How Europe speared JPMorgan's whale

A complex bet on corporate bonds caused big losses for the bank after the eurozone crisis flared up in April.

By Anthony Mirhaydari May 11, 2012 2:28PM

Stocks were basically flat Friday as the market reacted to Thursday's bombshell announcement from JPMorgan Chase (JPM) that it suffered a $2 billion-plus loss on credit derivative positions taken by a trader in its London office.


This is a complex story, but the main takeaway is this: Wall Street banks are still making risky bets with their own money to compensate for a lack of profitable, traditional banking opportunities. This worked well for most of the year as risky assets moved higher on cheap-cash injections by the world's central banks. But as the eurozone crisis flared up in April, with new worries over Spain and Greece, the trade went wrong. Here's why and what it means.


The trader, identified in the press as Bruno Michel Iksil and dubbed a "whale" by hedge funds that caught the scent of blood months ago and started betting against him, was essentially selling "synthetic" insurance against default on a basket of investment-grade corporate bonds. So as bond prices moved higher, to reflect falling credit and default risks, his trade in "synthetic CDS" moved higher too.


Originally, this was done to hedge other credit market positions held by JPM. But eventually the trade got out of control and became speculative. That's when the hedge funds moved in.


Iksil was dabbling in what's known as the CDX.NA.IG.9 credit index, which is the main synthetic CDS index still trading after that market died down in the wake of the 2008 financial crisis. If you own the index, you get paid when companies within the index default. Alternatively, if you're selling the index, you make money when they don't.




So what went wrong? Details are still murky, but what we do know is that the index jumped in early April as high-yield corporate bonds came under pressure as the market freaked out over new problems in the eurozone -- from the collapse of the Dutch government over austerity measures to Spain's backsliding on closing its budget deficit to the rise of anti-bailout parties in Greece.



You can see this drop in the chart of the iShares High Yield Corporate Bond Fund (HYG) above. Compare this with the chart of Spain's 10-year bond yield below. Both events are saying the same thing: Risk off.



Back to Iksil.


The weakest links in the CDX.NA.IG.9 index include Radian Group (RDN), MBIA (MBI), Sprint (S) and R.R. Donnelley & Sons (RRD). All four stocks had excursions below their lower Bollinger Band in early April (a sign of an extended, persistent and unexpected decline) along with the rest of the market.



Radan's drop was particularly nasty and set off a decline that has taken the stock down nearly 50% from its March high.


I think there are three takeaways from all this. One, bank regulation remains in a sorry state, since a dramatic drop in a single stock put one of America's largest banks in a very bad spot. Two, the Federal Reserve's ultra-low interest rate policy is encouraging dangerously aggressive risk-taking behavior by a financial system desperate to maintain net interest margins in a low-rate environment. And three, this is just one example of why the situation in Europe, and in Greece, matters to the U.S. economy and its financial system.


This is the butterfly effect in action: A decision by politicians in Madrid to ease the tension of an angry electorate suffering 50% youth unemployment results in embarrassing losses for JPM and CEO Jamie Dimon, one of the most vocal critics of tighter regulation, via the synthetic CDS market, an artifact of the Fed-created housing bubble. What a mess.   



Trading update

JPM's misfortune is boosting the Edge Letter Sample Portfolio's short positions against the financial sector. Highlights include a 10.3% gain in Citigroup (C) and a 4% gain in the Direxion 3x Financial Bear (FAZ).


I found both C and FAZ with the help of technical screens developed with Fidelity's Wealth Lab Pro back-testing tools, which you can find here. (Fidelity sponsors the Investor Pro section on MSN Money.)


Check out Anthony's investment advisory service The Edge. A two-week free trial has been extended to MSN Money readers. Click here to sign up. Contact Anthony at anthony@edgeletter.c​om and follow him on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.

