JP Morgan's Concentration Risk and Outsized Egos

How does one firm “lose” $2 billion…and likely more….in the course of less than two months?

Well, it is doable if there is a massive market move. In the case of JP Morgan and the loss it announced last week, though, the markets broadly speaking had not moved that significantly. Certainly nothing like we experienced during the middle of 2011 let alone 2008. So the question begs, how does a firm lose that amount of money?

Concentration risk combined with another factor. What might that be? Let's navigate. 

JP Morgan supposedly had ENORMOUS exposure to one corporate credit index, that being the CDX NA IG 9 Index.The graph below of this index was sourced from Reuters,

As JP Morgan had sold protection (meaning sold insurance on the underlying corporate credits that make up this index) it was betting that the premium paid for that protection would fall thus generating a profit for the firm. As one can see from the graph, the premium has increased.

Bloomberg broke this story in mid-April from sources within the market talking about the massive size of the trades that JPM had put on in this index. Based purely upon the price action denoted by the graph of the index, it would appear that JP Morgan was likely putting on or adding to its position in this index in the early part of the year but it stopped adding to the position in mid-February when the premium for this index started moving appreciably wider. One would imagine that at that point in time the bells and whistles were going off inside JPM.

All of this seems to make sense but still does not address the question as to how does a $2 billion+ loss get generated so quickly. Well, as industry insiders are now speculating, the size of JPM's exposure to this index was somewhere in the vicinity of $100 billion. That fact is almost unfathomable. How does one trader/portfolio manager allow a position to get so large? First and foremost a total breakdown in risk management. Any credible risk management process would have certain position limits to a sector in general and an individual index specifically. Why is that?

Outsized concentration risk comes with a price of outsized liquidity risks. That is, how does JP Morgan methodically unwind its exposure to mitigate its risk and the potential for even greater losses. Having seen this occurrence more than once, all to often the wizards who enter into these trades do not appreciate that liquidity is provided not by black boxes but by other human beings.

This breakdown in portfolio risk management is where street smarts far outpaces the black box book smarts of the quants engaged in this casino type behavior. What is typically the critical factor behind these situations? Ego. The traders/portfolio managers truly believe they are smarter than the market itself. They never are.

These scenarios have happened many times in the past and I can assure you they will happen many times again. Why? There is no real hedge for an individual who has an outsized ego along with a large portfolio and a suspect risk management process.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. The opinions expressed are my own. I am a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.