The JP Morgan Caper

by Jerry O’Driscoll   

J.P. Morgan Chase & Co., one of the nation’s leading banks, revealed that a London trader racked up trading losses reportedly amounting to $2.3 billion over a 15-day period. The losses averaged over $150 million per day, sometimes hitting $200 million daily. The bank states the trades were done to hedge existing risks.

How did this happen and what are the lessons? The two questions are related.

It appears the individual traded on the basis of observed relationships among various derivative indices. The relationships broke down. Such a breakdown has been at the heart of a number of spectacular financial collapses, notably that of Long-Term Capital Management in 1998 and a number during the financial meltdown of 2007-08.

In short, there is nothing new in what happened. Yet financial institutions permit their traders to make the same kind of dangerous bets. In a Cato Policy Analysis, Kevin Dowd and three co-authors examined some of the technical problems with standard risk models utilized by banks.  It is an exhaustive analysis and I commend it to those interested. The analysis goes to the question of how these losses happened.

Now to the lessons. Continue reading