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“LONDON WHALE” INSIGHTS FOR COMMODITY RISK MANAGERS
I encourage those of you who manage trading in the agricultural commodities to read the internal report produced by JP Morgan concerning the “London Whale” fiasco. Here is a link to the report:

JP Morgan Report

Put aside the magnitude of the loss and the fact that it was in financials, you will find that all of the mistakes were the result of basic missteps in the practice of accepted best practice. Mistakes that we have all made or seen at one time or another….just not all at once and not for $5.8 billion! A quick read through the report illustrates my point.
Failure to communicate hedging strategy from top to bottom and allowing bona fide hedging strategy to comingle with proprietary trading. Consider the fact that the traders on the ground were given conflicting directives concerning the Synthetic Credit Portfolio (the portfolio within the Chief Investment Office that caused the loss). I will paraphrase the directives but they can be read on page 85 of the report.

  • Get even on a directional or flat price basis
  • Reduce the overall risk profile
  • Don’t lose money (The Synthetic Credit Portfolio had made $2 billion since its inception in 2007. It stands to reason that the firm may have become complacent expecting a “hedge” portfolio to continuously contribute to the firm’s profitability. Taking a “hedge” loss was actually ruled out at an early stage and this in my opinion was the single most critical mistake made in the entire fiasco.)
  • Reduce VaR exposure (no matter if you have to change the mathematical assumptions underlying the model and introduce a flawed and untested methodology at the height of the crisis)
  • Be sure to hedge portfolio against excessive downside risk (what is referred to as “jump to default” protection; how can you be even and reduce risk if you need to take additional risk to protect underlying positions?)

From a trader’s perspective, you can see how the desire to please all parties and respond to all directives led to the construction of the ticking time bomb that was the Synthetic Credit Portfolio.

  • Failure to oversee the marks to market set by the traders. The marks were the basis of day to day p/l and a basis for VaR measurements. The report gives an example of the latitude the traders were given in setting the marks. In the immediate aftermath of the “London Whale” story breaking, a junior trader gave an initial estimate of $700 million loss but a senior trader became angry with the estimate. That initial estimate turned into a reported loss of only $5 million only to be updated latter after yet another conflict between traders to a loss of $450 million. (page 64-65)
  • Failure to monitor day to day volumetric positions for the key risks: directional, differential, tenor and volatility. The Chief Investment Officer looked only at VaR and P/L …both were flawed and in any case would not have given the required insight into differential exposure (correlation) combined with liquidity issues given that the positions were way too big for the market. Upside/downside scenarios were hopelessly optimistic; for instance 2Q portfolio results were predicted at -$150 million/+$250 million. The firm concluded that reports had to be sufficiently “granular” to expose the risks underneath VaR and criticized the CIO for not requesting reports that would have detailed the positions and properly identified the risk elements responsible for the problem.
  • Failure to respect limits. When limits were exceeded they were “temporarily” raised. There was no standard protocol to initiate a wind down. (page 78 and 80-81)

And there is much more……happy to discuss in greater detail with my clients, colleagues and contacts.