Digging Deeper: Banking Should Be Boring

Share on FacebookTweet about this on TwitterShare on Google+

What happened? How did JPMorganChase lose at least $2 billion and nobody knew?

With the sensational size of the loss involved, this is one time when it’s important to understand the technical steps that led to the debacle. It’s not the size of the loss, or whether risk is inherent, or Dimon’s reputation. but whether the risk could have been foreseen–the policy question ignored in every news report.

This loss came with a “Will Robinson” danger sign (a reference to the ’60s television show, Lost In Space). First the market for the derivatives was small (despite the size of the loss!) involving a limited number of trading firms. This limited trading range produces an illiquid market, a market where it’s difficult to make trades because there are too few buyers and sellers. In JPMorganChase’s case, the company was actually phoning other companies to make sales of their products. So the market also wasn’t blind; most traders easily figured out JPMC were the originators of the market and market makers. The product was a credit default swap. It requires payment or liquidation when the market reaches certain points.

Secondly, JPMorganChase was on one side of the market, acting as seller for instruments it created. JPMC made a one-way bet. The firm was completely exposed to changes in the market and had nowhere to hide.

Third, profit or loss of JPMC trades depended solely on the market demand and on the market raising, not on any of traditional fundamentals of profit, debt, management, product, sales, or other outlook measures. In fact, the derivative was “naked”–it was detached from all measures of business values and depended completely on the market’s movement for its value.There’s the risk! There’s the danger! The red flag!

Fourth, as the market turned, no traders were willing to let JPMorganChase buy out its position–there were no sellers on the other side. Go back to the first point, when the market is illiquid (buyers and sellers are small), there is no market, only trades, and nobody would trade with JPMorganChase; the firm was being squeezed. Thus JPMC violated the oldest market adage. Bulls and bears both can make money, but a hog gets slaughtered. Theirs was not a bad bet or trading error, but a classic textbook mistake, easily foreseen by the warning signs.