Irony 101 Or How The Fed Blew Up JPMorgan's 'Hedge' In 22 Tweets

Tyler Durden's picture

Many pixels have been 'spilled' trying to comprehend what exactly JPMorgan were up to, where they are now, and what the response will likely end up becoming. Our note from last week appears, given the mainstream media's 'similar' notes after it, to have struck a nerve with many as both sensible and fitting with the facts (and is well worth a read) but we have been asked again and again for a simplification. So here is our attempt, in 22 simple tweets (or sentences less than 140 characters in length) to describe what the smartest people in the room did and in possibly the most incredible irony ever, how the Fed (and the Central Banks of the world) were likely responsible for it all going pear-shaped for Bruno and Ina.

Of course we do not know exactly what positions were undertaken and what the mandate was for the CIO Office but our assumption is that they are 'smart people', had no positional constraint (i.e. any asset class, any instrument), and more than likely were human emotionally.

1) Post QE2, JPM's CIO group needed to hedge tail-risk of bank debt portfolio.

Credit risk was rising rapidly and had reached levels not seen since the the real chance of tail events was creeping up fast...

2) JPM traders/risk managers are not stupid - can manage curves/levels in 'normal' market but firm needs 'extreme' risk hedge.

Critically - these guys are not dummies - they don't simply buy/sell index protection or curves (as some have suggested) in ultra-massive quantities (since risk models would flash) unless there is an edge. More importantly, they can manage risk at desk levels on term structures and exposures (and even jump-to-default risk to some extent) but on the aggregate portfolio there is a lot of un-covered risk of an extreme event (which seems ever more present) occurring.

3) VaR risk model can 'comprehend' most of 'normal' market moves but not extreme tail risk (illiquidity, basis, correlation shocks).

VaR models (even the most sophisticated Monte Carlo engines) will have significant problems integrating the kind of extreme risks that need to be hedged to avoid catastrophic loss (such as basis risk (the risk that a hedge disconnects from its underlying), illiquidity (some models incorporate a market-impact but very few do it well or even close to reality), and most assume correlations to be relatively stable (not a dynamic variable - which is critical to the pricing of many credit instruments).

4) Goal: Find as low-cost a 'systemic risk' hedge as possible (with longer maturity than options allow).

So, likely at the behest of management, the CIO office set out to find cheap ways to manage this extreme risk. Equity protection was (and is) expensive as evidenced by skews and term structures but credit offered some room for value (and moving from options to tranches - not important what they are other than levered complex credit positions - allows a longer-maturity hedge to be placed - typically at lower cost than rolling options premia over time)

5) Hedge choice made:- Senior Tranche (Low cost, Low spread delta BUT hard to model risk in agg. book & very long correlation).

Senior (or the highest position in the capital structure) tranche positions provide attractive hedges for a systemic (or even cyclical) tail-risk. As seen below, courtesy of Morgan Stanley, the hedge is 'low' /'medium' cost and has high sensitivity to systemic risk. Implicit in this is the fact that it is very sensitive to the correlation of asset defaults.

6) Bought CDX Tranche Q3/4 2011. Provides systemic hedge (will payoff if things are VERY bad but relatively calm if things are OK).

See table above (perhaps was a more complex tranche term structure, cross-quality (IG-HY) or pairs-trade but the endgame was the same - to get long correlation, at a low cost, in a systemically careful - unsuspected - manner).

7) Tranche is sensitive to spread movements (low), volatility (medium - due to hedging gaps), and correlation (high).

These characteristics appear fantastic at first glance - not too sensitive to spread movements overall (ceteris paribus), volatility will cause some drama (as the position will need to be rebalanced), and while correlation is a big sensitivity it is directionally in our favor and has relationships in line with spreads that should help us.

BUT, sometimes the tranches do not always behave exactly as one would expect - due to the second and third derivative interactions of the model parameters...

8) Correlation is market's way of thinking about systemic risk (low correlation equals idiosyncratic risk dominates).

