As One JPMorgan Trader Sold Risky Contracts, Another One Bought Them

For hedge funds that could smell blood in the water, it seemed to be an opportunity to take on JPMorgan Chase and win.

It was, in fact, such a sweet trade that even another part of the bank couldn't pass it up.

Even as a trader for JPMorgan in London was selling piles of insurance on corporate debt, figuring that the economy was on the upswing, a mutual fund elsewhere at the bank was taking the other side of the bet.

The trade contributed to more than $2 billion in losses for JPMorgan, which disclosed the loss last week. The hedge funds, including Blue Mountain Capital and Blue Crest, have profited handsomely thus far, as the markets move against JPMorgan.

But perhaps one of the most surprising takers of the JPMorgan trade was a mutual fund run out of a completely different part of the bank. The bank's Strategic Income Opportunities Fund, which holds about $13 billion in client money, owns about $380 million worth of insurance identical to the kind the "London whale" was selling, according to regulatory filings and people with knowledge of the trade. It is unclear how much the fund made.

That one hand of the bank was selling while another was buying is not uncommon in the dog-eat-dog world of Wall Street. Yet that trading is typically done on behalf of clients, not in a way that, inadvertently or not, undermines what the bank is doing for itself.

In that way, it is different from the example of Goldman Sachs in 2007, when it sold subprime mortgage securities while betting against them. In the case of JPMorgan, it was the reverse: the bank took risk with its own money to sell the insurance contracts that have cost the company money. The asset management division, meanwhile, invested on behalf of its clients when it bought the contracts.

In this case, it may turn out to be a silver lining. If nothing else, it indicates that the asset management division, run by Mary Callahan Erdoes, acted independently from the bank, as is required.

"You've got so many different businesses, they are not coordinated and they are not telling each other things and that turns out in this case to have been a virtue," said Robert Litan, vice president for research and policy at the Ewing Marion Kauffman Foundation. "But that also feeds into another concern, and that is that JPMorgan is not only too big to fail but too big to manage."

JPMorgan declined to comment.

The trading losses have been a major source of embarrassment for the company and its chief executive, Jamie Dimon. They have also reinvigorated the debate over risk-taking at banks.

Analysts familiar with the Strategic Income Opportunities Fund say it is typical for money managers there to seize on lucrative trades. The fund, which is run by William Eigen, began to buy the insurance contracts roughly a year ago. By last May, the mutual fund had built a position of about $150 million in coverage, which it doubled over the summer. Since then, the position increased about $80 million through March.

"If you take JPMorgan chief investment office out of the equation, it's exactly the kind of trade you'd expect them to be doing," said Eric Jacobson, an analyst with Morningstar . "It's like a hedge fund trade. This is kind of what the mandate is."

For JPMorgan's chief investment office, which sold the insurance, the move was ostensibly to protect the bank from potential losses. The division was supposed to hedge the bank's overall risk, and the insurance contracts were supposed to be a part of that strategy.

But the bet could now wind up costing the company billions more in losses, according to people with knowledge of the trade, as JPMorgan struggles to offload the holdings.

While JPMorgan has been reluctant to share the details of the transactions, it is believed that the London trader, Bruno Iksil, sold default protection on a specific index: the CDX IG 9. That index tracks the default risk of 125 major North American companies, including Aetna , Walt Disney and Lockheed Martin . If the default risk increases, JPMorgan effectively loses money. By January and February of this year, brokers were relentlessly calling hedge funds and trying to sell the contracts to them, according to investors. Given the size of the position in the relatively quiet market, the seller was quickly revealed as JPMorgan. Hedge funds and others began to chatter about the merits of the trade.

The rationale for the hedge funds was simple: with JPMorgan selling so much of this insurance, the price was artificially cheap. In buying it, the funds were betting that the cost would increase when the bank eventually stopped selling. Such a move would notch them a tidy profit while causing steep losses on paper for JPMorgan.

Similarly, any hiccup in the markets for corporate debt would also potentially hurt the bank's position, as it would make the cost of insuring the corporate debt more expensive. That, too, would be lucrative for the buyers.

Over the last month or so, that situation has to a large extent been playing out. As of Monday, 10-year protection sold on a certain amount of the index through 2017 cost about $147,000, up from roughly $119,000 two weeks ago, according to the data provider Markit.

JPMorgan has come under fire for failing to identify the risks associated with the huge bet. The bank has said there was a breakdown in supervision of the division where the trades originated, the chief investment office in London. That office, which has already suffered some high-level departures, was largely disconnected from other parts of the bank, officials have said.

That explains how it is possible for another division of the financial institution to pursue the opposite strategy and profit from it. There is no indication that the bank foisted those contracts upon the asset management unit as it was selling them. Some argue that it is evidence that the bank was truly walled off from the asset management division, as required by federal regulations.

The Strategic Income Opportunities Fund bought the insurance contracts through a number of banks, none of them directly from JPMorgan.

"There's really effectively only one lesson other than the interesting irony," said Douglas J. Elliott, a researcher at the Brookings Institution. "The lesson is that the asset management firms really do act like different bodies. They don't share info. They don't always have the view of the rest of the firm. That's how we want it to be, and that's how it was in this case."

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