Question

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

Answer 1

A Synthetic Credit Portfolio trader, Bruno Iksil, was given the title of the “London Whale” in the April 6, 2012 issue of the Wall Street Journal and Bloomberg. The London Whale is a trader who earned his nickname by betting huge sums of money in the derivatives markets from his home base in London.
JPMorgan Chase & Company is the largest financial holding company in the United States, with more than $2.4 trillion in assets. It is also the largest derivatives dealer in the world and the largest single participant in world credit derivatives markets. Its principal bank subsidiary, JPMorgan Chase Bank, is the largest U.S. bank. JPMorgan Chase has consistently portrayed itself as an expert in risk management with a solid balance sheet that ensures taxpayers have nothing to fear from its banking activities, including its extensive dealing in derivatives. But in early 2012, the bank’s Chief Investment Office (CIO), which was at that time managing $350 billion in excess deposits, placed a massive bet on a complex set of synthetic credit derivatives that, in 2012, lost at least $6.2 billion.

The CIO’s losses were the result of the so-called “London Whale” trades executed by traders in its London office. The trades were so large in size that they disturbed the entire world credit markets. The magnitude of the losses shocked the investing public and drew attention to the CIO which was found, to be bankrolling high stakes, high risk credit derivative trades that were unknown to its regulators.

The JPMorgan Chase whale trades provide an insight about how synthetic credit derivatives have become a multi-billion dollar source of risk within the U.S. banking system. They also demonstrate how inadequate derivative valuation practices enabled traders to hide substantial losses for months, risk evaluation models were manipulated to downplay risk; and derivative trading and financial results were misrepresented to investors, regulators, policymakers, and the taxpaying public who, when banks lose sunstantially, may be required to finance multi-billion-dollar bailouts.

The JPMorgan Chase whale trades provided a warning signal about the urgent need to tighten the oversight of banks’ derivative trading activities, including through better valuation techniques, more effective hedging documentation, stronger enforcement of risk limits, more accurate risk models, and improved regulatory oversight. The Dodd-Frank Wall Street Reform and Consumer Protection Act is intended to provide the regulatory tools needed to tackle those problems and reduce derivatives-related risk.

JPM’s CIO's main investment was in high quality income bearing securities such as whole loans, mortgage backed securities, corporate securities, sovereign securities, asset backed securities, etc. The synthetic credit portfolio (SCP) was constructed in 2007 in order to protect the bank against adverse credit scenarios such as widening credit spreads during the financial crisis.

A synthetic is an investment that is meant to imitate another investment.Synthetic products are custom designed investments that are created for large investors. Often synthetics will offer investors tailored cash flow patterns, maturities, risk profiles and so on.
There are many different reasons behind the creation of synthetic positions. A synthetic position, for example, may be undertaken to create the same payoff as a financial instrument using other financial instruments. A trader may chose to create a synthetic short position using options as it is easier than borrowing stock and selling it short. This also applies to long positions, as traders can mimic a long position in a stock using options without having to lay out the capital to actually purchase that stock.
Synthetic products are more complex than synthetic positions, as they tend to be custom builds created through contracts. For e.g. convertible bonds.
Synthetic derivarives is an asset class. These are the securities that are reverse engineered to follow the cash flows of a single security.

Synthetic Credit Default Options/Synthetic Derivative Portfolio, for example, invest in credit default swaps. The synthetic CDO itself is further split into tranches that offer different risk profiles to large investors. These products can offer significant returns, but the nature of the structure can also leave high-risk, high-return tranche holders facing contractual liabilities that are not fully valued at the time of purchase. The synthetic products has been a boon to global finance, but the financial crisis of 2007-09 showed that the creators and buyers of synthetic products are not as well-informed as one should be.

The synthetic credit portfolio positions were based on standardized credit default swap (CDS) indices. The positions were the purchase and sale of protection against credit events of the corporate issuers tied to the basket of CDS included in the indices. If the protection was bought (short risk positions) the cash flows were as follows:

• Pay Periodic Premiums
• Receive payments if and when a company included in the Credit Default Swap basket defaulted, filed for bankruptcy or restructured debt.

