Bloomberg | April 9, 2012
By Shannon D. Harrington, Bradley Keoun and Christine Harper

JPMorgan Chase & Co. trader Bruno Iksil’s outsized bets in credit derivatives are drawing attention to a little-known division that invests the company’s reserves and fueling a debate over whether banks are taking excessive risks with federally insured and subsidized money.

Iksil’s influence in the market has spurred some counterparts to dub him Voldemort, after the Harry Potter villain. He works in London in the bank’s chief investment office, which has assembled traders from across Wall Street to its staff of 400 who help oversee $350 billion in investments. While the firm describes the unit’s main task as hedging risks and investing excess cash, four hedge-fund managers and dealers say the trades are big enough to move indexes and resemble proprietary bets, or wagers made with the bank’s own money.

The trades, first reported by Bloomberg News April 5, stirred debate among U.S. policy makers over the Easter-holiday weekend as they wrangle over this year’s implementation of the so-called Volcker rule, the portion of the Dodd-Frank Act that sets limits on risk-taking by banks with government backing. The law passed after the collapse of the subprime mortgage market triggered the worst financial crisis since the Great Depression. (INDU)

“I wouldn’t be surprised if the pro-Volcker folks used this as a test case,” said Douglas Landy, a partner at law firm Allen & Overy LLP who is representing Canadian banks in opposing a current draft of the rule.

Merkley, Miller

Senator Jeff Merkley criticized the transactions in a statement that called for the rule’s prompt implementation, while Representative Brad Miller said they show why related U.S. laws should apply internationally.

Joe Evangelisti, a spokesman for New York-based JPMorgan, declined to comment on Iksil’s specific transactions, and Iksil didn’t respond to phone messages and e-mails seeking comment. Neither Iksil nor JPMorgan have been accused of wrongdoing, and the full extent of his trading and the bank’s total risk of loss, or total gain, on his investments isn’t known.

Authorities will need more information from JPMorgan, the biggest U.S. bank by assets, to discern the precise purpose of Iksil’s transactions, said Clifford Rossi, an executive-in- residence at the University of Maryland’s Robert H. Smith School of Business.

“It clearly calls attention to the Volcker issue,” said Rossi, who previously was a managing director at Citigroup Inc.

Competitive Issues

Arthur Levitt, the former chairman of the U.S. Securities and Exchange Commission, said banks may be required to reveal more specifics about their derivatives holdings in order for regulators to enforce the Volcker rule.

“That’s unfortunate,” Levitt said today in an interview on Bloomberg Radio’s “Bloomberg Surveillance” with Ken Prewitt and Tom Keene. “That raises all kinds of competitive issues.”

Levitt is a board member of Bloomberg LP, the parent of Bloomberg News, and a senior adviser to Goldman Sachs Group Inc.

Harvey Pitt, also a former SEC chairman, said he would ask JPMorgan to explain the trades and then have the agency report to the public.

“Any time any trader can be dominant in the marketplace, that has to raise appropriate regulatory concerns,” Pitt said today in a phone interview on Bloomberg Television’s “InBusiness With Margaret Brennan” program. “That means the markets can be influenced by a single actor, and that is not the way our markets ought to operate.”

Dimon’s Letter

JPMorgan Chief Executive Officer Jamie Dimon, 56, sent a 38-page letter to shareholders last week, saying he agrees with the Volcker rule’s intent to eliminate “pure” proprietary trading and ensure market-making won’t jeopardize banks. Still, as with derivatives laws, the rule must be written so that it doesn’t put U.S. banks at a global disadvantage, he said.

“We cannot and should not be in a position where the rule affects U.S. banks outside the United States but not our foreign competition,” he wrote.

Iksil drew attention from market professionals in recent months as trading accelerated in a group of credit-default-swap indexes created before and during the 2008 financial crisis. Until then, transactions had been dwindling as Wall Street banks stopped creating structured debt that the indexes were used to hedge against. Investors use credit-default swaps to shield themselves from losses on corporate debt or to speculate on a firm’s creditworthiness.

‘London Whale’

The trader became such a big client of credit-derivatives dealers that some started calling him Voldemort, the Harry Potter book-series villain so powerful he simply was referred to as “He Who Must Not Be Named,” said one fund manager, who asked not to be identified because his firm does business with JPMorgan. Iksil also has been dubbed the “London whale,” another trader said.