The critical part of our story is comprehending what it takes to crush the most senior part of a capital structure of a portfolio of credits. A few defaults here and there will not affect the most senior or 'secured' aspects of the balance sheet of a portfolio (which is what we call idiosyncratic risk - CHK there, ALLY here, EK then, SHLD soon etc.) but what really worries a manager is if systemic risk rises rapidly due to some event (say a huge liquidity crunch or Greece leaving the Euro and a run on Italian/Spanish bank deposits) which could cause many firms to default simultaneously from a total lack of funding or credit availability (think 2007/8/9). The probability of this 'systemic' event is priced into these credit tranches using the term 'correlation' - low correlation in generally good times when systemic risk is low and idiosyncratic risk dominates (individual firm balance sheets etc.); high correlation in systemically bad times (when something systemic is sinking all boats).

As seen in the chart below - correlation had been stable from the start of Jan11 and was rising modestly as USA downgrade and European woes picked up - though not crazy enough to make pricing expensive...

9) Q3/4 2011: European/US Chaos reigns: Correlation high (hedge doing well) - CIO office reveling in glory of smartness.

See chart above for Sept/Oct movement in correlation - rising

10) Nov2011: Fed/ECB start coord. global easing program -> starts to crush correlation as systemic risk is 'supposedly' removed from system.

And here comes the critical aspect of our story!


The actions of the Fed/ECB/rest-of-world with massive and unprecedented easing efforts was perceived by the market as a tail-risk crushing event - i.e. they removed the systemic risk from the system once again.


Look at the chart above to see what happened to the short-term correlation (red arrow) - it was squelched to levels we had not seen before

11) JPM CIO office forced to sell IG9 protection to manage tranche position as correlation drops (think: delta rebalancing).

What this meant was very important. The tranche - which had been purchased as a hedge for JPM's aggregate (likely long) book required rebalancing as the 'models' used to price and risk manage such positions would have demanded some hedging of the hedge. This is similar to maintaining a delta-hedge on an option position as the market moves one way or another and volatility (a secondary parameter) changes. The trouble is - these systemic risk tranches are HIGHLY sensitive to this somewhat 'magical' measure.

12) Q1 2012: Correlation plummets massively: the 'tail-risk' hedge is needing huge amounts of index rebalancing to keep it 'stable'.

As correlation plummeted - i.e. the market pricing forced the inputs to the models to change which altered the risk sensitivities - so the tranche 'tail-risk' hedge itself needed to be hedged in increasing size. This is likely when Iksil began to be forced to sell IG9 (this is the index upon which the only liquid tranches are based) protection - an oddly bullish position given the bearish nature of the tranche hedge - as all sorts of wonderful second derivative interactions played havoc with his models. Given the size of the firm-wide tranche hedge, and the implicit leverage this tranche infers, this would have meant very heavy index protection selling (in what was not a hugely liquid index anyway.)

13) Mar/Apr 2012: JPM CIO corners IG9 index market as forced protection seller on tranche tail-risk hedge position.

This meant that the JPM CIO office began to sell more and more protection at the index level (dark blue line below) which forced the index to trade differently to its intrinsic or fair-value. These kinds of disconnect (red arrow) are often arb'd by sophisticated hedge funds - but this time the arbs were being frustrated (orange line) by a SIZE player dominating the market and soaking up their demand for protection (the funds would be buying protection on the index - the opposite of JPM CIO - while selling the underlying names protection).

14) Funds complain of richness of IG9 to intrinsics and how technicals are crushing their attempts to arb - the Whale Is Born.

See chart above (red arrow) as the whale began to dominate the market flow. This means that no matter what effort the hedge funds put into the arbitrage (to try and move the orange line higher - back to its more normal zero level) - they made no difference - and in fact were often hurt significantly

15) Momentum takes over and Iksil becomes self-aware - and potentially presses his position (unbalancing the hedge).

