When Is A Hedge Not A Hedge? The Accounting For JP Morgan’s Bet

Overgrown Hedge

Yesterday’s column at American Banker digs into the accounting for JP Morgan’s reported “hedge”.  I was shocked – OK, not really – that no main stream media outlet had explained the stunning announcement made by Jamie Dimon last Thursday of a $2 billion loss on a series of trades made by the Chief Investment Office in accounting terms. CIO is the group purportedly managing the investment of the bank’s excess deposits.  In London. As in, the low risk sweep function. Uh-huh.

There’s lots of speculation about the nature of the trade itself. The best I’ve seen is the ongoing coverage at FT Alphaville by Lisa Pollack, in particular.

The gist of all the stories is that the CIO was selling protection on the CDX.NA.IG.9 (going long) to balance out the tranches on the high yield index that they’d bought (going short, which turned out to be profitable when Dynegy and AMR Corp defaulted).

In this way the trade would be both a curve play and across indices — one high yield, one investment grade, with the high yield play levered further because it was a tranche. The long on the IG.9 also would have helped to fund the rather expensive short on the high yield tranches.

If you are an expert in this stuff, please get in touch. I’d buy a big steak for someone who can walk me through it, maybe at a quiet table at Gene & Georgetti’s.

I took a long look at the 10K and 10Q and the first clue was the pretty stark statement, all over the place that the credit derivative number, “Represents the net notional amount of protection purchased and sold of single-name and portfolio credit derivatives used to manage both performing and nonperforming credit exposures; these derivatives do not qualify for hedge accounting under U.S. GAAP.

So from a financial reporting perspective, all the media and trader chatter about “hedge or bet?” is moot.

The bank may now be calling the positions an “economic hedge” but, in hindsight, they look to me like a series of trades designed to generate income that spiraled out of control on incorrect or ignored risk information and lack of control over traders.

“It was there to deliver a positive result in a quite stressed environment,” Dimon said on the May 10 emergency conference call, “and we feel we can do that and make some net income.”

The rest of the American Banker column provides the details.

I left out a discussion of PwC and VAR and risk management and Sarbanes-Oxley because of space limitations at American Banker.  I have been getting a lot of questions about whether or not PwC “audited” the Value-at-Risk or VAR number.

Dimon also admitted on the conference call on May 10 that the bank’s primary risk management tool, Value at Risk or VAR, had failed to signal the magnitude of the looming losses. VAR is a statistical risk measure used to estimate the potential daily loss from adverse market moves. The results are reported to senior management and regulators and they are utilized in regulatory capital calculations.

The first quarter press release reported an average VAR of 67 for the CIO. According to Dimon, CIO implemented a new VAR model on its own recently, which it, “now deemed inadequate.” So CIO went back to the old one, which it “deemed to be more adequate.” (Dimon probably feeling less than adequate about now.) The actual VAR number for CIO for the period was 129. There are now reports that the CIO used a different VAR model than the rest of the bank. That sort of negates the argument that CIO was aggregating risks via VAR from the rest of the bank and “hedging” that risk at a portfolio level. There have also been reports that another area of the bank was making the opposite trades that the CIO was making.

As a non-GAAP metric, JP Morgan’s financial statement opinion provided by auditor PwC doesn’t cover the VAR number or the model that produces it. (The audit opinion doesn’t cover press releases or MD&A either although the auditor has an obligation to review disclosures to make sure they are not misleading or incomplete.) However, as the bank’s primary risk management tool, the VAR model and the policies and procedures around it are certainly reviewed as part of the internal controls over financial reporting.  VAR should be on the auditor’s radar as a key indicator of the quality of the bank’s risk management policies and processes. Added May 25: It may or may not be applicable to CIO as some have noted. Changing the model for CIO after several years of “adequate” performance for the bank as a whole should raise red flags. Was the model change properly executed, reviewed and approved at the highest levels?

