The London Whale: Rogue risk management

August 31, 2014 07:00 PM

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

During the financial crisis, the CIO team used their cash to purchase more speculative investments and earned strong returns for the bank. They made significant purchases of distressed European government securities, as well as mortgage- and asset-backed securities. And, of course, they bought plenty of CDS. 

Among the traders was a Spaniard named Javier Martin-Artajo. He had been hired by Macris in 2007 and quickly rose to become the head of credit equity trading. 

There was also a junior trader named Julien Grout, who joined the London office in 2009. Grout’s main job was to value the positions. And finally, there was Bruno Michel Iksil, a thirty-something Frenchman who was well-known in London’s trading circles. Iksil was a skilled mathematician who was fond of starting discussions with mathematical jargon. Colleagues referred to him as a “monster trader,” though at JP Morgan, Iksil was the senior CIO trader in London. In time, he would earn the nickname The London Whale.

During the middle of 2011, Iksil’s analysis suggested that the credit markets in Europe were deteriorating, so he began buying a large position in high-yield CDS indexes that were set to mature at the end of 2011, while selling protection in the investment-grade CDS index. 

Iksil was counting on a credit event in the high-yield index by year end. The net position boiled down to a long of $51 billion in credit default swaps, which was a huge bet for a high-yield company default. If there was one, Iksil would look like a genius.

A group of hedge funds figured they’d found a sucker in Iksil, and decided to bet against him. 

By the middle of November, it looked like Iksil had bet wrong. But a month before the CDS contracts would expire, AMR Corp. (American Airlines) filed for bankruptcy. The credit event triggered a massive payoff in the high-yield index, making Iksil over $550 million in a single day. 

Iksil had made a name for himself. JP Morgan executives were suddenly full of confidence with their trading wunderkind who had managed to foresee AMR Corp’s impending bankruptcy. 

JP Morgan rewarded Iksil with a larger trading budget for 2012 based on his 2011 success. However, management wanted the CIO team to reduce the risk-weighted assets (RWA) by $25 billion as calculated by the Basel I. It would cost Iksil’s portfolio $516 million if it had to liquidate. However, he found a loophole. 

The new Basel III model measured risk differently and would cut in half the VaR calculation. Just by changing the methodology for calculating risk they would be able to almost double the amount of risk they could take and still be compliant. The shackles holding them back had been removed and now they were free to ramp up their positions. Both Jamie Dimon and Ina Drew signed off on the new methodology.

One month after Iksil’s “trade of the century” he was left short his investment-grade index totaling approximately $51 billion. On Jan. 19, Eastman Kodak filed for bankruptcy. As a result, all of the CDS indexes rallied and Iksil’s short position in investment-grade CDS lost about $22 million. Within a week, that loss had grown to $67 million, and by February the book would be down $100 million. 

Despite the added breathing room, Iksil was still in a bind. They were carrying a large loss. Iksil stayed with what worked in the past and went long the high-yield credit index and short the investment-grade index. Macris liked the move and gave Iksil the go-ahead.

On Jan. 25, Iksil sold $2.78 billion worth of protection in the North America Investment-grade Index Series 9 (IG) at an average spread of 126.5 basis points. With such a large seller, the index began to decline immediately. Buoyed by that initial success, he sold an additional $2.17 billion the following day. By the end of the day, the market closed at a price of 117.5, booking a nice profit at the end of January. Iksil was convinced the market would continue to move in his favor. This time around, however, it wouldn’t be so simple. The hedge funds that Iksil had beaten down at the end of 2011 were back. Not only were they still smarting from the blows they’d taken, but they were lined up against him again, intent on extracting revenge. The ring-leader was a hedge fund called Saba Capital Management. 

Saba and several other hedge funds knew that the CDS indexes were being pushed around by Iksil’s oversized bets, and despite their losing bet against him they saw an opportunity. By the end of January, Iksil’s positions were the largest the CDS market had ever encountered. 

On Jan. 30, the index rose to 121 basis points. Iksil was still in-the-money on his recent sales, but the positions he had been holding since the beginning of the year were down. Iksil began losing faith in the trade and wanted to end it immediately. It was essentially an act of ripping off the Band-Aid in one quick motion. Take the losses and move on. He told Martin-Artajo that they should “take the pain fast” and get out. Sell it at a loss immediately before it got worse. 

From rogue trader to rogue desk 

Getting out was momentary burst of rational thinking from the otherwise glory-obsessed trader. But the moment quickly passed as Martin-Artajo simply told Iksil to “stop taking losses.” 

In every rogue trading story there is a critical point in time and this may have been it for the London Whale. This is also where this rogue trading story departs from the norm. Usually it is a glory-seeking trader unable to acknowledge being wrong and take his medicine—not his superior—who loads up on risk. 

