Bruno Iksil: The Wailing Flailing Whale Update

Well wail whale

JPMogwarts.

Your wizard's a bad one.

It turns out that the strategy that moves markets just got awkwardly filed away as an egregious error. The highlights:

• "The portfolio has proven to be riskier, more volatile, and less effective as an economic hedge than the firm previously believed"
• "In hindsight, the new strategy was flawed, complex, poorly reviewed and poorly monitored"

An awkward egregious $2 billion error.

That Jamie D CEO called a "tempest in a teapot" way back when it first got reported. Mr JD: it's either too big to fail, or too small to make a difference. But I think that you need to pick one.

Except, um, fail.

Bloomberg's article: $2 billion loss at JP Morgan's CIO.

For a better breakdown of how it all went wrong, I defer to Matt Levine: Whale Sushi on the Menu.

Bruno Iksil: the Volkermort of JPMogwarts

Bruno Iksil: he rules from the shadows.

So for those who haven't been following, the recent story shaking the Bloomberg Buzzworld is that of the JPMorgan credit derivatives trader with enough capital to break indices. Other traders are upset and calling him names. Names like "He Who Must Not Be Named" and "the London Whale". And probably more conventional ones like "bastard" and "that irritating mother-f***er with the mother-f**k of a capital base".

As a non-investor in credit-derivative indices, I get to use names like "Hero" and "Legend". But out of envy and a little disdain, I'm going to keep using "Voldemort". Partly because Voldemort was a big bully with some panache, but mostly because his large amounts of inbuilt power were the result of (ma)genetics and the size of his wand. If you have the entire resources of the internal capital base of JPMorgan at your disposal, you get to be the big boy on a small playground when you start throwing your weight around.

To be upfront, I'm letting everyone know that I'm going to engage in a little rinse-and-repeat from some of my earlier news posts.

So what is breaking an index?


Well most people have some memory of George Soros breaking the British Pound. And what that meant is that George Soros' Fund had enough capital to break the fixed exchange rate regime at the time. A fixed exchange rate regime combined with no capital controls effectively meant that the Bank of England was willing to sell and buy as much currency as sought by any counter-party, all at the same rate. However, the fundamentals at the time had Britain sitting with low interest rates and high inflation, while still attempting to maintain its fixed rate under the European ERM (Exchange Rate Mechanism). Fundamental fail, is what is. 


Enter George.


Enough capital to buy such vast quantities of pounds that when he eventually dumped them on the market, the BoE couldn't meet the other side of the transaction and was forced to float the currency. Followed immediately by a sudden and dramatic devaluation (the so-called breaking of the pound). 


Indeed, capital controls at Reserve Banks in many (if not all) developing countries are there to prevent exactly that. 


And the theoretical principle with Mr Iksil is nearly the same. Enough purchasing power that when he makes a trade move, things happen. 


And what is a broken credit index? Well - the credit index is meant to represent a basket of investments in credit default swaps held over various companies. In theory, we could replicate the index by buying those underlying CDS instruments. And this is quite a useful tool. Because if we price the underlying investments, and we see that they are not equal to the index: we would then sell the more highly priced option and buy the cheap one, bidding up the price of the undervalued side of the transaction, and lowering the price on the overvalued side by increasing its supply on the market. In other words, under efficient market conditions, this temporary mis-pricing self-regulates as investors trade under the expectation of price reversion.


However, when a trader can dramatically change the price of the index just by trading it, the index stops replicating its underlying investments indefinitely. Why? As the story goes: because Iksil can take such large positions, and is not liquidating them, there is not enough supply for the reversion to take place. 


And the Volker Rule?


The reason that this is such a fun topic at the moment is the much controversy around the Volker Rule (which sounds like the joke name from a Ben Stiller movie about meeting the parents). The Volker Rule is the part of the Dodd-Frank Act that everybank is protesting. The key points:

• The Volker Rule is going to regulate the risks that a bank can take with its own money (ie. its capital).
• The reason for the rule is the merging of Commercial and Investment Banking activities since the repeal of the Glass-Steagal Act.
• The merging of the two arms of banking means that the "traditional" banks of loan and deposit are exposed to the much riskier activities of Investment Banks. 
• This puts the layman's money at risk. Scratch that. This puts your average American voter's money at risk. At least - that's the theory and the political party-line.
• More likely: after the subprime mortgage crisis and the big bail-outs of the banks, there was pressure on the legislators to do something. And the Dodd-Frank Act was that something. And then someone noticed the incentive mis-alignment between the two types of banking and said "let's regulate that and we'll name it after Mr Volker". 
• But sadly, however much weight is thrown around in the area of Iranian sanctions, America can only really regulate the capital activities of American Banks.
• The foreign banks based in London and Switzerland and Germany and Tokyo and Shanghai and such are just going to calmly continue as they did before. Which makes the Goldman and the JPM throw around terms like "internationally competitive" and "we need to be".
• So now the legislators are confused as to what they want. But the bank lobbyists - they are not. 

