JP Morgan’s CEO Jamie Dimon recently revealed that the company lost more than┬átwo billion dollars in the span of only┬átwo weeks on some poorly executed hedging trades.┬á The next day the┬ástock price┬áfell by more than 9%.┬áThe trades appear to have been related to bets on the health of corporate investment grade bonds, which were intended to offset the bank’s overall exposure to European contagion.┬á The hedge did not behave in the manner that it was intended to, and the positions were so large as to cause disruptions in the credit markets.┬á Bruno Iksil, the trader who implemented the hedges, was given the nickname “The London Whale” due to the market movements that he caused.
While the magnitude of the error is unlikely to have much impact on the long term earnings power of JP Morgan (the┬á$2 billion┬áloss pales in comparison to its $19 billion┬áin earnings in 2011 and $2.2 trillion┬áin assets), it does call into question the wisdom of the current structure of the massive banks in the US financial system and the value that it is creating.┬áThe risk/reward tradeoff for employees is quite clear:┬á a roll of the dice on a large speculative bet that pays off results in massive bonuses, one that does not pay off results in smaller bonuses, and one that loses billions of dollars might result in being fired, but that risk is discounted given the exit opportunities from these banks into other forms of financial wizardry.┬á The hedge fund Long Term Capital Management famously blew up in the late┬á1990s from speculative bets on various financial markets, and the principles have subsequently started two additional funds with similar strategies.
Paul Volcker – a former chairman of the Federal Reserve – once said that the biggest financial innovation in decades has been the ATM machine.┬á Despite the questionable value of ever more complicated derivative securities and structured products, the financial sector has grown from 2.8% of GDP to 8.4% in 2011.┬á The growth is even more apparent in earnings, with financial company profits reaching 41% of all corporate profits earlier this decade, up from less than 16% in the 1970s.┬á It is difficult to not be somewhat skeptical of whether the high compensation in the sector is truly merited relative to what it brings to the table.
While the circumstances surrounding JP Morgan’s large loss are suspicious and dubious from an ethical and business standpoint, CEO Jamie Dimon has been very straightforward about the problem and come forward to take responsibility for it.┬á┬áAfter originally dismissing rumors surrounding the outstanding trades as “a tempest in a teapot”, in┬áa conference call to investors he said “We know, we were sloppy. We know we were stupid. We know there was bad judgment.”┬á It is refreshing to hear a leader fess up to an error and admit to a mistake rather than resort to lies and spin.
Time will tell whether the hedges are able to be unwound with little additional damage, or whether increased volatility will cause JP Morgan to take further writedowns on their book from these trades.┬á There may be additional regulatory fallout as well given the ongoing overhaul of financial regulations.┬á Whatever the consequences, at the least this event should serve as a reminder that even the most brilliant geniuses in the room are still only human.