Iksil joined JPMorgan in 2005, according to his career- history record with the U.K. Financial Services Authority. He worked at the French investment bank Natixis (KN) from 1999 to 2003, according to data compiled by Bloomberg. Public records showing Iksil’s date of birth couldn’t be located. One person who has done business with Iksil said he’s in his late 30s.

When a group of hedge-fund traders last year bet that a cluster of companies in one of the indexes wouldn’t default before contracts expired in December, Iksil was taking the opposite view, according to four market participants at hedge funds and banks, who spoke on condition of anonymity because they aren’t authorized to discuss the transactions.

Concentrated Risks

Iksil’s bet won out, and the hedge funds faced losses of 25 percent, when American Airlines parent AMR Corp. filed for bankruptcy less than a month before the insurance-like swaps matured, the market participants said. The trades were made in so-called tranches of the index, which take concentrated risks on the member companies.

This year, Iksil has been betting on an index of 121 companies that all had investment-grade ratings when the benchmark was created in September 2007, the market participants said. Trading in that index surged 61 percent the past three months, according to data from Depository Trust & Clearing Corp.

The net amount of wagers on the index, which is tied to the creditworthiness of companies such as Wal-Mart Stores Inc. and now-junk-rated bond insurer MBIA Insurance Corp., soared to almost $145 billion at the end of March from $90 billion three months earlier, according to DTCC, which runs a central registry for credit-default swaps and reports weekly aggregate volumes.

Iksil’s trades have been so large that they’re widening gaps between the relative value of the indexes and the average price of contracts tied to companies in those indexes, according to the market participants. That has frustrated some hedge funds that had bet the gaps would close, the people said.

First Quarter

Iksil has been selling default-protection on the index using swaps that expire in December 2017, meaning he would cover the counterparty’s losses if a company in the index fails, the market participants said. The price of the index falls as more insurance is sold against it. The index declined 38 basis points in the first three months of 2012, the biggest quarterly drop since 2009. A basis point is 0.01 percentage point.

The positions, by the bank’s calculations, amount to tens of billions of dollars and were built with the knowledge of Iksil’s superiors, a person familiar with the firm’s view said.

Iksil may have built a position totaling as much as $100 billion in contracts in one index, according to the market participants, who said they based their estimates on the trades and price movements they witnessed as well as their understanding of the size and structure of the markets.

Buying Protection

The trade on the index, known as the Markit CDX North America Investment Grade Series 9 (IBOXUG09), probably isn’t a one-way bet, the people said. Iksil may be offsetting the trade by buying protection on the same index with contracts that expire about eight months from now, the people said. That strategy would pay JPMorgan the difference between the long-dated contracts and the short-dated ones, about 47 basis points as of April 6, and the trade would gain when the gap narrows. The hedge would end in December unless another trade is made to replace it.

“Someone in that position at JPMorgan would typically not be doing pure speculation but would be involved in strategic risk management for the firm,” Darrell Duffie, a professor at Stanford University’s graduate school of business, said in a telephone interview.

JPMorgan profited from a similar strategy as the credit crisis erupted in 2008 by buying protection on short-dated contracts linked to high-yield indexes while selling protection on longer-dated contracts, a bet that a spike in corporate defaults would happen sooner than markets were pricing in, according to a February letter to regulators from Barry Zubrow, the bank’s head of corporate and regulatory affairs.

Losses Reduced

“This strategy resulted in the firm recognizing some gains as near-term default risks increased,” Zubrow wrote. “The gains recognized on these derivatives strategies offset in part the losses that occurred on credit assets held by the firm.”

Zubrow said the trade, which was booked in the bank’s market risk capital trading account, was a hedge that may have been banned under the Volcker rule.

The chief investment office’s revenue swelled following the financial crisis as federal regulators pushed banks to keep more of their funds in liquid investments, and as deposits flooded in because of JPMorgan’s reputation as one of the industry’s strongest banks. Total securities holdings in the corporate segment, which includes the chief investment office and treasury, more than quadrupled to $340.2 billion in 2009 from $76.5 billion in 2007.

