Pedestrians walk past the JP Morgan Chase headquarters in New York.

Jpmorgan Chase & Co lost at least $2 billion in its failed hedging strategy not only because it was sloppy, but because it grew too big in a rarified market of complex financial instruments that it had created.

The strategy involved credit default swaps, a kind of derivative that was at the centre of the 2008 financial crisis. The swaps were originally used to hedge the bank's exposure to other investments it owns and included contracts tied to North American investment grade and junk corporate bonds, as well as bonds in Europe and Asia.

JPMorgan helped invent the market for such swaps, known as "synthetic" positions because they trade risk without trading the actual bonds. But two things made these particular positions untenable and costly for JPMorgan, according to traders in the market and derivatives experts.

First, as bond markets shifted and forced JPMorgan to realign its hedges, the bank layered swap on top of swap, complicating the structure and increasing the risk that its hedges would fail to offset losses from one swap with gains from another.

Second, the sheer size of JPMorgan's swap position became more than the thinly traded market could easily manage. The lack of liquidity meant the exit door was too small for JPMorgan to fit through quickly once the trades started to deteriorate.

Making matters worse, because JPMorgan was so dominant in this market it became clear to hedge funds and other trading entities that it was isolated and at risk -- providing opportunities for those who could successfully trade against the bank's position. The complexity of the trades made it difficult for the bank to stay on top of the risks as its position worsened.

Jamie Dimon, JPMorgan's CEO, has acknowledged sloppy execution and oversight of the trades. And he said it could take the rest of this year or longer to unwind the positions. He has declined to give details about how illiquid the positions are, but has said the bank could lose another $1 billion or more before the company can trade them away. Competing traders could force JPMorgan to pay even more to exit the trades, now that many have figured out details of the bank's position.

The effects of JPMorgan's stumble are still being tallied.

Though the bank can easily absorb a loss of $2 billion or more, its credit rating was cut on Friday by Fitch Ratings and its reputation for avoiding problems was dented. Dimon's calls to ease pending regulations have lost credibility. After all, the regulations are supposed to prevent banks from taking big risks of this kind with their balance sheets. On Friday, the bank's shares plunged more than 9 percent, wiping about $15 billion off its market value.

The bank is investigating how it got into the mess, and it is expected this week to accept the resignation of Ina Drew, the New York-based head of the Chief Investment Office where the trades were made, and ask for the resignations of two of her subordinates, London-based Achilles Macris and Javier Martin-Artajo, according to sources familiar with the matter.

A JPMorgan spokesman declined to comment for this story.

JPMorgan created the credit default swap market in the 1990s, when a team of its financial engineers designed the instruments so institutions could hedge, or speculate on, changes in the creditworthiness of bonds. In 2001, the bank launched an index of swaps that helped pave the way for the instruments to be actively traded.

At the root of the losses, traders at other firms say, were bets tied to debt through an index known as CDX.NA.IG.9, which tracks credit default swaps on about 127 investment grade companies in North America, including Target, Home Depot, Kraft Foods, Wal-Mart and Verizon Communications.

The position came to consist of layers of index positions that were both for and against corporate creditworthiness getting worse. Some of the positions were supposed to offset, or neutralise, one another. But traders say the risk that the layers would not work together as intended increased as more were added.

For two decades, "financial institutions have been gambling, and often losing, based on assumptions that historical correlations will remain constant or converge," said Frank Partnoy, a former derivatives trader who writes books on the instruments and teaches law at the University of San Diego.

Some traders believe JPMorgan's assumptions began to go awry early this year. One position in favour of a broad improvement in corporate creditworthiness lost money when credit weakened. Worse, a hedge on that position lost money, too, when credit ratings fell for fewer companies than the bank expected in that situation.

The growing problem in the layers of positions probably stayed below the surface because of the way the portfolio was constructed, said Janet Tavakoli, an expert in derivatives and structured financial instruments.

"The nature of JPMorgan's large CDS book is that even a fool will appear to be making money as revenues pour in" from selling protection against default, said Tavakoli, adding that in her view the kind of valuation models JPMorgan uses "cannot distinguish between dumb trades and smart trades." The overwhelming flaw is that assumptions can be manipulated - whether intentionally or otherwise - so that an income stream that isn't hedged appears to be hedged, she said.

But hedge funds and other institutions in the market smelled weakness and dozens took advantage of the bank, according to traders. Reports by the Wall Street Journal and Bloomberg in early April about the bank's giant positions only made awareness of JPMorgan's problem and its isolation greater.

While Dimon has declined to describe the specific positions, he said the bank made the portfolio "more complex" as it tried to "rehedge" its positions over time.

The losses from these trades are embarrassing for JPMorgan not only because the bank helped invent the market, but because the trades themselves are designed to protect the bank from losses. Like insurance policies, the contracts give a buyer the right to collect a payment from a seller if a bond goes into default. As market demand for these insurance instruments increased, banks created ways to trade cross-sections, or tranches, of the synthetic indices.

Now JPMorgan, which emerged from the financial crisis with relatively few wounds and enormous new power and influence, has, by Dimon's own admission, lost credibility because of its mishandling of derivatives.

The Daily Star/ Bangladesh/ 15th May 2012