We suspect that at some point the daily rebalancing of the hedge's hedge and the constant and consistent rally in credit and equity markets became too much for Iksil who just became another momo monkey, perhaps leaving a little too much long index protection on the basis of the rally extending...i.e. over-hedging LONG his implicitly short credit/systemic hedge

15) European sovereign, China slowdown, and US growth risks spur deterioration in credit risk - meaning losses on IG9 index position.

Between his huge size and the velocity of the shifts in the index as things began to go wrong fundamentally, Iksil was in trouble. Not only that but 'correlation' began to pick up and so the hedge of the hedge needed to be unwound...

16) JPM CIO faces huge losses from small move in spreads since they have sold so much protection and tranche unbalanced.

He found himself the dominant long player in a market in which fundamentals, technicals (arbs), and his own models (correlation) were saying unwind/short - which starts the pain trade for Ina and Bruno and more than likely this is when the bells started to go off in risk manager's ears and Dimon got the call...

17) Funds arb the skew and press IG indices knowing JPM needs to unwind/hedge the index hedge of the 'tail-risk' hedge.

It was a poorly kept secret obviously and left a market smelling blood. JPM looks for any way to manage this position - i.e. find any liquid hedge to cover the overly-long index protection that Iksil had over-hedged the original tail-risk hedge with. There's not enough liquidity in the original instrument so any and every credit instrument gets hit...

18) All credit instruments blow wider (as JPM - or front-run by peers) look for any and every liquid hedge to manage over-hedging.

last week or so this has been occurring with the worst happening post Dimon's call...

19) IG9 skews normalize (today) relieving some pressure - seen this the last 2 days.

The arbitrage between the index and its intrinsic value has smashed back to almost zero (-3bps or so - see chart above) as the technical pressure from the whale is relieved and the arbitrageurs flow can 'correct' the index back to its idiosyncratic reality. This likely slows the pain trade as the arbs will unwind their position removing some pressure from JPM now.

20) HY18 massively cheap (and HYG underperforming) - suggests long HY position but scary technicals remain.

The on-the-run high yield credit index (meaning the most recent vintage HY spread index in credit derivative land) has seen its index spread (dotted line red arrow) explode relative to its intrinsic value (orange arrow). This is an example of the 'technical' flow that reaching for any and every liquid hedge has caused in the last few days - and leaves HY18 extremely cheap to its fair-value.

Today also saw HYG (the high-yield bond ETF drop dramatically) as another example - and most notably - perhaps JPM was the cause of the HYG collapse relative to NAV at the start of April (orange ovals below)...

21) Did JPM unwind some of tail-risk hedge? What further losses did they take on index hedge of tranches?

We can only hope so - and would suspect so given the recent gappiness but it is unclear what losses they faced on those positions and what model parameters they are now using to price the underlying tail-risk hedge that is likely up in value significantly in the last few days - this is where we suspect the truth is being hidden. At some point the market will once again force a rerack of the model parameters and we suspect the worst is not over here - especially if we see systemic risks continue to rise rapidly - more rapidly than the unwind can occur - key to this will be the number of defaults but the MtM volatility will pressure JPM's earnings without doubt - though it seems unlikely that JPM would not have managed to hedge a lot of this systemic over-exposure - though basis risks become even more complex.

22) Summary: JPM tail-risk hedge imploded thanks to Central Banks' Systemic Risk reduction - unintended consequence...

The key factor is that if systemic risk had remained in even a 'normal' range of possible regions based on history, then the JPM CIO office would have had no need to over-hedge their tail-risk hedge position, no greed-driven need to press the momentum, and no need for such an epic collapse as we are seeing now.

The point is - this was a trader/manager with a good idea (hedge tail risk) that was executed poorly (and with arrogance) but exaggerated by the unintended consequences of the Central-Banks-of-the-world's actions (and 'models behaving badly' as Derman would say). 

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hedgeless_horseman's picture the real chance of tail events was creeping up fast...

This article just increases my man crush on Tyler, and per our President, that is ok.

BlueCollaredOne's picture

This article reminded me that I know absolutely nothing about finance.

hedgeless_horseman's picture



Trading is easy.  

