$2 Billion Hedge of Darkness : The Risks Hiding in Today’s Complex Portfolios

Financial complexity

By now everyone knows that JPMorganChase reported a $2 billion loss. But did you know that the same team responsible for the loss generated a profit of $5 billion in 2010? Where were the inquiring regulators and the politicians then? Our financial markets and regulators have been content to allow financial institutions to assume risk in their hedging operations—as long as they are making money. This double standard, seemingly accepted by both regulators and investors, has created a web of challenges for directors of our largest financial institutions.

Most people know that the recent loss had something to do with hedging. But it’s likely that most people, including senior management and the boards of directors of major financial institutions, are less familiar with the specific instruments that bank treasury departments are using to hedge their massive portfolios.

Managing the Mismatch

People often forget that banks have mismatched assets and liabilities. A bank takes demand deposits and lends them to home buyers.  This creates a long-term asset in the form of the mortgage and short-term deposits – a lopsided mismatch. Banks issue bonds to raise long-term funds to better match the nature of their assets.

Of course, banks don’t issue a new bond to perfectly offset every loan that the institution makes. Instead banks manage ‘pools’ of loans against ‘pools’ of deposits and bonds. However, the tenor and terms of these pools rarely align, and over the years prudent bankers have learned that the key to successful banking is managing the mismatch in the portfolio.

Enter Credit Default Swaps

Since the early 1990s financial institutions have been using credit default swaps (CDS) to hedge portfolios. A CDS is simply a contract that the seller of the CDS will compensate the buyer in the event of a loan default or other credit event. Originally the swaps were customized to fit specific portfolios. Voila, a hedge. But finding a counterparty with the exact opposite credit appetite and reasonable terms brings with it a raft of complexities.

In the last decade indexed credit default swaps were introduced. Now a purchaser of a CDS could be protected if a pool of assets, most commonly the top 125 blue chip U.S. corporates, suffered defaults or a serious drop in credit quality.

CDS instruments were now marked in price daily and the liquidity was growing rapidly. Financial institutions looking to hedge their vast portfolio of corporate debt could buy such index CDS and, while not perfectly correlated, it could serve as a proxy for their overall portfolio.

How complicated are index CDS? While not rocket science, the rules explaining the credit index cover 32 pages of dense reading. Is it reasonable to expect that the busy directors of our major financials have all studied how these swaps perform?

While politicians are demanding that directors and officers take greater accountability for the day-to-day management of our largest institutions, the complexities underlying most financial hedging programs make that commitment difficult to fulfill.  While receiving mixed messages on the acceptability of hedging strategies that produce gains or losses, directors are also asked to approve use of products that are almost certainly beyond the comprehension of anyone not solely dedicated to their study.

The Bigger Questions

JPMorganChase CEO Jamie Dimon has publicly stated that mistakes were made in the execution of the bank’s hedging program. But while the loss is raising lots of political issues – including calls for a stronger Volcker Rule or Compensation Clawbacks –the primary issue remains elusive. What hedging is allowed? What amount of profit or loss is allowable by a treasury department before they are no longer hedging and are simply speculating?

How can a CEO, director or officer be held accountable until these questions have answers?

About Richard Magrann-Wells

Richard is a Executive Vice President with Willis Towers Watson’s Financial Institutions Group based in Los Angel…
Categories: Financial Services | Tags: ,

One Response to $2 Billion Hedge of Darkness : The Risks Hiding in Today’s Complex Portfolios

  1. Daniel Baltz says:

    Please add me to all of your Financial Industry publications list to receive all by email.

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