JP Morgan CIO to Increase Risky Derivatives Trading: Report

JPMorgan pledged to improve its Chief Investment Office (CIO) risk management practices after the 'London Whale' employee lost $2bn in bad bets in May this year. But according to unnamed sources by the Wall Street Journal, the unit is actually looking to increase its portfolio of other risky derivatives instruments that in many ways resemble a portfolio that plunged the banks into a credit crisis in 2007.

JPM's strategy will apparently remain unchanged when it comes to permitting a wide variety of other, potentially risky investments, including instruments that were widely blamed for the creation of the credit crisis five years ago.

While asset back securities and troubled corporate debt make up a minority of the CIO's portfolio, WSJ's sources say that the unit is expected to increase these holding, due to the instruments' generation of big gains in the past.

According to JPM and WSJ data, its CIO's mortgage- back securities holdings reached $187.4bn this year, up from 4.45 percent in 2011. Meanwhile, asset backed securities holdings also increased this year to $38.1bn.

Overall, the CIO's available for sale debt securities portfolio increased by over 13 percent, reaching $370.82bn for this year.

JPM declined to comment on the report.

Rethinking Risk

In May this year, JPM confirmed that the bank has lost billions of dollars, after an employee at its CIO unit made a series of enormous bad hedging bets.

In one of the largest legal losses for a bank in recent history, Bruno Iksil, who reportedly deals in huge volumes, earned himself the nickname "the London whale" - which echoes gambling terminology that refers to a "whale" being a leviathan gambler who frequently bets monumental amounts of money.

In the aftermath, the bank's CEO, Jamie Dimon said that the CIO has $7bn in unrealised gains that may be used to offset the damage testified in front of the US Senate Banking Committee in order to defend the banks practices.

The bank's supervising body Office of the Comptroller of the Currency (OCC) Thomas Curry agreed that the amount lost in the 'London Whale' event will not create a solvency issue for the investment bank or threaten the broader financial system.

However, one of the key issues arising from the event was the banks failure or lack of sufficient risk management practices and the latest report from the WSJ seems to be at odds with this.

Subsequently, JPM said in an official statement that the "CIO will narrow its focus to its core mission of conservatively investing in high quality securities."

However, risk management will need to be relooked at, as Dimon is claiming that "a series of events led to the difficulties in the synthetic credit portfolio," managed by the CIO, which includes "CIO's traders did not have the requisite understanding of the risks they took."

JPM is expected to unveil more details of what led to the $2bn loss, in its second quarter earnings on July 13 this year.

Will Improved Use of VaR Help?

One of the key criticisms Dimon, JP Morgan and its CIO still faces is the flawed, inadequate or misuse of VaR, which is a broad calculation model, used by trading firms and investment banks to measure the potential losses of a portfolio.

Virtually all investment banks use this as part of their risk management practices in order to prevent substantial swings in profits and losses. However, implementing such a measure is only an indicator of risk and does not necessarily dictate trading actions.

Dimon has infamously dismissed the use of VaR in 2006, he said it was "a very bad number if you think it actually represents risk". A few years later, in 2009, he said he didn't "pay that much attention to VaR."

Given the whale-like losses at the London CIO, it may seem like a clear cut case in terms of "dismissing VaR at your peril." However, the case is not black or white.

JPMorgan changed its some of the calculations and measurements in its VaR model this year, and indicated that the average Value-at-risk figure by $2m to $67m for JP Morgan's CIO unit.

However, reports suggested in April that the CIO's portfolio was so large that is was distorting market prices. Dimon shrugged-off the suggestion as a "tempest in a teapot". The following month, he said the CIO loss of at least $2bn and announced a return to the previous VaR formula, which revealed that average figure had in fact almost doubled to $129bn.

The JP Morgan case is not new, in terms of the flawed or misuse of VaR, but it does highlight the critical situation banks and firms can be faced with when risk management goes wrong.

"VaR popularity and the concept have definitely been tarnished by recent high profile losses," says Risk Limited's Burchett, who once worked for JPMorgan, although not directly in its risk metrics group. "Losses by the firm that is considered to have originated the concepts and primary methodologies that lead to VaR, has particularly caught the market attention. Probability analysis is not going away, but it is going to be intensely scrutinized and will also be supplemented."