This next week, or two, just keep buying this:

Sell half when it goes up 20%, the remainder when up 40%, and all if down 10%.

...but only if you believe, like I do, that European banks, and especially France, are FUBAR tout suite.

Viva, Monte Carlo, bichezzz!!!!

Oh regional Indian's picture

Butt it's all okay HH, because Gaybama was on the View telling the ladies last night that JPM is the bestest managed bank in the whole world.

No worries. All is 

No wowwies.

Let's accelerate this train to wreck o=point, shall we?



AldousHuxley's picture

only hedge against extreme long tail risk is....diversification.


you never know which bank is going to fail due to scandles, executive mishaps, terrorists, etc.

so spread your wealth around in different banks, gold, house, rare art & collectibles, etc.


It is GOLDman sachs, not FIATman sachs...

GetZeeGold's picture



How The Fed Blew Up JPMorgan's 'Hedge' In 22 Tweets 


That damn Tweety bird....


WhiteNight123129's picture

Well well well, those tail risk and modeling hedges are circular, in other words, they are not objectively verifiable, and hence it is the belief that they work that make the tail risk and other hedging seemingly efficient. However this depends on other people view on whether or not it will work and behave. So while they look objective because of the mathematical allure those are almost entirely behavioral. It is the behavior of the central bank which changed the reality. So everyone is thinking he (she) is a price taker of observable reality, while in reality, it is the collective action of people using those models which drives the price, so the cause and the effect are totarily blurred. Is it the reality of price which is driving the need to hedge, or is it the behavior of hedging which is driving the price, the dog and its tail back and forth.... Useless waste of time.

We could try voodoo rules, make sure everyone is convinced about those voodoo rules and the game of expectation counter expectation would be the same. In the meantime buy productive agricultural land at 3,000 USD per hectare in Malaysia, have a look at 200 years of history of prices, interest rates, market behavior and let people scramble to pick-up a few pennies in front a streamroller, while you will make 3-4 times your money in 5 years. WHy? The smash of the exponential function into the finite world coupled with monetary hose...


Convolved Man's picture

Before the introduction of stabilizing compounds, the production and handling of nitroglycerin, though lucrative, was extremely hazardous.

Wells Fargo can attest to that.

So its nice to know that JP Morgan & Chase are in the completely predictable and safe business of investing/trading/hedging/betting with synthetic credit derivatives.

LongBalls's picture

What this article explains to those who do not understand it is not to play a game they will get slaughtered at. And the investment community can't understand why retail investors have left the building!! See ya sucka's. I'm out of your game and into the game of true weight and measure. Gold and silver.

Dr Benway's picture

Well it seems the so-called pros don't know what the fuck they're doing either. It just resembles gambling to me. With other peoples money.


The thing with all these supercomplex models and formulas and shit in finance is that a lot of them are just bullshit. They may require advanced mathematics, but crucially, that doesn't mean that they will work.

BurningFuld's picture

True can make all the models you want but you can not predict the future. What these guys are doing now is feeding on each other because the money from fake mortgage loans is no longer there and they have most likely burned through all the money from Uncle Sam at this point.

Gloomygus's picture

Actually, you can predict the future if your actions are precisely designed to bring it about. First you need to amass a great deal of power - then you simply apply it.

orangedrinkandchips's picture



So does that mean you are down with OPM? yea you know me.....Other People's money. I put YOUR money on ANY bet in a casino....duh....why not!




Let these fucks do what they want, but, if you blow it and go belly up then YOU PERSONALLY LOSE EVERYTHING.....PERSONALLY. CLAW BACK.




sunnydays's picture

I am with you on that.  the only thing I do know, is I couldn't be happier as it couldn't have happened to a "better" bank.  Now, I am just waiting for Goldman Sachs information and them coming out with billions of losses.  It is Christmas in Spring.

Day_Of_The_Tentacle's picture

To me the big question is, why did Mr. Dimon publish this in the first place?

