J.P. Morgan and its CEO Jamie Dimon have one of the better (relative) reputations on the street. JPM’s diversification, relative conservativeness and balance-sheet strength have all been positives for the Financial Giant.

Yesterday we got news that one trader, Bruno Iksil (also dubbed the London Whale) perhaps managed to wipe many if not all of those perceptions away in one fell swoop. This one man allegedly cost the bank close to a billion dollars if not more. And all because of a bad hedge? What's worse is that these "egregious mistakes" took place in JPM's chief investment office, which is the side of the bank that is supposed to be a bit more conservative and is engaged in hedging (protecting) risk associated with bank’s money. Credit products and derivatives are used to gain or protect from exposure in all sorts of investments; everything from sovereign debt to corporate bonds. They are traded over the counter (OTC), have little regulation and often are illiquid to an extent. The value of many of these products are derived from mathematical models that create risk profiles based of a couple of inputs... According to several sources, Mr Iksil was placing bets using short synthetic CDSs against a portfolio of long corporate bonds. His “hedges” were so immense that they were moving markets in a big way, creating price abnormalities and attracting funds on the other side of the trade, making it hard for Iksil to unwind them. The analogy would be selling thousands of complex hurricane insurance policies along the gulf coast just ahead of hurricane season because you don’t believe there will be a hurricane. Perhaps they are your “hedge” because you have bought flood insurance in the same area but at a cheaper rate and perhaps less coverage. In this scenario, you may capture more money than you bring in... If hurricanes do develop, the damaged caused may begin to escalate exponentially and your long insurance policies may NOT be paying off because the hurricane damage is triggering more of the policies you sold than the ones you bought. The worst part is that now NO ONE wants to take those short hurricane policies from you and if more hurricanes occur your losses will escalate. If you want to buy more hurricane policies (to add protection), chances are those are going to be pricey. So now you either take some serious losses or wait it out and pray... I am over-simplifying here, but essentially this is what seems to be happening. I'm curious to know your thoughts on this news; which is sure to have serious effects on the creditability and stability of banks around the world. Do you think it's acceptable and perhaps just an honest mistake that one man (or unit) was able to create this risky position and subsequent loss? Should this be considered a fluke and simple consequence of a credit product trade gone wrong? or Are there serious flaws in the risk management ability of the largest banks that should be examined carefully? Does the Dodd-Frank bill even help or hurt overall risk management? RELATED ARTICLES

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