The London Whale, 2012

At a glance

What happened

JPMorgan's Chief Investment Office ran a synthetic credit portfolio described as a hedge against a downturn. In early 2012 it grew to a huge web of positions in credit default swap indices and their tranches, selling protection on some and buying it on others. Hedge funds noticed index prices drifting away from what their constituents implied and took the other side. Losses emerged through April and May 2012 and reached at least $6.2bn, and the bank restated its first-quarter results.

Why it went wrong

On the risk report the spread sensitivities largely cancelled out, which is why the book could be called a hedge and stayed inside limits. What did not cancel was the basis between indices and their constituents, and the correlation exposure in the tranches, both of which grew with the offsetting notional. The position was also too big for its market, so everyone could see it. A new VaR model introduced in January 2012 roughly halved the unit's reported risk, and favourable marks delayed recognition of the loss.

What it teaches

A hedge is defined by what it offsets, not by what it is called: a book whose headline sensitivities net to zero can still carry large basis and correlation risk. Size relative to the market is a risk in its own right. And when a risk number falls because the model changed rather than the book, that deserves questions, not relief.

Key terms

Synthetic credit portfolio

A book of credit derivatives held for hedging or positioning rather than lending — here, indices and tranches.

Index basis

The gap between a credit index and the sum of its constituents, and what an index hedge leaves behind.

Tranche

A slice of an index’s loss distribution, whose value depends on default correlation as well as spread.

Marking within the spread

Valuing a position at a favourable point between bid and offer, which delays recognition of a loss.

VaR model change

A revision to the risk model itself, which can reduce measured risk while the position is unchanged.

Restatement

A correction of previously published financial results, here for the quarter in which the marks were wrong.

Where it sits in the course

Case studies like this one are used throughout risk management teaching, including FRM® preparation, as worked examples of market and model risk; basis risk and position size. In OTC Learn the lesson runs in five steps: what happened, the position, why it broke, what it cost and what it teaches, followed by a worked example with the numbers. See the lesson outline.

The instruments behind it

OTC Learn lessons on the products this case turns on:

• CDX IndexA basket of CDS in one tradable index
• Credit Default SwapInsurance against a borrower defaulting
• CS01 and Jump to DefaultSpread risk and default risk are not the same number