What's up guys and welcome back to wall street millennial on this channel, we cover everything related to stocks and investing today we're looking back at a massive trading loss, the scale of which was never seen before and reigned as the biggest and most embarrassing trading loss by A wall street firm all the way until the archagos disaster of 2021.. It all happened in the chief investment office of jpmorgan, specifically in their synthetic credit portfolio. While this investment division was supposed to be managing a portfolio with the purpose of conservatively hedging, the firm's overall risk, it instead decided to try to make profits by putting on enormous market moving positions in the credit markets. The whole saga ended with a cease and desist order from the sec on jpmorgan, nearly a billion dollars in fines from multiple regulators and more than six billion dollars in losses for the company and perhaps most embarrassingly, there is really no market event that caused the losses.

Jp morgan created these losses themselves through poor risk management in this video we'll go over what exactly led to this unprecedented loss? How such a blunder could have happened at wall street's biggest bank and what it meant for jp morgan's business going forward, but before we dive in make sure to subscribe to our free podcast the wall street millennial podcast. This way you can listen to our content on the road while waiting in line or anywhere else just search for wall street millennial in spotify or apple podcasts. Jp morgan is the largest and most impactful bank in the us and the most valuable bank in the world. It is considered one of the big four, along with bank of america city and wells fargo, but has a clear number one in terms of the amount of deposits and assets they make a staggering 10 billion dollars of profit every quarter give or take by looking at Their total revenue expenses and net income over time you can see that they've been becoming steadily more profitable over the past 10 years.

The company engages in a number of finance related business lines, but only one of them is really relevant to the six billion dollar loss that we're covering today they operate a traditional banking operation under the chase name in which they take deposits from clients, ordinary people open Savings and checking accounts with chase around the time of the losses the company held more than a trillion dollars in deposits. The vast majority of these deposits only paid out negligible interest to the depositors, as is the case at most banks, access to and smart usage of this huge pot of depositors. Money is the key to a bank's profitability, but the ways that banks utilize it to make more money can get more complicated than you might think. The traditional way that banks make money is by turning around and lending out these deposits to businesses, home buyers etc.

At the prevailing interest rates, that could mean anywhere from less than three percent to more than ten percent for certain types of loans. When a bank borrows money from depositors for almost zero interest and lend it out again at a much higher interest rate, they essentially make free money before taking into account credit risk. But if you look at jp morgan's balance sheet over time, they never lend out nearly as much money as they have in deposits. In this graph, the red line is jp morgan's total deposits and the green line is their loans.

In 2012, they had about 1.1 trillion dollars in deposits, but only lent out about 700 billion dollars of it. By the way you can build your own charts like this for any public company for free on our website at wallstreetmillennial.com. Since covid, they have lent out even less as a percentage of their deposits less than one half the reason is largely regulatory and that lending money is risky. If there's a recession like in 2008, they may have borrowers defaulting on their loans.

If that happens, the bank makes a loss, and if it happens on a large enough scale, they might not even be able to pay back their depositors. That could easily be the end of a bank even one as powerful as jp morgan. But that doesn't mean that jp morgan didn't want to somehow utilize that 350 billion dollars of excess deposits around 2011 and early 2012 jp morgan was taking advantage of its large deposit base to engage in trading activities that it thought was beneficial to the bank, in particular Their chief investment office was in charge of managing the approximately 350 billion dollars of deposits that had not been used to write loans, while making a positive return on that massive pile of cash was, of course, desirable to the bank. The main goal was at least officially to hedge, the bank, against unforeseen credit risk associated with the main loan portfolio.

Here's what ceo jamie dimon said about the role of the chief investment office when he testified in front of the senate banking committee. Let me start by explaining what the chief investment office does like many banks, we have more deposits than loans at quarter end, we held approximately 1.1 trillion in deposits and 700 billion in loans. In short, the bulk of ceo's responsibilities is to manage an approximately 350 billion dollar portfolio in a conservative manner, while their primary purpose is to invest excess liabilities and manage long-term interest rate and currency exposure. It also maintains a smaller synthetic credit portfolio whose original intent was to protect or hedge, the company against a systemic event like the financial crisis or the current eurozone situation.

However, around april and may of 2012, a rogue trader and jp morgan's london offices had a different idea about how to use the money. Bruno ixil started, putting on larger and larger bets in the credit default swap market the same market where the 2008 financial crisis unraveled. He put on huge trade after huge trade bidding that credit markets would continue to strengthen as the economy continued to recover from 2008 on a firm, wide level. Jp morgan was trying to reduce risk at the time in anticipation of the onset of increasing bank regulation and capital requirements.

But despite this, the chief investment office in bruno ixel in particular instead chose to put on more trades using more capital in taking on more risk. So what happened in december 2011 as part of a firm white effort, in anticipation and in anticipation of new basel cap requirements, we instructed cio to reduce risk rate assets and associated risk to achieve this in the synthetic credit portfolio, the cio could simply have reduced its Existing positions instead, starting in mid-january, it embarked on a complex strategy that entailed any positions that believe it offset the existing ones. This strategy, however, ended up creating a portfolio that was larger and ultimately resulted in even more complex and hard to manage risks. This portfolio morphed into something that, rather than protect the firm, created new and potentially larger risks as a result, we've let a lot of people down and we are sorry for it.