May 11, 2012 3:15PM
Surprise.  Surprise.  Surprise.  Bank bonus and profits.  Got any more bailout money left?  Smile
May 11, 2012 4:13PM
Maybe people will now realize, as some people have known for a long time, that Chase isn't being run by any gifted CEO.  Gee, what did Jamie get paid last year for his so-called great leadership? 
May 11, 2012 6:55PM
Its a shame many of these bankers are not in prison by now....!
May 11, 2012 5:34PM
This "rogue trader" will probably get a bonus for not losing the Chase as much as he "could have". How doees once person lose as much money as some small countries annual GDP? This is scary if this is what could happen at the big banks, with all our tax payer money. Is this how they plan on paying it back with gambling winnings? Why not take it to Vegas and put it on Black?
May 11, 2012 5:06PM
Think Jamie Dimon will still get paid at the end of the day?  That's one bet you don't want to go against.
May 11, 2012 5:37PM

I don't know s--t about economics but my intuition is telling me us little people just got F---ed again somehow. Wall Street and other trading markets should be in hell. The rich get massaged while I get screwed as usual. I don't understand all this crap but somehow I can feel it, as the shaft get a little deeper in my ****. As for all you expert wannabes out there F off. I'm tired of your bulls—t rhetoric.. They will find some way to f us to make up the loss.

May 11, 2012 7:05PM
Yes, banks absolutely need regulation. And to be managed by people who actually know how a bank is supposed to operate. As it stands now, they are being run by people that have no idea what is really going on. They come from the bottom of the CEO barrel. They know the government is always going to bail them out no matter what they do ( too big to fail ). The problem that none seem to understand is, sooner or later they are going to have to fail. This system can't be sustained eternally, and the longer it goes on the more catastrophic  the collapse !!!!!!
May 11, 2012 4:36PM
I love it!! The big boys and big government screwing themselves!!!! Socialism even for the big corporations don't work!!!
May 11, 2012 7:36PM
Bottom line, trying to make up what they lost when they were operating without rules. Which they still are. Easy to do, when you have NO rules, and it isn't your money! To Dr. R, I understand your frustration. There will be no change. These guys are the 1%, of the 1%. Rogues!!
May 11, 2012 7:02PM
Wow I'm sure glad he put that in laymen terms otherwise 99.99% of the people wouldn't have a clue as to what he said or what really happened :)
May 12, 2012 7:48AM
Bottom line is we deserve to know that our banks are safe and stable - Banks should be forced to separate from Investment ( Gambling) institutions. Glass-Steagall needs to be brought back and that's just the way it is. Get the banks out of the gambling business!
May 13, 2012 3:21AM

Two things are more apparent than ever:


1)Glass-Steagall needs to be reinstated.


Banks must register their charter as either a COMMERCIAL or INVESTMENT bank,they cannot be both as this represents a serious conflict of interest.For 66 years,Glass-Steagall provided the stability necessary to keep the banks from speculating with their own money and prevented the now unfortunate TOO-BIG-TO-FAIL fascist business model and culture.What ever happened to investing in capital goods,materials,equipment,and labor to fuel business/corporate growth to stimulate TANGIBLE,PRODUCTIVE GDP which enriches society?Clearly,speculative asset bubbles will continue to pop and prop trading like this will continue until ALL paper money is a smoldering ash heap.


2)This event is just part and parcel with Wall Street.MF Global,COMEX fraud,0% interest rates, high frequency trading,currency swaps,you name it,all of it is fraud,nothing more.And its exactly why the coming collapse will radically transform life as every American born after WWII has known.

May 11, 2012 7:46PM
the whale's big mistake was betting on politicians to tighten their financial  belts - drunken sailor syndrome
May 12, 2012 8:37AM
It's always other peoples money. Doesn't synthetic mean fake. Makes a good story. I wonder what really happened.
May 12, 2012 6:42AM
If you want to Gamble,go to Las Vegas. You will get burned and now you learned your Lesson. I hope somebody will pay a high price for this Fiasco.
May 13, 2012 9:28PM
OK JpMorgan lost 2 billion!!!! now who has the 2 billion???? where is the money who outsmarted jp that's rest of the story. I want to invest with the people with the 2 billion 
May 11, 2012 6:41PM



The banking industry is already one of the most regulated industries there is. Look at how it has done over the past 50 years versus the computer industry which is largely unregulated. Government control doesn't work in banking any better than it works in any other industry.

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