Bigger Pool

The extra liquidity meant a bigger pool of money for the chief investment office to manage -- and more revenue. The bank’s annual report for 2009 showed $6.63 billion of revenue for the corporate segment, up from $4.42 billion in 2007. It cited “the chief investment office’s significant purchases of mortgage-backed securities guaranteed by U.S. government agencies, corporate debt securities, U.S. Treasury and government agency securities and other asset-backed securities.”

Revenue in the corporate segment climbed again in 2010, to $7.42 billion, reflecting a “repositioning of the portfolio in response to changes in the interest-rate environment and to rebalance exposure,” JPMorgan said in a regulatory filing. The bank rewarded Chief Investment Officer Ina Drew with a $15 million pay package for 2010, saying in a shareholder letter that she “was instrumental in setting the course and directing the firm’s repositioning of the balance sheet.”

Revenue Tumbled

Last year, revenue tumbled 44 percent to $4.14 billion in the corporate segment, “driven by repositioning of the investment securities portfolio and lower funding benefits from financing the portfolio,” according to an annual filing. Drew, 55, got a 6.8 percent pay cut to $14 million, the bank said in a regulatory filing last week. Her pay for the past two years was higher than that of Chief Financial Officer Doug Braunstein. Drew referred a request for comment to Evangelisti.

The chief investment office is affiliated with the bank’s treasury, helping to control market risks and investing excess funds, according to the lender’s annual report.

“The chief investment office is responsible for managing and hedging the firm’s foreign-exchange, interest-rate and other structural risks,” Evangelisti said. It’s “focused on managing the long-term structural assets and liabilities of the firm and is not focused on short-term profits.”

Some people hired by the group have come with risk-taking pedigrees. Irene Tse, 42, a former portfolio manager at Stanley Druckenmiller’s now-closed hedge fund, Duquesne Capital Management, joined last year as the group’s head in North America, reporting to Drew. Achilles Macris, 51, a former co- head of capital markets at German bank Dresdner Kleinwort Wasserstein, runs the group in Europe and Asia.

Experience, Connections

A search through profiles on the LinkedIn professional- networking website shows current and former executives in the chief investment office citing their proprietary-trading experience and connections.

One executive who worked as a portfolio manager in JPMorgan’s chief investment office said he ran what he called a proprietary macro and relative-value trading book that produced a 12 percent return on capital. An executive director wrote that before he worked in fixed-income trading in the office, he was a vice president in proprietary trading at JPMorgan.

A technology specialist who worked in the chief investment office in New York in 2009 and 2010 wrote that he led New York development and business analysis for a proprietary-trading risk-management system.

The Volcker rule is supposed to take effect in July, though regulators are still determining how it will make exceptions for instances where firms are hedging to curtail risk in their lending and trading businesses.

‘Illuminate the Risk’

Iksil’s “big bets illuminate the risk inherent in hedge fund-style trading,” said Senator Merkley of Oregon, who added the Volcker rule to Dodd-Frank along with Senator Carl Levin, a fellow Democrat from Michigan. If the trades collapse, Merkley said, “you want the resulting meltdown to happen outside of the banks we depend on for loans to families and businesses.”

After the Republican-controlled U.S. House of Representatives returns from a spring recess, members are set to vote on a bill that would limit Dodd-Frank clearing, trading and collateral regulations from applying to trades between foreign- based affiliates of U.S. banks and their overseas clients.

The JPMorgan trades are an example of why such exceptions are misguided, said Representative Miller, a North Carolina Democrat who sits on the Financial Services Committee.

Miller’s Vote

“Even if these trades are done in London and even if they are done by a foreign affiliate, there’s no doubt that JPMorgan would be liable and that any solvency issue would be visited upon the U.S. and the U.S. economy and the U.S. taxpayer,” said Miller, who voted against the bill at a preliminary stage in the committee.

Even without regulatory scrutiny, reports that Iksil’s trades were so large that they moved market prices are likely to concern JPMorgan, Stanford University’s Duffie said.

“If the trades were indeed part of a risk management strategy, then the intent wouldn’t be to move markets,” Duffie said. “The most obvious remedy is to reduce the extent to which they put on such large trading positions in the future.”