The London Whale, 2012

A hedge that grew into the market it was hedging

JPMorgan’s Chief Investment Office ran a synthetic credit portfolio that was described as a hedge against a downturn. By early 2012 it had grown to a notional in the hundreds of billions, spread across credit indices and their tranches, and it was large enough that the market could see it and trade against it. The bank lost at least $6.2bn, restated a quarter’s results, and paid around $920m in fines. The mechanism is CS01 netted to nothing while the real exposure sat in the basis.

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What the lesson covers

1. What happened
2. The position
3. Why it broke
4. What it cost
5. What it teaches

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.

In practice

Every credit desk reports CS01 by name and by curve bucket, jump-to-default by issuer, and index basis separately, because this episode is the standard argument for why one net number is not a control. Risk model changes now carry their own governance, with the old and new measures run in parallel.

Read next

• CDX Index — A basket of CDS in one tradable index
• Credit Default Swap — Insurance against a borrower defaulting
• CS01 and Jump to Default — Spread risk and default risk are not the same number

In the app, The London Whale, 2012 carries a five-step lesson, a worked example and a bank of twelve questions drawn differently every sitting.

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