Tuesday, May 22, 2012

JP Morgan and The Whale

The ongoing saga about J.P. Morgan’s multi-billion trading loss involving the “London whale” reminds us of a timeless story – the parable of Jonah and another whale in about 750 B.C.

As the legend goes, Jonah found it difficult to convince people to live the virtuous life, despite being held up as an example.  To pay for his failure, he was tossed out of his boat one day and was swallowed by a whale. After spending three days in the belly of the beast, he repented and promised to try again. The whale then spit him out.

J.P. Morgan’s trading blunder involved a different kind of whale – the so-called London whale. Since then, the London whale’s mammoth trading loss has engulfed an institution previously thought to be exemplary in risk management. The fallout has reignited the debate about proprietary trading, the Volcker Rule and too-big-to-fail.

The modern and ancient storylines are similar, but it’s an open question how J.P. Morgan will re-emerge from the whale.

Were they lucky or good?

Post-crisis, J.P. Morgan found it difficult to live by the Dimon Principle, which is supposed to guard against stupidity born of hubris.

The Dimon Principle and advanced risk management techniques, such as value at risk (VaR), were a key reason J.P. Morgan was one of the most successful in protecting assets during the financial crisis. Unlike the reputation of other bankers, Jamie Dimon’s grew in stature after the crisis because the bank appeared to manage risk so well.

VaR was a core of the bank’s risk management strategy. This technique was supposed to help the bank quantify risk.  In the end, it didn’t work.  The VaR reported to Mr. Dimon showed the trade made by the London whale had a VaR of less than $100 million, not the reported loss of $2 billion that could possibly grow to over $5 billion.

This is not the first time risk management models have failed Wall Street.  The subprime mortgage debacle that triggered the financial crisis is a recent example of a sophisticated model that faltered badly. Mortgage lenders, aided by investment banks and ratings agencies, believed they had cracked the code and were able to properly measure the risk in lending to people previously considered too dodgy for a home loan. We know what happed next.

Is Redemption Next?

To redeem itself, J.P. Morgan has admirably tried to make amends.

Mr. Dimon has owned up to the problem and has admitted that avoidable mistakes were made. He held a conference call to discuss the loss, went on Sunday talk shows, and will testify before Congress.  Those responsible for the loss have resigned or been fired.

The real question is whether J.P. Morgan will renounce proprietary trading – the root cause of the problem.

It’s quite possible it won’t.

There is too much money to be made in proprietary trading. J.P. Morgan, like the rest of Wall Street, relies on “prop trading” to produce huge profits. In fact, big financial institutions still have as strong an incentive as ever to take the unrepentant risk to make up for falling earnings.

Given the pressure to deliver results, it will be interesting to see how J.P. Morgan responds. Until it figures out what to do, the bank will remain trapped inside the whale.


Anonymous said...


Best piece I've read about this issue.

Anonymous said...

A nice post but a bit of a red herring. Prop trading was never in the list of top 5 problems that contributed to the Financial Crisis. AIG, WaMu, Countrywide, Lehman, Fannie, Freddie, plus the hundreds of banks that went under did not fail because of prop trading. While Congress and regulators have made prop trading a target, there is no evidence that has demonstrated that the cons (occasional losses) have outweighed the pros (profits, improved market liquidity).

Jeff Spears said...

Valid point on AIG, WaMu, Countrywide, Fannie, Freddie, plus the hundreds of banks that went under did not fail because of prop trading.

Lehman Brothers and Bear Stearns - not so much.

While prop trading is a potentially profitable business. Do we really want our FDIC insured firms having this as a part of their business?

Sounds like your vote is yes, my vote is no - as they say "that is what makes a market"

I appreciate your comments

Anonymous said...

Jeff- It was not prop trading that put Bear Stearns and Lehman under. It was all the mortgage crap that they were creating and selling that imploded. Very different businesses and completely unrelated to the JPM issue.

BTW- FDIC was not insuring Lehman or Bear Stearns so again a red herring. As a counterpoint, GS' prop trading where they shorted their mortgage book actually contributed to saving them.

Jeff said...

Interesting article in The New York Times today about JP Morgan. One opinion caught my attention.

"Regulators are not typically stationed at divisions like JPMorgan’s chief investment office, which are known as Treasury units. The units hedge risk and invest extra money on hand, and tend to make short-term investments. But JPMorgan’s office, with a portfolio of nearly $400 billion, had become a profit center that made large bets and recorded $5 billion in profit over the three years through 2011. "

Anonymous said...

nice posting.. thanks for sharing.