Question

What was the money making strategy of the Synthetic Derivative Portfolio (London Whale)? And how does it go wrong?

Answer 1

The money making strategy of the Synthetic Derivative Portfolio (London Whale) was to invest excess cash of the bank (JP Morgan or JPM) high quality income bearing securities such as whole loans, mortgage backed securities, corporate securities, sovereign securities, asset backed securities, etc. SCP (i.e. Synthetic Credit Portfolio) was made for the purpose of protecting JPM against adverse credit scenarios such as widening credit spreads. The SCP portfolio positions were based on standardized credit default swap (CDS) indices.

It went wrong after the new VaR (value at risk) model was incorporated after the European default crisis. The new model did not work as market environment and correlation between positions were not as per the expectations of the traders. This combined with factors like absence of regulatory and corporate oversight, reporting line and disclosure deficiencies, inadequate controls and pricing deficiencies caused the portfolio to go wrong.