And then along comes this kind of scandal, where JPM is playing around with its own money and breaking things. This incites the liberals and makes for bad press. Or is it good press? There are a couple of theories floating around out there as to where this story is coming from:

1. The jealous hedge fund managers: who are upset and embittered because the markets are not working the way they expected when they made their trades; or
2. JPMorgan itself: showing the world that it can and will do what it wants with its own money, through its London Chief Investment Office (I'm not sure if I entirely understand the theory of this point, but I refer to my favourite blogger, M. Levine, who wants to know why we say Voldemort like it's a bad thing).

Either way, the point of the Chief Investment Office is to hedge risk and invest excess cash. I think everyone is concerned because the firm's investments are around $350 billion, and wagers on this particular index are sitting at around $145 billion. According to Bloomberg, who have this figure according to market participants, who have this figure according to their observations of trade patterns and such, Iksil has built up a position that may be as large as $100 billion. In a single index: the Markit CDX North America Investment Grade Series 9 (IBOXUG09). 

The trade involves selling long-term default protection (ie. expiring in 2017) and buying short-term default protection (expiring in the next 8 months). Basically, the strategy implies a bet on defaults happening sooner rather than later. JPMorgan then earns the difference in spread (around 47 basis points as of early April). There is some controversy around whether that even makes sense - after taking into account transaction costs and such. Again, refer to Mr Levine's article (link above). 

However you look at it though, the reality is probably more complex than "this serves as a great example of why the Volker rule is needed" or "this serves as a great example of why the Volker rule is irrelevant".

Because let's be honest - no one really knows what's going on. There's lots of hype and speculation and great name-calling. Politicians have reacted by making many statements punctuated with "effects on the US Economy" and "effects on the US taxpayer". 

And poor Bruno is sitting in his London office going "WTF, dude? I was all getting-my-morning-starbucks and missing-my-girlfriend when *wham* - my sh*t hit the Bloomberg fans".

Awkward.

Daily News Roundup 2012: Monday 9 April

Good morning

The headlines:

1. JP Morgan trader Bruno Iksil, recently dubbed Voldemort (not by me - but high fives to whoever did), has drawn attention to the little-known area of the bank that invests the bank's own capital. This comes back to the debate around the Volker Rule (part of the Dodd-Frank Act), which seeks to regulate the risks that banks take with their own money. Why regulate it? Well - the money is subsidized by depositors, and federally insured (if they fail, they get bailed out). Although the debate is a bit irrelevant - the investment division that plays those risks lives in London. The US may try to force external compliance with the Volker Rule, but will they do that at the risk of putting the US banks at a serious competitive disadvantage with the other non-US internationals? Unlikely. JPM waves a wand, "Avada Kedavra", gets a green light. Like a boss. Link: The JP Morgan Trading Debate.
2. Myanmar is asking the US to lift sanctions faster. Admittedly, in some very broken English. "This is the time giving more carrots will help more". Hilary Clinton announced last week that the US would allow companies to invest in certain sectors, but didn't give any specifics. The question being asked is whether the sanctions are still required to encourage democracy. After all, President Thein Sein's party, The Union Solidarity and Development Party, is still granted 25% of the Parliamentary Seats under the current constitution. Either way - if US companies can't go there, the famed mineral wealth of Burma will be the exclusive treasury chest of China, no doubt. All hail the soon-to-be-bejazzled Chinese overloads. Link: Myanmar wants more carrots.
3. Chinese consumer prices rose more than the expected 3.4% in the year ended 31 March. The CPI rose 3.6%, which is still below the government's benchmark of 4%. Food-related costs, however, rose 7.5%. This data may slow the introduction of new quantitative easing measures by China's Central Bank. Interestingly, this turns the real savings rate of interest negative again (it was briefly positive in February - the first time in 2 years). Negative real rates of interest occur when inflation is higher than nominal interest (the interest rate offered by the banks). In theory, this means that it costs you to deposit money with a bank - and you should therefore spend your money/invest it, rather than leave it with the bank. However, this is offset by the convenience of having money on hand. The danger comes when interest rates are so deeply negative that it exceeds the benefit of convenience. And more so, when the cost of borrowing becomes so deeply negative that borrowing for non-productive purposes (ie. speculation) becomes incentivised. At that point: hyperinflation risk. But I've digressed - that's unlikely to happen to China. The US, on the other hand... Link: Chinese Consumer Prices rise faster than anticipated.
4. And the African Business News in brief. The highlights:
• Malawian Vice-President Joyce Banda has been sworn in as the new President of Malawi after the death of Bingu wa Mutharika. And there is a collective sigh of international relief. Mr Mutharika was going a bit crazy toward the end there - tell foreign investors and the World Bank where to get off, and such. Also, Joyce and Bingu had fallen out. Read how here: Joyce Banda: in her own words.
• Nigeria has launched a new taxation system, to "change the way that Nigerians see tax". Read more here: Nigeria's New Tax System.

That's all for now.

Have a good day.