Tyler Durden has released a 22 point step-by-step summary of JPM’s derivatives crisis and exactly how The Morgue’s CIO office lost billions.
To summarize (as Durden’s explanation is extremely technical), Bruno Iksil and his CIO office were given the task of hedging tail risk for JPM’s net long (equity/bond) positions in mid-late 2011. In late 2011 when Europe nearly collapsed and the Fed bailout out Europe through unlimited ECB swap lines, the correlation on JPM’s tail-risk hedges collapsed- meaning that the market priced out the possibility of tail-risk collapse scenarios because the market implicitly understood that The Fed stood ready to print to infinity, and beyond. This created the need for Iksil to hedge his tail-risk hedge that was rapidly losing correlation.
The credit instruments available to hedge a tail-risk hedge were few, and Iksil soon dominated the entire IG9 index attempting to hedge his de-correlating tail risk hedge.
Then, when the European crisis began to intensify in early 2012, and the US economy began to roll over again, Iksil’s original tail-risk hedge began to again correlate as it was intended (the market began to again price in the possibility that a tail-risk disaster scenario was a possibility)…creating a need for Iksil to eliminate the hedge of the hedge.
As JPM had essentially became the market in the IG9 index, unwinding the hedge of the hedge became a major issue due to liquidity, the hedge funds and sharks smelled blood, and the rout was on. $2 billion in losses later Jamie received a late night phone call.
That’s the cliff note summary version. For our highly financial lingo literate readers, Tyler Durden’s full analysis is a MUST READ (for those who aren’t highly literate in finance we still recommend reading the analysis, as tail-risk hedging is very similar to delta-risk hedging in options, which is the mechanism by which JPM and the cartel are able to blow out stops and manipulate the metals markets so violently just prior to options expiration).
Summary: JPM tail-risk hedge imploded thanks to Central Banks’ Systemic Risk reduction – unintended consequence…
The key factor is that if systemic risk had remained in even a ‘normal’ range of possible regions based on history, then the JPM CIO office would have had no need to over-hedge their tail-risk hedge position, no greed-driven need to press the momentum, and no need for such an epic collapse as we are seeing now.
The point is – this was a trader/manager with a good idea (hedge tail risk) that was executed poorly (and with arrogance) but exaggerated by the unintended consequences of the Central-Banks-of-the-world’s actions (and ‘models behaving badly’ as Derman would say).