JPMorgan hit headlines this week for the up to $3 billion loss made on a single bet, which has seen their share price drop close to 19% since the beginning of May.

Luckily, JPMorgan is a big enough institution to wear these losses, with a few golden handshakes and an investment team shuffle.

However, if the same investment strategy had been taken by a number of big players at the same time, as was the case when many people in the market held collateralised debt obligations on US subprime housing, we would be an entirely different scenario.

In reviewing the investment strategy that led to such a colossal loss, burningpants has to wonder; are our memories that short, or are we destined to continue repeating our past mistakes?

At the centre of the scandal is the chief investment office, based in London, where JPMorgan takes care of its hedging activity. The chief investment office had been tasked with reducing the bank’s exposure to “high yield” or junk bonds.

High yield bonds are riskier in nature than investment grade corporate bonds, and JPMorgan had come to own a large amount of them, so needed to get some insurance against the risk associated with these, as if they were all to go bad at the same time then there could have been significant consequences for the bank.

So they sought an investment opportunity that would be expected to do well in the event of high yield bonds doing badly; the answer? High yield bonds.

However, there are more ways than one to skin a cat, and in order to cut their risk on junk bonds JPMorgan’s chief investment office looked to bring the infamous credit default swaps (CDS) into the equation.

This was roughly the bet that JPMorgan was taking.  They had identified that investment grade bonds were doing particularly well, with defaults looking very unlikely.  They had then looked at their large holdings of high yield debt and decided that the best way to hedge out the risk from their high yield assets was to go short on investment grade CDS’s. They had identified an investment grade index that they could make a bet that investment grade bond CDS’s would fall in value on.

However, the size of the bet that JPMorgan took was so big that other players in the market began to take notice.  They looked at the underlying companies on the investment grade index that JPMorgan was shorting CDS’s, saw that some of these didn’t look like companies that had zero chance of defaulting, and decided to take the other side of the bet that the CDS’s would increase in value. A number of hedge funds bought the CDS’s from JPMorgan, and once default became more likely for some of the underlying companies in the index, the value of the CDS’s increased, and JPMorgan began to lose money.

Now, this would have been fine if JPMorgan had only made a small bet, as investment managers lose money all the time on strategies that don’t pay off.  However, through the use of complex CDS’s, and leverage, JPMorgan’s entire position approached close to $100 billion, so only a small loss percentage wise was going to add up to a big loss dollar wise.

Derivatives allow for markets to function properly, by shifting risk.  However, when they are bunched together in large bets the consequences can be overwhelming.

Let’s not forget what got us into the global financial crisis in the first place.

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