JPMorgan’s trading debacle: why $2 billion is just the start

May 11, 2012, 10:02 PM UTC

Update May 13, 11:00 PM

FORTUNE — For years, JPMorgan Chase (JPM), perhaps the riskiest bank in the world, got a pass. Sure there were minor hiccups along the way. But basically investors had the attitude with the bank run by Jamie Dimon that they were going to be hands off. Sub-prime mortgage loans: You’ve proved you can handle them. Foreclosure problems: We’re sure you’ve got your best people on it. A derivative portfolio roughly the size of the GDP of India: We trust that you have covered your bets.

In fact, despite its huge size and complexity and risk, investors have allowed Dimon and JPMorgan to skate by on one of the smallest capital cushions, which is how much equity you have to protect against losses, on Wall Street. When you sort JPMorgan’s loans and investments by riskiness, a dubious calculation, but used by Wall Street nonetheless, the bank holds an equivalent of just 10% of that as capital. That compares to 13% at Citigroup (C) and 15% at Goldman Sachs (GS).

That shortfall, though, didn’t seem to bother investors. JPMorgan’s shares were rewarded with one of the richest valuations on Wall Street. Until recently, it was one of the few big banks to trade above book value, meaning Wall Street believed it was worth what it said. Citigroup’s shares trade at a price-to-book of 0.5.

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All that is likely to change. On Thursday afternoon, Dimon told analysts in an emergency conference call that JPMorgan’s chief investment office, a division that is supposed to place investments that lower the risk of the bank, not increase it, had lost $2 billion on a trading strategy in the past 40 days. JPMorgan’s shares fell nearly 10% on Friday and closed at just under $37.

Some have focused just on the $2 billion loss, commenting that it’s not that big a deal for a bank that has typically been earning $5 billion every three months and has $55 billion in cash. There’s no question JPMorgan can handle it. In fact, factor in all of the division’s other trades, and the bank’s loss from the division shrinks to $800 million. Overall, the bank will still likely show a hefty profit this quarter.

But the actual cost of the loss will be much bigger than that. First of all, JPMorgan could end up losing more on the bet than it has already disclosed. Others have reported that the trade that got JPMorgan into trouble, which is mostly attributed to a single trader who is based in the UK and has come to be known as the London Whale, could be as large as $100 billion. The bank won’t lose anywhere close to that. But transactions like the one JPMorgan appears to have, where it makes multiple bets involving a particular index, in this case one that has to do with large, credit-worthy companies, can be very costly to unwind. Dimon on the conference call with analysts said the bank’s losses on the trade are likely to increase but he didn’t say how much.

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Second, Dimon is facing much bigger losses than this one trade. Dimon reportedly began pushing the chief investment office about five years ago to invest the bank’s excess cash more aggressively. Up until recently, it has worked. In fact, in some years JPMorgan’s CIO office has been a huge source of the firm’s profits. In 2008 and 2009 alone, the CIO’s office added $4.6 billion to the firm’s bottom line. While Dimon has yet to say whether he is shutting down the division, it’s likely he will at the least have to scale it back. Already, Ina Drew, the head of the unit, has left the bank. Investors will demand it. Expect the division, which used to go mostly unnoticed, to be the focus of a barrage of questions each quarter until it is shrunk dramatically or goes away. No one will ever trust to ignore it again.

And that might not be the only business that JPMorgan has to retreat from. By far what makes JPMorgan the riskiest bank on Wall Street, and one of the most profitable, is the bank’s derivative trading book, which is far larger than any other bank in the world. JPMorgan holds derivatives contracts with a notional trading value of just over $1.6 trillion. (Update: Notional value is much, much higher: $73 trillion, but that’s just the size of the debt being insured not how much the bank might owe if the bets went bad. (h/t bbmoney)) That’s enough to wipe out the bank’s capital nearly 10 times over. Of course, JPMorgan says its derivative bets aren’t nearly that big or as risky as they appear.  Factor in hedges and collateral, and the bank says its actual exposure is just $66 billion. But we have just seen how well JPMorgan’s hedges can work.

Lastly, one of the reasons that Dimon has been able to claim the crown of King of the Street, besides the fact that his bank had smaller losses in the financial crisis than rivals, is that, even after the credit crunch, he has continued to show better results. JPMorgan’s return on equity, a key measure in finance, is higher than any other bank. Last year, the bank’s ROE clocked in at 16%, compared to 9% for Goldman Sachs. But one of the reasons that JPMorgan has been able to turn in such high numbers is because the bank has had relatively low levels of capital.

If investors demand JPMorgan raise its capital level to what Goldman has, the company’s ROE would drop to around 10%. All of a sudden, Dimon is no longer leading the pack. He’s just average. And that might be the biggest blow to JPMorgan. Part of the reason for investing in the company in the past few years is that Dimon, and his ability to manage risk, comes along with the package. We all seemed to have placed way too much faith in the idea that one individual could protect a bank with $2 trillion in assets from blow-ups.

“Banks are always black boxes,” says Michael Mayo, an analyst at Credit Agricole and author of the recent book Exile on Wall Street. “You have to rely on the executives and the systems in place to manage that risk.” Betting on Dimon, and JPMorgan, just became a lot less reliable than it used to be.

Update: It appears I underestimated how important the CIO’s office was to JPMorgan’s bottom line. Also the notional value of its derivatives were much larger than I thought. Neither are good things for JPMorgan.