Eventually, the trades were so big that other market participants took notice and gave him the nickname the london whale. One of the challenges with dealing with such large amounts of money is that traders eventually single-handedly move the entire markets. Jpmorgan's traders shorted an index that measures the spread between corporate interest rates and the prevailing libor interest rate. It was a bet that corporate interest rates would go down as companies became more creditworthy.

However, the trades were so big that they dislocated the market in relation to what the consensus economic estimates would support. Multiple hedge funds are known to have noticed the outsized trades and put on their own positions against them. Well, at first, the london will was so big that it was able to resist the smaller opposing trades. Eventually, enough traders went against him that the position unraveled within a few months excel had lost billions of dollars for jp morgan.

To add insult to injury, there was no single major geopolitical or otherwise significant event that caused the losses. They were purely the result of putting on too large of a position and having the market react. Unfavorably. Here's what jamie dimon said enabled the disaster to happen.

Now let me turn to what went wrong. We believe the series of events led to the difficulties in the synthetic credit portfolio. These are detailed in my written testimony, but highlight the following: cio strategy for reducing the synthetic credit portfolio was poorly conceived and poorly vetted. In hindsight, the traders did not have the requisite understanding of the risk they took.

The effects of the splendor were extreme in absolute terms: jp morgan's first quarter of 2012 incurred losses of 2 billion as a result of the trading disaster, but by the end of the next quarter, the total losses associated with the trades had increased to 4.4 billion and By the end of the year, the total losses reached a final 6.2 billion dollars to put that number into perspective. That's over fifty percent, more money than the cost of building the new world trade center skyscraper in new york, the tallest building in the western hemisphere. In addition to the trading losses, jp morgan was also subject to hefty fines from multiple u.s and british securities regulators. In 2013, they agreed to pay close to a billion dollars in fines to the sec, the federal reserve and other agencies, but perhaps more surprisingly, jp morgan admitted to actually breaking security's laws according to an sec, cease and desist order against jp morgan.

When the company began. Taking losses on outsized trades, a senior trader in the chief investment office instructed other traders to stop reporting them. They also engage in other gimmicks, such as reporting mark-to-market loss numbers using the most favorable prices available on one particular day, for example, while their true losses reached. As much as a quarter billion dollars, they only reported about half that amount of estimated when the full scale of the losses were finally revealed to the public.

It was a major embarrassment to jp morgan. Jp morgan is supposedly one of the most powerful and sophisticated banking institutions on wall street. It was only a few years since the great recession highlighted the need for strict risk management at the big banks, but missed steps were made at all levels of jpmorgan from upper level management of the firm down to the individual trader for much of history, banks were Pretty much allowed to do whatever they wanted with their excess deposits in 2012, that was about 350 billion dollars for jp morgan, and it would seem like a waste to just let it sit as cash. They could do.

Things like invest in hedge funds, build their own portfolios like hedge funds, do and even engage in proprietary trading, such as high frequency trading and market making. In fact, some of the most advanced quantitative hedge funds today are remnants of proprietary trading arms of big banks. However, as one of the results of the 2008 financial crisis, a comprehensive set of new rules were introduced by the us government under the obama administration. In particular, former federal reserve chair paul volcker, argued vehemently that excessive risk taken by banks like jp morgan fundamentally undermined the stability of the entire financial system.

If banks continued making risky bets using depositors, money and something like the real estate crisis happened again, it could lead to another disaster of enormous proportions. But the thing that really affected jp morgan was the dodd-frank wall. Street reform and consumer protection act the volcker rule within it specifically laid out restrictions on what banks are allowed to do with depositors money. This still allowed banks to do most of the activities that they always did, such as market making trading derivative securities and running hedge funds, but it did require banks to not make trades risky enough to put the firms on unstable financial footing.

Importantly, it also required large banks to disclose their trading activities to the government and undergo regular stress tests. Although the dodd-frank act was enacted around 2010, the volcker rule did not go into full effect until 2015, three years after the jp morgan disaster. Despite the embarrassment, the reality is that the 6 billion loss did not have a very meaningful impact on the firm's profit. It didn't stop them from making a record 21 billion dollars in profit in the year of 2012, off of total revenue of close to 100 billion dollars.

The reality is that the scale of jp morgan's business is so large that even a 6 billion loss from time to time could be viewed as just a cost of doing business. After a few hundred million in fines from the regulators. In a day of the ceo testifying before the senate, it's back to making money alright, guys that wraps it up for today's video. What do you think about jp morgan's, embarrassing 6 billion dollar trading blunder? Do you think they should do more to desentivize your traders from taking on that much risk? Let us know in the comments section below in the meantime.

Thank you so much for watching and we'll see in the next video wall street millennial signing out.