One of my friends suggested that I write a post explaining what happened at JP Morgan Chase, in plain English.
The bottom line is that they bought a lousy insurance policy.
The company has a big debt portfolio, which is no surprise given that it is a major corporate lender. If some horrible economic event came along to cause several companies to go bankrupt, then Chase would lose a lot of money.
The company’s corporate investment office was trying to come up with a way to protect the bank against the effects of an extreme event. To make the insurance less expensive, they set up a second hedge based on the assumption that the assets would increase in value. They did this by buying credit default swaps against an index of large US corporations known as the CDX.NA.IG.9 – not one of your common everyday market indexes. The index tracks the health of 125 companies. It assumed things would be getting better, but they are actually getting worse for a handful of companies in the index. European exposure, an ongoing recession, merchandising mishaps at JCPenney all combined to take the index down, and that cost the company money.
The analogy on this would be buying car insurance to protect you against the costs of an accident, then selling the car to pay for the insurance. You’d be left with the bill for the insurance and nothing to drive. Chase’s staff was trying to come up with a hedge that would be neutral, but instead, they came up with a hedge that was crazy.
Insurance is a bit like a gamble. The insurance company is betting that you won’t need it, and you are betting that you will. The more likely you are to need the insurance, the more expensive it is.
If you are so inspired, you can listen to the conference call yourself. One of the best changes in the investment business since I left was the passage of regulation FD, which means that all of this information has to become public information – as it should be.
I’m a Chase customer mostly because every bank I ever dealt with has ended up being acquired by them. And, I have to say, their takeover of Washington Mutual was seamless. I don’t know what will happen, but this has been an interesting one to watch.
