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JP Morgan’s Concentration Risk and Outsized Egos

Posted by Larry Doyle on May 15, 2012 8:38 AM |

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 a $2 billion+ loss got 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 too 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.


  • RJB

    What is most interesting is Dimon’s argument that banks need to be able to hedge their risk. What “risk” was JPM hedging against? That is the question no one seems to be able to answer. Appropriate hedging should mitigate not exacerbate risk as it did in this case. Time re-enact Glass-Steagall… and break up the TBTF “banks”. IMHO

  • Rich

    Bring back the Glass-Steagall Act now! Leverage must be reduced immediately to no more than 3 to 1 (down from 40 to 1), and all Credit Default Swaps (CDS) should be banned from use by banks.

    No bank should have more than $1 trillion in assets, and must be subject to takeover by the FDIC. Last year the Big Banks gave themselves $155 billion in bonuses. This is modern day BANK ROBERY and they belong in prison.

    All banks need to focus all their business on fiduciary responsibility to customers! The old banking rule “Too big to fail” is an obscene policy. The rule that we need today is “Banks are never too big to FAIL, never too big to JAIL, and always too big to BAIL.

  • JR

    Larry…if the JPM position in this standardized CDX contract was $100b, what is the total notional amount of that contract outstanding? Is it a lot more than $100b?

  • LD


    Here is a link from the FT which indicates an 80% increase in the notional from late last year until a few months ago when the total notional appeared to be ~145bln.

    Is it possible that JPM was effectively long 2/3rds of the outstanding notional? Who knows? But the enormous spike in outstanding notional starting late last year is a strong indication that something was going on.

  • Obsvr-1

    Good read over at Times Business

    Chasing Chase: The Difference Between Bank Robbers and Bank Bunglers

    Read more:

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