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How JP Morgan's 'London Whale' Lost $2 Billion

 May 16, 2012 04:05 PM

(By Matthew Weinschenk) Last week, after a month of speculation that something might be awry, Jamie Dimon, CEO of JPMorgan Chase(NYSE: ), placed an emergency conference call and admitted to a $2 billion investment loss.

The loss, he explained, was a result of a "new strategy that was flawed, complex, poorly reviewed, poorly executed and poorly monitored."
Details remain obscure, however, as JPMorgan hasn't been forthcoming with exactly what this trade was and how it went so wrong. It's referred to only as a "synthetic credit portfolio" and a "strategy to hedge the firm's overall credit exposure."

We do have a little more information, though…

In April, some hedge funds tipped off reporters to unusual activity happening in the credit default swap (or CDS) market. The story broke on Bloomberg that the trades were coming from JPMorgan's London-based Chief Investment Office.  And the particular trader in question – dubbed by other investors as the "London Whale" (for his massive positions) and "Voldemort" (for his power over the markets) – was identified as Bruno Iksil at JPMorgan.

The trades Iksil made were based on the Markit CDX.NG.IG.9 Index. It sounds complex, but it's simply an index that tracks the corporate bonds of 125 high-quality companies like General Mills, Pfizer and other household names. Iksil was trading CDSs – a type of derivative – on that index.

Exactly what method Iksil was employing is still up for debate, but so far the best theory is that Iksil placed a "flattening trade" on the Index (described in detail by Lisa Pollack). Here's how the flattening trade works: A CDS is a derivative contract, but it's easier to visualize as an insurance contract. For any bond, you can find a price to "insure" that bond against default. If a bond is more risky, the price for insurance is higher. In the CDS market, traders can choose to be either insurance buyers or insurance sellers.

Now, if you chart the cost of insurance over different time periods, you get a curve like this one:

The above is the curve for the Markit CDX.NG.IG.18, a similar index to the one Iskil traded.

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