Last Thursday was Groundhog Day, again, in US markets. A large sophisticated institution surprised everyone with a 10-figure loss on derivatives, its stock price crumbled, a few pundits said “I told you so”, and some politicians clamoured for reform. The same happened in 1995 with Barings Bank, in 1998 with Long-Term Capital Management, in 2000 with Enron, and in 2008 with several Wall Street businesses, notably Lehman Brothers and AIG. Four days ago it happened with JPMorgan Chase, which stunned investors with a $2bn derivatives loss.
In each case the victim was thought to be a well-run, relatively safe institution. And in each case the culprit was financial innovation and mathematical models that wrongly suggested positions were low-risk. Each of these firms traded complex financial contracts and then used a single number – “value at risk” – to estimate its maximum probable loss, just as a weather forecaster might estimate the likely cost of hurricanes during an upcoming season.
Until recently, JPMorgan put its value at risk for the relevant trades at just $67m, meaning it had calculated that 95 per cent of the time it would not lose any more than this amount. Given that disclosure, investors might have imagined a worst-case scenario loss of $100m – but not $2bn. Ominously, Jamie Dimon, the bank’s chief executive, warned on Thursday that losses might escalate even higher and admitted that the model the bank used to calculate its trading risks was “inadequate.” Twenty-four hours later, $14bn had been wiped off JPMorgan’s market capitalisation.