In his Senate committee testimony, Dimon did not refer to the London Whale as a rogue trader, or put the blame on Bruno Iksil.
Bloomberg quoted JP Morgan executives who said Dimon treated the chief investment office differently to the rest of JP Morgan, saying it was exempt from the "rigorous scrutiny he applied to risk management in the investment bank". Bloomberg said one reason it did not spot trouble at the office was because of Dimon. It said he had no intention of stepping down.
Cyber watch keeps you informed
Zerohedge.com is a lively financial news website allegedly headed by a former Goldman Sachs employee who was penalised for insider trading on a bet that was worth $800.
Founded in 2009, it has the fictional Tyler Durden, taken from the movie Fight Club, as its lead author.
Known for exposing misdeeds in the financial sphere, it has questioned why JP Morgan could put such a large amount of money at risk. Zerohedge believes the risk on one single trade was easy to take, claiming JP Morgan is well aware and confident that the "taxpayer" – through the United States Federal Reserve – would come to the rescue should things go bad.
It argues that if banks did not have access to cheap money and bailouts, they would not be taking such large risks.
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