Trading Surges Boosted Whale Positions Before Audits
Trading surges that temporarily boosted the value of credit derivatives held by JPMorgan Chase & Co. (JPM) may provide clues about whether traders at the bank masked losses that have spiraled to $5.8 billion.
Spikes in late January and again at the end of February, which more than doubled the volume of trades in an index tied to the creditworthiness of companies, lowered the cost of the index, raising the value of the bank’s holdings. The surges came just before end-of-the-month bank audits to verify prices.
The trading patterns offer a road map for investigators after the biggest U.S. bank by assets restated first-quarter earnings to account for a larger loss on the derivatives than previously disclosed. JPMorgan, which shut the London-based group responsible for the trades in its chief investment office, said an internal probe found evidence, without providing specifics, that employees may have tried to hide losses.
“That’s a huge red flag,” Craig Pirrong, a finance professor at the University of Houston in Texas whose research focuses on derivatives markets, said in a phone interview about the bank’s comments on the integrity of how the holdings were valued. “It could open a Pandora’s box.”
Investigators will want to look into whether traders tried to manipulate the price of an index to boost the value of holdings, said John Coffee, a securities-law professor at Columbia University Law School. Such actions resemble what’s called “painting the tape,” in which a trader engages in “purchases that are motivated only by a desire to influence a price in a thin market,” he said. Prosecutors and plaintiffs’ lawyers would need to prove intent, Coffee said.
Because JPMorgan had amassed such large positions in the Markit CDX North America Investment Grade Index Series 9, known as IG9, even a small change in prices could generate a big difference in the value of the trades.
JPMorgan said July 13 that the internal review raised questions about the integrity of prices the chief investment office used to value its positions in credit derivatives, insurance-like instruments in which sellers agree to cover losses if the debt they’re linked to defaults. The bank said it adjusted prices used at the end of March, leading the New York- based bank to reduce first-quarter net income by $459 million.
“E-mails, voice tapes and other documents, supplemented by interviews” were “suggestive of trader intent not to mark positions where they believed they could execute,” the bank said in a presentation July 13 as it reported second-quarter net income that fell 9 percent to $4.96 billion. “Traders may have been seeking to avoid showing full amount of losses.”
The U.S. Justice Department and Federal Bureau of Investigation in New York started a probe of the trading losses in May, a person familiar with the matter said at the time. Regulators from the Securities and Exchange Commission also are reviewing trades that led to the losses.
Jennifer Zuccarelli, a spokeswoman for JPMorgan, declined to comment on the trading pattern or strategy.
Volumes in the IG9 index, which tracks credit swaps tied to 121 companies, all of which were investment grade more than four years ago, surged in the three days ended Jan. 27 to twice the average, Markit Group Ltd. data show. More than $19 billion of the index changed hands in 184 trades from Jan. 25 through Jan. 27. The average daily volume of $6.4 billion in that period is double the $3.3 billion during the first quarter, the data show.
The cost of protecting against default on the index dropped 6.7 basis points in the period, raising the value for those like JPMorgan that had sold insurance, even as a more recent and widely used version of the index fell by just 3.6 basis points. A basis point, or 0.01 percent, equals $1,000 annually on a contract protecting $10 million of debt. The data don’t identify which firms are making the trades.
In the last two days of February, trading volumes again ballooned to twice the quarterly average, fueling a 5-basis- point drop in the index even as the more active benchmark fell 1.4, Markit data show.
As the cost of default insurance on the IG9 index fell, JPMorgan’s position benefited. Similar to how the price of a bond rises when yields on the debt falls, the value of a credit swap rises for traders who sell protection when the premium on that contract declines.
An internal control group at JPMorgan verifies all prices across the bank’s trading businesses at the end of each month and quarter, according to three former chief investment office executives and a senior executive in market risk. Bloomberg News, citing people familiar with the matter, reported May 30 that the office was valuing some of its trades at prices that differed from those of its investment bank, the biggest swaps dealer in the U.S., potentially obscuring by hundreds of millions of dollars the magnitude of the loss.
At the center of the trading was Bruno Iksil, a French-born trader in London who ran the credit-derivatives book that generated the losses. He came to be known as the London Whale because the size of his bets grew so large. When market-makers asked Iksil how much he wanted to trade, he implied he was able to handle as much as they liked, according to two people with direct knowledge of the trading who asked not to be identified because the interactions are private.
“This guy definitely had a substantial influence on the market,” David Kelly, director of financial engineering at New York-based Calypso Technology Inc. and a former manager of counterparty risk at JPMorgan, said in a phone interview. “Window dressing your book at the end of the month or year is certainly nothing new.”
No regulators or prosecutors have accused Iksil or other traders in the group of wrongdoing.
Iksil, who no longer works at JPMorgan, hasn’t commented publicly on the trading loss and didn’t return phone calls. His lawyer, Raymond Silverstein, said in an e-mail that Iksil “considers he did nothing wrong and will cooperate fully with the authorities.”
While trading data don’t show how much of the surge was caused by JPMorgan, the bank had amassed a position in the IG9 index that may have been as much as $100 billion, Bloomberg News reported April 5, citing traders outside the firm who said they based their estimates on trades and price movements they witnessed as well as their understanding of the size and structure of the markets.
In the 14 weeks ended April 6, outstanding bets on the index using credit swaps rose an unprecedented 65 percent to $148.2 billion, according to the Depository Trust & Clearing Corp., which runs a central registry for the market.
Dealer positions in IG9, or the amount of protection they sold less what they bought, jumped 28 percent in the week ended Jan. 27 to $28.5 billion, according to the DTCC. JPMorgan is the only one of the six biggest U.S. banks to have sold more protection on investment-grade companies than it bought, data compiled by the Federal Reserve through the end of March show.
JPMorgan said July 13 that it ousted managers responsible for the transactions and would claw back their pay. The company didn’t name the managers.
Chief Executive Officer Jamie Dimon said last month that the group’s credit-derivatives bets initially were intended as a hedge for the bank against a financial crisis or economic slump. Executives ordered the chief investment office to pare those positions at the end of 2011, before tougher capital rules were set to kick in. Instead, the team started executing trades intended to offset the hedges, including selling protection on IG9 largely using contracts set to expire in December 2017, market participants have said.
The net amount of credit-derivatives protection JPMorgan sold on investment-grade companies using contracts expiring in more than five years doubled to $101.3 billion in the three months ended March 31, according to Fed data.
After the bank’s initial bets, the largest trades typically came at month-end, Markit data show.
The trades starting in January left the bank with even bigger and harder-to-manage exposures, Dimon, 56, told the Senate Banking Committee last month. The group “embarked on a complex strategy that entailed adding positions that it believed would offset the existing ones,” Dimon said in June 13 testimony.
JPMorgan cut its positions in IG9 by 70 percent through July 13, and the bank transferred about $30 billion of risk- weighted assets to the investment bank from the chief investment office, an amount that is “down substantially” from the peak and back to levels at the end of 2011, Dimon said.
Losses on the botched trades in the first two quarters grew to $5.8 billion, and the bank could lose an additional $1.7 billion, he said.
JPMorgan “would love to say that this was all done by a rogue employee” and that the bank was the victim, said Coffee, the Columbia securities-law professor. At the same time, “if he was manipulating the price, he was an authorized person of JPMorgan, and they could be held vicariously liable for what he’s doing,” he said.
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