If I understand the article correctly, JPM put on a "bulk wholesale" hedge to cover all the "thrown-in-a-bucket" risks that cannot be calculated and modelled on individual positions. The hedge is made from a negative outlook on the systemic risks of the world. Very sensible.

The hedge is made out of some senior credit paper, that would benefit from general panic and problems, because it is percieved as safehaven, and therefore less likely to suffer from lack of liquidity and mass defaults. The hedge is doing great for a while during the unrest, because investors are flocking to the senior safe paper bidding up the value. 

The Fed/ECB/BOE/BOJ ramps up the market meddeling, and reverses the picture. JPM has to go against their true opinion and sell alot of index protection to hedge the hedge. Fed/ECB/BOE/BOJ reduces market meddling, downplays possibility of QE etc. and original bulk hedge starts doing better again, while index hedge gets nasty. Index hedge is not easy to unwind because index is not very liquid, and because Hedgies play against them. The unbalanced hedge-hedge will get worse as the general market situation gets worse again. That unwind seems to have become more difficult and expensive due to Mr. Dimons conference call.

So why did he do it? Is it because he needed the Fed to get the bloodhounds of his back? Was it a ploy to get this well connected new CIO on board? Is it because he knows that something else is coming up that will positively explode everything, so he needed cover to do some very detectible repositioning? 


Gloomygus's picture

Recall after 9-11 there was a great deal of inquiry into who might have profitted from the mother-of-all-systemic-collapses - the World Trade Center fell over (actually it fell precisely straight into the ground). If one knew that the father-of-all-systemic-collapses was coming, and one wisely insured oneself against it, you would reasonably expect an inquiry into why the insurance was purchased when it was. If you perhaps had some friends that could help you in advance of the father-of-all-systemic-collapses make your wise insurance purchase look like a horrible decision, you could broadcast your "horrible" decision far and wide. By changing the perception of your wise decision to that of a horrible decision, you would suffer far less scrutiny when the "insurance" pays off. And it will, very very soon I'm afraid - just look at the power of the players arranging their pieces and altering public perceptions. Is anything going on this weekend? Maybe you all should get yourselves some insurance, just like those idiots at JPM who had their insurance all "messed up" by the central banks - maybe you should do so right this very second.

Gloomygus's picture

Speaking personally (and quoting the late great Janice Joplin):

"When you ain't got nothin, you got nothin to lose."

If you still have something, protect it now.

Day_Of_The_Tentacle's picture

It is scary how much that makes sense to me. Thank you so much for your answer. I have the same sense of an imminent "sequoia-in-anthill" episode coming down.

It is just odd to my oldfashioned logic, how debt can function as insurance in what I anticipate to be an upcoming debt-destruction mayhem. I guess, that if you are sitting on that kind of money, you cannot put eveything into tangibles - or rather, that the way to lay your hands on tangibles in the process, is through taking collateral on defaulting debt.

You have a nice subtle tone to your post, so you probably do not like too direct questions, but I will try anyway. Today, when everything is trading completely contrary to common sense, would you agree, that if one has got somethin', and one is indeed seeking to protect said somethin' - that one would do well by taking guidance from 5000 years of historic precedent?

Day_Of_The_Tentacle's picture

Oh yes, you pose the question, if something is going on this weekend. The immediate thought is a missile-slinger convention in Chicago, followed by a somewhat unorthodox bi-national gathering of men in green in Colorado the week after. Is that what you are alluding to?

Gloomygus's picture

I am sorry but I can't help you

Day_Of_The_Tentacle's picture

Please don't get too discouraged by those vultures in the other thread. Many have been here for a long time, and have aquired a very cynical tone. We are probably all suffering from disaster fatigue and are very thankful that this site is publishing, what it does. Without it, most of us would have continued to be sitting ducks. You seem to have something on your mind, so please do not let the roughness shut you up. There are many more "listening in" than those, who are quick to judge and ridicule. In any case I appreciate your answers above. They have given me food for thought.

