Food For Thought

Food For Thought[1] is a collection of articles written by one of our Principals:

May 18, 2012

How does a major bank lose more than $2 billion on just one trading strategy?

The short answer to this rhetorical question is that we do not know for a fact because we are not privy to all the details, which we expect would emerge with time. However, we do have a sense.  Based on what we know so far, it appears that the loss making trades in question stem primarily from synthetic credit derivative positions taken on an index known cryptically as CDX.NA.IG. This begs the question, what is the underlying that comprises the CDX.NA.IG index? We were able to procure from the public domain one example of this index, though we are not sure if this is the specific version of the index that caused the aforementioned loss making trades.

 Why would a large bank need to trade this index?

 The CDX.NA.IG index comprised 125 equally weighted North American Investment Grade Credits. Because of the broad diversification provided from owning the index, a large bank that needed to hedge itself from a potential downturn in the US credit markets, could do so by buying credit protection on the index. However, this decision would also require the large bank to pay monies upfront to buy credit protection. If the large bank’s concerns about the potential downturn in the US markets proved to be prescient, purchasing protection on the index would make money for the large bank because the cost of buying similar credit protection, after the US markets had in fact deteriorated would increase, which in its turn would add value to the cheaper credit protection contracts bought by the large bank earlier. The large bank could then profit from this differential in the price of the index and cash out of this “in the money” position and use the money made on the trade to offset any losses actually experienced on its loan book.

 Notwithstanding the previous paragraph, the same concept could also be used to make a speculative bet on the direction of the US credit markets, if the large bank had reasons to believe that the US credit markets were trended upward. Under that thesis, the large bank would sell credit protection with the expectation that once the US credit markets experienced an upswing, the cost of buying credit protection would decrease and the large bank would profit from the differential in index prices. Based on what we know so far, it appears that one set of trades pertain to contracts to buy protection until 2012, but sell protection until 2017, which appear to be the cause of the current woes. Also, there appear to be other trades to sell protection from 2014 to 2017 which also appear to have lost value and may contribute to additional losses, over and above the $2 billion in losses already mentioned.

 Keeping the amounts in perspective            

 While we acknowledge that $2 billion is a large amount for most of us, it is important to keep the amount in perspective. For a large bank with Tier 1 Capital of $150 billion in 2011, even a $5 billion loss would be only a little more than 3% of the large bank’s Tier 1 Capital. That being said, the fact that one set of losing positions could be allowed to accumulate to such large amounts without being closed out when the losses were much smaller (by taking an offsetting position after they had reached a loss limit of say $20 million per position) appears to indicate some form of deficiency in internal controls. Also, it is curious that the large bank’s Value At Risk (VaR) models did not warn management of this potential problem before it mushroomed to a level that captured the attention of the markets.

 Another aspect of the trading book is the aggregate size of the loss making positions. If the aggregate size of the position had been allowed to build to say, $200 billion, then even a small change in the value of the index could result in large losses. Simply put, a 1% change in the value of the index on a $200 billion position could result in a loss of $2 billion.

 Impact on Volcker Rule

 Large banks have argued (quite persuasively until now) that the kind of trading we have outlined above should be permitted so that they may efficiently hedge their internal risk exposures on a portfolio basis. That being said, now that this issue is again in the public domain, it appears that it will be vetted both in the media and Congress.

 Silver Lining

 As we keep a watchful eye on the unfolding drama, the good news is that we are currently not aware of any insurance companies that engage in this type of trading. That being said, we are aware of at least one insurance company that owns an index similar to the CDX.NA.IG, but as a “buy and hold” investor and not as a trader. We plan to keep you posted, as warranted.

[1] Food For Thought is a periodic publication of JP CONSULTING tailored to address specific issues of interest in the insurance and banking industries. The opinions expressed in this publication are those of its authors alone – Joseph Prakash, CFA and/or Adjunct Instructor Roderick Carmichael.