Whale watching, the official tour January 16, 2013 at 3:15 pm
How large sea creatures should avoid trying to optimize their capital requirements
First, regulatory capital optimization under the post-crisis rules was a critical motivation:
Two of the recent Basel Accords, commonly referred to as “Basel II.5” and “Basel III,” alter the RWA calculation for JPMorgan and other banking organizations. As the new standards become effective over a phase-in period, certain assets held by banking organizations such as JPMorgan will generally be assigned a higher risk-weighting than they are under the current standards; in practical terms, this means JPMorgan will be required to either increase the amount of capital it holds or reduce its RWA… In 2011, JPMorgan was engaged in a Firm-wide effort to reduce RWA in anticipation of the effectiveness of Basel III. The Synthetic Credit Portfolio was a significant consumer of RWA, and the traders therefore worked at various points in 2011 to attempt to reduce its RWA.
The initial position was long protection to hedge against the naturally long credit position in the CIO bond portfolio:
In the fourth quarter of 2011, the Synthetic Credit Portfolio was in an overall short risk posture
The combination of capital optimisation and trying to add jump-to-default protection to the short credit spread position did not help. In particular, rather than paying out, they funded the JTD protection by selling protection on the IG9s:
the traders began to discuss adding high-yield short positions in order to better prepare the Synthetic Credit Portfolio for a future default. The traders, in late January, also added to their long positions, including in the IG-9 index (and related tranches). These long positions generated premiums, and (among other things) would help to fund high-yield short positions
So what they had was an IG9 5 year short (short credit), high yield short (short credit but specifically long JTD protection) funded by an IG9 10 year long. The net position turned long credit, but they were well positioned against a shortish recession.
The firm’s main problem at this point was that two goals were in conflict. On one hand their position was so large (if unnoticed by regulators) that they would get crushed if they tried to leave too fast: on other other, they needed to leave to reduce capital. The solution, of course, was to try to change how capital was calculated.
the concern that an unwind of positions to reduce RWA would be in tension with “defending” the position. The executive therefore informed the trader (among other things) that CIO would have to “win on the methodology” in order to reduce RWA.
JPM were so big in the IG9s they could not do more — or significantly less. They had to contemplate taking yet more basis risk to balance the portfolio:
[The only option]… was to increase his long exposure in on-the-run investment-grade instruments, such as IG-17 and IG-18,… Beginning on March 19 and continuing through March 23, the trader added significant long positions to the Synthetic Credit Portfolio. These … included additions to the 5-year IG-17 long position (a notional increase of approximately $8 billion), the 5-year IG-18 long position (a notional increase of approximately $14 billion), and several corresponding iTraxx series, most notably the 5-year-S16 ($12 billion) and the 5-year-S17 ($6 billion).
This did not help the RWA usage of the portfolio: all of that basis risk is expensive in an IRC model. As the trader said, this is what kills me. They mis-marked it too, of course, for some definition of mis-marked, because it is impossible for traders to mark something that size accurately. But the real lesson is that JPM did not navigate between the Scylla of upcoming capital requirements and the Charybdis of close out costs very well. What is interesting is that without the RWA motivation, this probably would not have happened.