JPMorgan — Progressing up the league tables — derivative losses could top USD 7 Billion. – But no "Gold Medal"

It may be some time before the magnitude of JPMorgan’s derivative losses are known but market rumors suggest it could top USD 7 billion. Adjusted for inflation that would knock SocGen out of No.2 position. In current (inflation adjusted) USD terms Jérôme Kerviel cost SocGen USD 6.95 billion and takes a silver medal for France.

RANK: No.  2

LOSS: EUR 4.9 bn

LOSS: USD 7.22 bn

CURRENT USD: USD 6.95 bn

France

BANK: Société Générale

INSTRUMENT: European Index Futures

YEAR: 2008

TRADER: Jérôme Kerviel

However, it is very unlikely that this Morgan will de-throne the other Morgan to take the crown for the largest all-time-derivatives loss — which goes of Howie Hubler of Morgan Stanley who lost over $9 Billion in 2007.

Michael Lewis, in The Big Short, explains how Howie caused the massive losses to Morgan Stanley:

Jérôme Kerviel  – Société Générale

“It’s now April 2006, and the subprime mortgage bond machine is roaring. Howie Hubler is Morgan Stanley’s star bond trader, and his group of eight traders is generating, by their estimate, around 20 percent of Morgan Stanley’s profits. Their profits have risen from roughly $400 million in 2004 to $700 million in 2005, on their way to $1 billion in 2006. Hubler will be paid $25 million at the end of the year, but he’s no longer happy working as an ordinary bond trader……”

To keep their “star” happy Hubler agrees  a deal with Morgan Stanley to establish  his own proprietary trading group and take his existing desk’s swaps positions with him. Hubler’s new group is given a target of  $2 Billion in profits.

Howie Hubler — the $25million dollar man

Hubler begins to realize that a lot of the bonds he’s selling, for which Morgan Stanley has built its own origination system to capture the entire profit stream, are not entirely devoid of risk. Together with Mike Edman, they put together a new derivative instrument to hedge billions of dollars of some of the riskily subprime-backed mortgage bonds they hold. 

Lewis explains that the hedge that Howie devised “was betting that some of [his]  triple-B-rated subprime bonds would go bad, but not all of them. He was smart enough to be cynical about his market, but not smart enough to realize how cynical he needed to be.”

The original credit default swaps which Hubler sold required a 4% default rate among the subprime mortgages backing the bonds (which was the “expected loss” in good times) to allow the swaps to pay off. However they did not cover all the potential losses — only the lower portion of the capital structure. The rest of the portfolio was considered virtually “risk free” (and as a consequence there was no need to a loss buffer).

Enter the “risk police” — (which we now know are more like the Keystone Cops).

Morgan Stanley’s risk department was run by Zoe Cruz considered one of the most powerful women on Wall Street (aside: is there a gender bias for these jobs –  think of Ina Drew at JPMorgan?).

Cruz performed stress tests of Hubler’s aggregate positions under scenarios involving a default rate of 10%. Hubler and his staff  protested that such losses could never occur. 

Thus Morgan Stanley’s risk group slowly realized the Value at Risk  (VaR) reports on Hubler’s groups risks were meaningless. The 10% stress test showed that Hubler’s group wasn’t short subprime mortgage-backed bonds but was long. A simulated 10% default scenario would result in a $2.7 Billion loss. 

The actual default rate on the bonds in Hubler’s fund (which were supposedly hedged and “risk free”) were closer to 40%. Lewis writes:

“[Hubler was] . . .  allowed to resign in October 2007, with many millions of dollars the firm had promised him at the end of 2006. The total losses he left behind him were reported to the Morgan Stanley board as a bit more than $9 billion: the single largest trading loss in the history of Wall Street……Hubler and his traders thought they were smart guys put on earth to exploit the market’s stupid inefficiencies. Instead, they simply contributed more inefficiency.”

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