Trading Against Your Clients Works Best When You Lose Money

This is sort of a strange footnote to the London Whale: one of the hedge funds that made money feasting off his carcass was run by JPMorgan*:

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. …

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.

This is … not surprising. Some people want to sell CDS, some people want to buy it. That’s how there’s a market. And when you’re as big and interconnected as JPMorgan, it’s not surprising that the market often crosses between bits of yourself. That is, it’s sort of silly to think of JPMorgan as a market participant; it is rather a nexus of many many market participants. Some of those participants are “JPMorgan,” in that they’re interested in the performance of JPMorgan as an entity; others of them are “clients” in the sense that they are buying securities from JPMorgan or having their assets managed by JPMorgan in some separate or mutual-fundy way; but to think of them all as JPMorgan is silly.

But the conclusions from this unremarkable fact are sort of interesting:

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.” …

“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.”

So, one: yes. I’m sure that’s true – that Bruno Iksil and the managers of this mutual fund didn’t sit down and talk out the risks and rewards of this trade and ultimately decide that one of them should go long and the other should go short.

Two, though: what if this had gone the other way? This trade is in some crude sense unnatural: you would naïvely expect JPMorgan’s CIO to be buying corporate credit protection and its Strategic Whatsit Whosit to be selling.** Imagine it had gone that way: the CIO had bought zillions of dollars of index credit protection, the mutual fund had sold a chunk of it, and then … well in this scenario imagine that CDX deteriorates, the CIO doesn’t get picked off and makes $2 billion, and the mutual fund loses some money. Would the conclusion there be “the asset management firms really do act like different bodies, bodies housing brains that are sometimes smarter and sometimes dumber than the CIO,” or would it be “ZOMG JPMorgan sold corporate credit to customers while betting against it”?

I don’t know! The whole thing where they actually probably don’t share info between asset management and CIO would probably be helpful. And JPMorgan making $2bn off a trade is probably less newsworthy than it losing $2bn. Still, I suspect the main reason that this trade “is different from the example of Goldman Sachs in 2007, when it sold subprime mortgage securities while betting against them” is that here JPMorgan-as-entity lost money and JPMorgan clients made money (maybe!).*** And that the one worse PR move for a bank than losing money for itself is making money trading against its customers.

As One JPMorgan Trader Sold Risky Contracts, Another One Bought Them [DealBook]

* Also not a hedge fund, whatever.

** That mutual fund is a credit fund; its natural state of being is to be long corporate credit though I suppose its purchases of CDX protection were a market hedge to being long specific names. (Or perhaps it is actually not that into corporate credit, whatever.) Similarly, the CIO is at least in part in the business of hedging JPMorgan’s broader credit exposures as a bank, so you’d think it would be interested in buying protection (as it was in addition to selling).

*** I mean, there are also other, more sensible differences, like that GS’s Abacus trades were marketed by the people who stood to gain on them rather than through independent brokers (bad fact for GS), or the fact that JPM’s Structured Whatsit investment decision was made by JPM rather than its clients (bad fact for JPM if it had lost money).

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66 Responses to “Trading Against Your Clients Works Best When You Lose Money”

  1. Guesticles says:

    Eigen used to be a PM at Highbridge, and has the most latitude of any PM at JPMAM- he has his little team up in Boston, and they kind of do their own thing without being bothered by NY, so long as the inflows continue to roll in (historically- they have). What CIO does is opaque to the rest of the Firm, and Asset Management has its own strategists to ignore while PMs make their own investment calls.

    Eigen is a smart guy with a hedge fund background running an opportunistic FI fund, with very little central oversight. If there's blood in the water, it's his job to get on it.

    I've read a few articles on this issue now, and one of the obvious things that the MSM fails to point out is that it's not that JPM was trading against itself- JPM actually lost its own money on a position that its mutual fund investors made money on.

  2. short vol guy says:

    Mutual gunds can't sell puts/naked CDS like that so "imagine" is as close as we can get on that.

  3. Hakuna Matata Guy says:

    I know this is wildly off topic, but what is the deal with the "welcome home Morgan Stanley, We've missed you"

    I feel like im taking crazy pills!

  4. Guest says:

    Thar she blows

    London Whale Said to Leave JPMorgan

  5. Guest says:

    "They don’t share info."

    This is too broad a statement to be true. In this case, the CIO and the asset manager were literally on opposite sides of the ocean, and not only that, but the asset manager wasn't even in the same offices as HQ. That very naturally limits the amount of communication that goes on.

    But with a bank where the asset manager and the prop desk manager – excuse me, I misspoke, I meant the *hedge* desk manager! – are in the same building, as they are with others of the Wall Street firms, the chances of information not flowing between the two are nearly zero. Factor in people who move between the groups, people who happen to know each other from other connections (e.g. college), and idle chatter in the cafeteria, and it's virtually guaranteed that information is going to flow, and that someone, between the prop desk (whoops!) *hedge* desk, and the asset manager, is going to be on the losing end of that.

  6. giest says:

    is that a sperm whale?

  7. Guesttt says:

    cutest picture on DB since Daniela Rausnitz

  8. Guest says:

    why does this matter? this is not like some single name or unique synthetic CDO. this is the IG index. wow – one guy thought the overall credit universe was overpriced while one did not. Isn't that what banks do – long credit risk? This is the equivalent of an event in the equity market where a prop desk is long futures and some mutual fund is underweight. I realize credit derivatives might be hard to understand for equity guys, but this is a non issue.

  9. obvious says:

    The key question that I'm sure you meant to ask was when the JPM asset manager managing the money of other people (aka the "Muppets") executed the trade, did all or part of that fill get soaked up by the Whale? If yes then did they handle the conflict of interest properly? In other words did the Muppets get a good fill on their trade(s) or did the Whale (who was hedging the bonus of the JPM asset manager) get a good fill or did they just trade mid-market or did the CDS desk rip both sides?

  10. J. Coorz says:

    The whole thing is that Dimon should have used better risk management…

    I mean I could see missing a bill six maybe….but two ?

    That's just… we should spend alot of time and resources on this.

  11. Baa3 says:

    not long enough

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