Added March 18, 2013: Appendix E to SEC Rule 15c3-1 The VaR model must be reviewed both periodically and annually. The periodic review may be conducted by the broker’s or dealer’s internal audit staff, but the annual review must be conducted by a registered public accounting firm.

For more about how models can be used to perpetrate fraud or serve as an excuse for reckless negligence, check out the presentation I made earlier this year at the invitation of Emanuel Derman for Columbia University’s Masters in Quantitative Finance Seminar: Modeling For Fraud, Models Behaving Nefariously.

6 replies
  1. Laurie
    Laurie says:

    Really like the link:

    Modeling For Fraud, Models Behaving Nefariously.

    Very well done!

  2. Len Green
    Len Green says:

    One answer to your headline question may be ” When it’s a fence.”
    As in the manner in which stolen goods are gotten rid of without trace.

  3. Brighter then Dimon becoming Easier
    Brighter then Dimon becoming Easier says:

    Appears another junk derivitive $2-4B deal hatched may 2 and sold to 14 banks who couldnt possibly have had time to
    review the May 1, UK MP 140page hacking report finding CEO of NWS “Unfit”. Did Dimon tell Bank Tokyo , Bank Australia
    that material findings ie Parliament 11th edition Report may1 released?

    -Would it have been JPMorgan’s job as sales agent and 1 of 14 investors to notify
    buyers of NWS Junk Debt of May1 Report before the May2 sale of $2-4B of junk debt
    that most logical buyers would agree a finding by UK Parliament the CEO of Issuer is “Unfit”
    and board of NewsCorp resposible for Coverup all to be things Bank of Australia’s debt buyer who
    has fiduciary duty to Shareholders of Bank of Australia or Bank of America would want to
    know existed prior to buying JPMorgan NewsCorp Junk Bonds.

    And why was JPMorgan rushing ? Why didnt JPMorgan review and take the time to read the
    140p report before closing sale of NWS securities ?

    Willfull Blindness? Additional showing JPMorgan is lacking in internal controls? Or evidence of malfeasance and
    corporate culture to evade law?

    When did Dimon become aware NewsCorp UK Hacking Report released May1 existed? When did he review or
    inquire from JP Morgan analyst? When did JP Morgan analyst read the May1 Parliament report? Who did he tell
    of his conclusions?



  4. david k waltz
    david k waltz says:


    Without detracting from the other points in the post, and acknowledging the conclusions may well be as stated, I would question the statement “Since the bank’s credit derivatives didn’t take advantage of hedge accounting treatment under U.S. generally accepted accounting principles, they’re nothing, in my book, but a bet”

    US GAAP is pretty strict when it comes to transactions qualifying as hedge accounting, and for that reason many risk management activities do not qualify even though they manage risk. For instance, if we owned a Heating and Cooling business we would be able to associate the impact of weather on our enterprise, and might enter into derivative transactions to ensure we earn a base level of income whether winters are warm or summers are cool. Not having a specific contract, obligation, or commitment to offset the derivative transaction, we would not qualify for hedge accounting even though the intent is protection rather than speculation.

    The International Swap Dealers Association, in http://www.isda.org/speeches/pdf/ISDA-hedge-effectiveness-test112003.pdf , on page 6 cites the circumstance where an airline hedging their fuel purchases also would not qualify for hedge accounting treatment, again even though the intent is risk management rather than speculation.

    My last two blog posts have looked at the JP Morgan news as an opportunity to explore Credit Default Swap pricing and how this might work in the context of the Lisa Pollack articles you have mentioned.


  5. Francine
    Francine says:


    You make a good point with good examples. I am making a point regarding further regulation that does not take into account, at all, the accounting treatment of a transaction when looking at which side of the fence – speculation or risk management – it should fall on. I agree that hedge accounting rules are some of the most complex GAAP there is. I’d just like to see a closer alignment so we don’t keep having two different conversations going on – accounting vs. trading – and have to deal with the confusion and surprises that this bifurcated discussion promotes.

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