If the protection was sold (long risk positions) the opposite would be true - in exchange for receiving premiums, the CIO would have to pay protection if a credit event were to occur in the concerned index.

Iksil had three discrete components to his trading strategy. They are as follows :-

(A) JPM purchased credit default swaps (CDS) on high-yield bonds in which JPM would make money if high-yield bonds went down.

(B) JPM wrote substantial amounts of CDX.NA.IG.9, which is a basket of CDS on investment-grade bonds from 121 different issuers.

(C) JPM bought CDS on investment-grade bonds

Component A (long CDS on high-yield bonds) was intended to act as a hedge on a loan book. However, these trades went against Iksil as the economy appeared to show some improvements.

Recognizing that Component A was performing poorly, Iksil created component B. Component B was possibly intended to act as a hedge on component A. Writing CDS on investment-grade bonds is intended to take advantage of the improving economy that Iksil thought he recognized. JP Morgan was trying to hedge some future obligations (letters of credit, future loan growth, etc.).

It appears that once Iksil realized that the market was moving against component B, he sought to make up for it with trades on component C, rather than unwinding component B.

We know, a hedge directly corresponds to some underlying asset. For instance, if one owns 100 shares of stock in Apple Inc. (AAPL) and want to hedge his downside risk, he can buy a put at a strike price of, say, $500. If the shares in AAPL fall below $500, he can sell the puts and collect the difference. However, if he had bought a put on Google Inc. (GOOG) to hedge his ownership of AAPL shares, then he might run into the risk that the stock prices of GOOG and AAPL may not move in tandem. It’s the same thing with JPM’s trades in credit indexes that are supposed to correspond to their loan book in some way. This phenomenon is known as basis risk.

Iksil actually compounded the basis risk with each subsequent tranche of the trade. But because these trades used unique instruments, not only they had basis risk, but also each instrument had its own liquidity risks.

Iksil’s trading in component B (writing CDX.NA.IG.9 index contracts) was so large that his trading activity created a huge gap between the price of the index and the sum of the prices on the underlying CDS. In fact, the aggregate notional value of this index (CDX.NA.IG.9 ) grew by more than 50% in just three months — hence Iksil’s nickname, the London Whale. At one point in the second quarter, buying CDS on the whole index was cheaper than buying CDS individually on all 121 companies it comprises. While the Synthetic Credit Portfolio performed well in 2009 netting the CIO $1 billion, the notional size of its synthetic portfolio increased significantly from $4 billion to $51 billion during 2011, in light of the European default crisis.

The causes of failure of Synthetic Derivative Portfolio (London Whale) strategy

1. Absence of regulatory and corporate oversight - The CIO was not a client facing unit of the bank. For this reason, it did not receive the same scrutiny as other portfolios would receive in terms of regulatory compliance and corporate oversight. There were no separate portfolio limits set for the synthetic credit portfolio (SCP) and there was no daily reporting that was specific for the SCP to senior management. In addition, Risk committee meetings were held infrequently and were rarely attended by other than CIO personnel.

2. Inexperienced and unqualified personnel - Risk management specifically for the credit derivatives portfolio of the CIO unit was not good. The task force assigned by JP Morgan Chase Bank to investigate CIO losses reported that the risks of the trading strategies were neither adequately analyzed nor questioned prior to their implementation.

3. Reporting line & disclosure deficiencies - Regular risk reporting of the CIO’s risk, prior to February 2012 was made officially to the bank’s CRO . The bank’s risk management team depended on the risk numbers reported by the CIO’s risk team.The CIO team was selective in communicating their strategy and portfolio position of the SCP to JP Morgan senior management.

4. Conflicts of interest - The investment and risk management teams would have conflicting interests, i.e. between optimizing returns from the investments for the trading team against reducing the risk for the risk management team.

5. Inadequate controls - VaR model (or Vlue at Risk model) which was mainly followed by JP morgan at that time, works well for liquid markets because of the existence of a credible price history- it may not be appropriate for illiquid markets with numbered institutional investors where price history is more fragmented and less frequent.