JP Morgan loses $2bn in "unbelievably ineffective" hedging bet.

Loss due to a "bad strategy, badly executed and poorly monitored".

A man walks past JPMorgan's offices in New York
A man walks past JPMorgan's offices in New York. Photograph: Getty Images

The bank JPMorgan announced last night that it had lost $2bn in trading on credit derivitives, through what chief executive Jamie Dimon called "errors, sloppiness, and bad judgment" and a "bad strategy, badly executed and poorly monitored".

The loss was made by the bank's chief investment office, which is under the aegis of Bruno Iskil, who earned the nickname "London Whale" earlier this year following accusations that his oversized bets on credit derivatives, one said to be as large as $100bn, were skewing the market.

The office has already drawn controversy due to its alleged breaches of the Volcker rule, an upcoming American law which bans banks from making trades with their own money purely for the purpose of boosting profit – an activity known as proprietary, or prop, trading. The rule does, however, allow for banks to engage in such trades if they are hedging other positions; that is, if the trade is being carried out to reduce, rather than increase, the amount of risk that the bank is exposed to. 

Dimon insists that this trade was an example of hedging, telling a conference call that:

I know it was done with the intention to hedge tail risk… it was unbelievably ineffective.

Some have their doubts, with Matt Yglesias writing:

In general if you just lost $2 billion that's a good sign that you're not hedging.

The loss was due to a failed attempt to engage in basis trading, where a trader exploits the difference between the cost of an entity's debt (the yield on their bonds) and the cost of a credit default swap, which is risk that that entity will default on the debt. The two are roughly equivalent, but because one comes from the cash market and the other from the derivatives market, gaps can open up between them. When this happens, it is possible to make profitable trades with very low risk (Felix Salmon explains the practice in greater detail).

The disclosure reduced the second quarter profits for the division from an expected $200m to a loss of $800m (some of the losses were made up elsewhere), and pushed JPMorgan's shares down 6 per cent in after-hours trading.