Achieving the status of a top trader takes more than just luck. Not only do you have incredible intelligence and market understanding, but you also have to be willing to take enormous risk. George Soros broke the Bank of England in 1994 and became a famous billionaire as a result. John Paulson bet that the U.S. real estate market would crash in 2007; two years and $3 billion later, he was considered a financial genius. Paul Tudor Jones made $100 million by shorting stocks in October 1987 just before the infamous Black Monday stock market crash. But for every success story, there are countless traders on the other side. Oftentimes the failures are based on the hubris of refusing to take a loss.
One would-be success story that was felled by an obsessive pursuit is that of Frenchman Bruno Michel Iksil, the man dubbed the London Whale.
The instrument that brought down the London Whale and cost JPMorgan $6.2 billion—and sullied its reputation for solid risk managemen—was the credit default swap (CDS). This was an instrument that JP Morgan itself invented in 1994.
The invention of the CDS allowed banks to protect themselves against defaults and drops in credit, letting them transfer credit risk from one party to another. As market participants caught wind of the new financial instrument and the potential for gains, a broader market developed. CDS became an instrument of outright speculation.
This was a major turning point in the CDS market. The whole conservative part of hedging credit exposure began to disappear. When you buy life insurance, you can’t buy it on someone else’s life, nor can you buy homeowner’s insurance on your neighbor’s house. As the CDS market grew, you could effectively do just that.
CDS indexes were created to track an entire market segment. They made it even easier for investors to buy and sell protection as speculative bets. Markit Group, Ltd. created an investment-grade (IG) index composed of companies deemed to be very credit-worthy and a high-yield index made up of companies with lower credit ratings and a higher risk of default.
In 2005, JPMorgan was flush with cash and felt it needed a dedicated investment office to handle those reserves, an amount that grew even larger after the 2008 panic when investors saw JP Morgan as the safest bank. The Chief Investment Office (CIO) was created to oversee those funds and by 2012 it was managing a $350 billion portfolio of excess reserves, as well as two smaller portfolios of JP Morgan pension funds.
The group was headed by Ina Drew. She was “instrumental in setting the course and directing the firm’s repositioning of the balance sheet.” Part of that repositioning effort included pushing the bank to expand the investments of the CIO portfolio and adding a trading outpost in the bank’s London office.
The man who was put in charge of that outpost was Achilles Macris. An aggressive trader commonly referred to as a “big hitter” by colleagues. By 2012, the CIO staff consisted of 400 employees split between New York and London, with New York serving as command central and Macris running the London office.
The CIO’s mandate was to optimize and protect the organization’s balance sheet from potential losses. The CIO office was never intended to function as a proprietary trading desk. The CIO traders were supposed to invest in relatively safe investments. But with the infusion of cash following the 2008 crisis, the CIO portfolio doubled in size and the traders needed to find new investments for their funds.
Those new products were placed under the rubric of the Synthetic Credit Portfolio (SCP), the creation of Macris. This new portfolio was the CIO’s expansion into derivatives on corporate and mortgage debt, a clear deviation from the original philosophy of hedging. Perhaps the first and largest red flag here.
The London Whale
Traders: Javier Martin-Artajo, Bruno Iksil, Julien Grout
Firm/title: JP Morgan, Credit Equity Traders
Date of rogue trading loss: 2012
Years with firm prior to incident: – 5, 4, 3
Market or trading vehicle: Credit Default Swaps (CDS)
Amount of loss incurred: - $6.2 billion
Trigger/event: Failure to take loss
Fatal flaw: Tried to hide losses by manipulating mark-to-market prices
Action by company: Fired
Legal or regulatory action: Firm paid $1.02 billion in fines to various regulators. Criminal charges are pending. Iksil has received immunity from prosecution by U.S. authorities for his cooperation.
Where they are now: Living in Spain, London, France