ACP's picture

Or more importantly, how the "professionals" know absolutely nothing about finance either.

dbomb12's picture

Just ask Randolph and Mortimer Duke

NewThor's picture

Randolph and Mortimer Duke are Dead. They have been replaced by SKYNET. Goldman Sachs suggests you buy your kids the new Predator Drone toy with the death from above grip.

StychoKiller's picture

I just wanna know where I can find some of these models behaving badly! (Don't tell my wife!) :>D

MayerRothschild's picture

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning" ~Henry Ford

Rubicon's picture

"Operator! Give me the number for 911!" - Homer Simpson

WallowaMountainMan's picture

'This article reminded me that I know absolutely nothing about finance.'

me too, but its fun to try to pick up the poetry, getting a sense of the flow of the article. thoroughly enjoyed, and will spend time right clicking and searching terms, picking up bits and pieces. great article. classic zh. and i do mean classic. when people look back at this time frame, no question, zh....must read source material.

ain't the internet great.

Ricky Bobby's picture

I call it working on my "ZHD". 

LawsofPhysics's picture

What is to know?  Just make sure you go to the "right" school and get as close to the "free money" as possible.  In a world where there are apparently no consequences for bad behavior and the wishes of a few can be granted on the backs of the masses there is nothing to know other than you want to be one of the "few".  Get it?

Unbezahlbar's picture

I  like it, Tyler. I learned 18 new english words by reading your article.

I am still working on the concepts.

BandGap's picture

This hints at a few things that should be noted.

1. There is no collusion between the governments and big banks. I think both can see a macro picture, neither understands the small wobbles being introduced.Whe you apply old models to new environments they fail this way.

2. Trend models to anticipate risk have gone to shit since variables - the meaning of the variable, the weight of the variable IS VARIABLE. People in hedge situations using this debacle as an example of what not to do have to be shitting themselves.

3. This is happening somewhere else, to someone else, as I type this. JPM is a leader and it's actions are noted by others.

dolly madison's picture

There is no collusion between the governments and big banks.

That statement is too bold for me.  It should be: There was no collusion between government and the big banks in this instance.

BurningFuld's picture

Wait a minute. Or course there was collusion somewhere just not with JPM. I think Jamie must have missed an important party. Idiot!

Gloomygus's picture

Right, no collusion. Try being a little less overt, you're screwing it up.

Gloomygus's picture

Don't put the conclusions they're supposed to draw in bolded block capitals - it's too obvious. From: Management

Gloomygus's picture

And really, he's right about the bank not colluding with government. You can't collude with yourself.

Eireann go Brach's picture

Just when you think you are getting a grasp on things, Tyler goes and writes this piece! Fucking geniusl lol!

HD's picture

Anyone else notice how the Tylers don't chime in on the comments section anymore?

I'm sure this is to present a detached professionalism and maintain ZH creditability, but this IS fight club afterall - I hope the days Tyler would pop in and tell a deserving asshole to "sit the hell down, and shut the fuck up" are not gone forever.

Ratscam's picture

he did so yesterday

Silvergood's picture

Fabulous article....Keep exposing Tyler!!!

battle axe's picture

Tyler great article, thank you. As I said last week, there is going to be more blood in the water on this trade, this bad boy is going to bleed some more $$$$ for JPM. 

LongBalls's picture

This shit is so complex why in the hell would anyone buy anything other than PM's?

Gidas19's picture

I remember my old professor used to tell students to explain every "complex" definition/theory in finance in ONLY few words. He said if you can't do than you don't understand it. Well, let me summarize this article in "few" word... JPM FUCKED UP

StychoKiller's picture

I always find it amazing that people have some sort of betting system at the roulette wheel(s).  Why not just give yer munny to the pit boss directly?

Mach1513's picture

I had a roulette system. Won seventeen consecutive visits to local casino - followed by eighteen consecutive losses.

Same thing - exactly! - happened buying call options.

Lesson I learned:  you ALWAYS LOSE more than you win.

And it isn't the system, dummy(me)

- it's pure luck.

Taleb also taught me that - but I read him too late.