June 4, 2012 / 3:28 PM / 6 years ago

Analysis: In failed JPMorgan hedge, lessons from past missed

NEW YORK (Reuters) - A well-regarded U.S. lender once lost a tidy sum on derivatives, and Jamie Dimon had to ride to the rescue.

Commuters are reflected in stone as they walk past the JP Morgan headquarters in New York, May 17, 2012. REUTERS/Eduardo Munoz

It wasn’t JPMorgan. It was Banc One, a regional lender that piled into derivatives in the early 1990s. Banc One’s shares tumbled as the trades went sour, eventually leading to the hire of Dimon as CEO in 2000 - and later, Banc One’s acquisition by JPMorgan.

The trades in a number of ways echoed those more recently under focus at JPMorgan (JPM.N). In both cases, the banks came under attack for losses on what they described as hedges but others feared were trades meant to enhance returns.

The banks built large portfolios at little cost, aided by low capital charges backing the contracts. Unlike other assets, such as bonds or loans, derivatives can be traded with little upfront cost, with collateral to back the trades often only collected as the trades move in value.

Fears over losses in derivatives were exacerbated by the opaque nature of these markets, which are now $650 trillion in size. Investors worry that other risks may be lurking on the balance sheets of JPMorgan Chase & Co (JPM.N) and other banks.

Both cases demonstrate that even the most sophisticated banks may not fully understand the risks of certain activities. They also tend to fail to learn from the past.

Excessive leverage and complex credit derivatives were a big factor behind the 2008 financial crisis that led to the Dodd-Frank legislation being passed by Congress in an effort to reduce risks. Until JPMorgan’s losses became known in May, bank-led industry groups were gaining ground in trying to head off many key tenets of the derivatives reform regulation.

But Dimon’s reputation as a top risk manager has been tarnished from the losses. JPMorgan shares are down about 23 percent since the losses were announced May 10, and the bank faces multiple regulatory probes.

People familiar with the situation say that the unit behind JPMorgan’s losses had looser controls than at the rest of the bank, and was able to build up risky positions without triggering alarms.

“You had the smartest guy in the room blind-sided to at least $2 billion,” said Michael Greenberger, a law professor at the University of Maryland and a former director of trading and markets at the Commodity Futures Trading Commission.

In Banc One’s case the losses came from relatively simple contracts, amortized interest rate swaps.

The contracts were attractive to Banc One as they could be booked off its balance sheet, while the interest gains from lending at long-term maturities and borrowing at a short-term rate were recorded on-balance sheet as net interest income.

Profits from the trades, while they benefited from falling rates, helped Banc One solidify a reputation of superior risk management and investment ability.

“Analysts had attributed income to their lending business and gave them credit for being smart, when in fact they were doing derivatives that at the margin created no value but brought with them a lot of interest rate risk,” said Donald van Deventer, chairman at Kamakura Corp., which specializes in credit and interest rate risk management.

“When rates moved the emperor was clearly seen to be stark naked,” van Deventer added.

Banc One used the gains from the contracts to fund an aggressive strategy of growth through acquisition.

By the third quarter of 1993 the bank had increased its swaps portfolio to a notional value of $36.41 billion, up from $4.72 billion at the end of 1990, according to regulatory filings.

That figure compared to total assets of around $80 billion at the end of 1993.

Soon investors and analysts began to express doubts over Banc One’s derivatives positions, concerned about the lack of transparency of the trades and worried about the associated counterparty risks of the contracts.

“The capital markets activity was overpowering the retail side of the bank,” said a former employee of the bank that was familiar with its strategy, who declined to be named.

Banc One took losses on the trades when as it was caught offside in both directions when rates rose, and fell then back down. In 1994, its shares fell 29 percent.

As with JPMorgan’s losses, for Banc One it showed how complexity can hurt, as investors flee from what they cannot explain.

“The lesson I learned from that was that you should never take an asset on your books that you don’t understand and that the chairman and everyone cannot understand and explain,” said the former Banc One employee.

Reporting By Karen Brettell

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