It was typical of Martin-Artajo to give blank, generic instructions to his traders. He would tell them “don’t lose money,” but never give clear instructions on what he specifically wanted them to do. 

On Jan. 31, the market moved against them again. At one point during the day, Iksil jumped out of his chair and shouted, “They’re all against us!” 

When the end of January reports were tallied, Iksil had run up a net short position of almost $200 billion in the IG credit index. Iksil was doing the exact the opposite of the CIO’s mandate of hedging the bank’s risk. He was adding to their risk. The original hedging strategy had morphed into outright speculation. 

Hedge funds saw blood in the water. They began buying the IG index. And then they waited.

Back at JP Morgan, the CIO traders were growing increasingly concerned about their mounting losses. But getting out was not an option. Martin-Artajo, fearful of what might happen if the market continued to move higher, ordered the traders to “defend the positions.”

“Defending a position” is short hand for the cardinal sin of adding to a loser, which has sunk many traders. Over the course of February the CIO traders added another $75 billion in new positions. On Feb. 29, the CIO traders, within a three-hour period, sold another $4.6 billion of the IG index. Their trades accounted for 90% of the day’s trading in the entire CDS index market. Constant selling was the only way to keep it from moving against them. Anytime they were not selling, the index would begin to drift higher, just to be hammered back down when Iksil started selling again. By the end of the day, their efforts resulted in a $69 million loss for the month.

They needed to get creative with the math for the end-of-day reports. They mismarked the IG contracts down to a spread of 115 from the real 119. Mismarking the index by four basis points distorted their P&L by $132 million for month-end. 

The month of March would not be any better for the CIO team as the SCP portfolio continued its downward spiral. The portfolio was being overwhelmed by the hedge fund consortium on the other side. Macris knew there was an impending doom hanging over them and they would not be able to defend their positions.

Meetings were taking place round-the-clock, and the CIO traders were wracking their brains to come up with a solution. In another critical point, they decided to continue the deception and change the mark-to-market system to something that was slightly more favorable. 

Julien Grout, the junior trader, was in charge of reporting the prices at the end of the day and he was using what is called the “crude mid.” He took the bid and offer prices at the end of the day and then took the mid-point between the two numbers. 

“Crude mid” is allowed under the Generally Accepted Accounting Principles (GAAP), so there were no conflicts of accounting integrity there. Things got a little shadier, however, when it was revealed that Grout wasn’t always using the bid/spread prices at the end of the day. Martin-Artajo instructed Grout to stop using the end-of-day methodology and, unless there was a major event that moved the market, find the most favorable bid/offer spread at any point during the day. In addition, he could take prices from any bank that would show him bids and offers, then use the best one for pricing positions. 

By the second week of March, Iksil knew the group had crossed the line between bending the rules and out-right breaking them. Grout confirmed to Iksil that he was “not marking mids as per a previous conversation,” and he also said that their new pricing method was nowhere near appropriate. 

By March 15, Iksil was still worried that their valuations were just not “realistic,” to which Grout replied, “I’m trying to keep a relatively realistic picture here.” Iksil’s frustration was obvious: “I don’t know where [Martin-Artajo] wants to stop, but it’s getting idiotic.” 

Iksil wanted to realize the losses and get out, whereas Martin-Artajo wanted to ignore the losses. By March 17, Iksil instructed Grout “to not make the additional effort to disguise the loss.” 

Losses continued to grow and he estimated that the SCP book was really down about $600 million. Still, the total amount that was being reported to the firm was half of that.  Iksil knew that his future was in jeopardy: “I am going to be hauled over the coals…You don’t lose $500 million without consequences.” 

Those consequences soon began to take shape when Ina Drew ordered the CIO traders to “put the phones down” and stop trading. Iksil knew what was coming next: “It is over,” he wrote in an e-mail. 


When the desk stopped “defending the position,” the market started to rise, further compounding their losses. On the last day of March 2012, the investment-grade index had moved a full 38 basis points against them since the beginning of the year. By “defending the position” to keep up the selling pressure, the short side of the portfolio had swelled to $157 billion. Achilles Macris sent JP Morgan’s chief risk officer and e-mail saying that he had “lost confidence” in his team and he was requesting “help with the synthetic credit book.”

Martin-Artajo continued to massage the numbers. 

The first inkling that there was a problem at JP Morgan began to trickle out via the financial news on Sunday, April 6. A trader who was called “The London Whale” was reported to be holding an unimaginably large position in the credit default swaps, positions that were creating “unusually large price swings” whenever he was in the market. Reports that various hedge funds were lined up against him also circulated. Jamie Dimon didn’t take the stories lightly and asked Ina Drew for a “full diagnostic” the following Monday.

After Dimon spent a week digesting Drew’s report and consulted with other members of his management team, he announced on an earnings call that the whole affair was “a complete tempest in a teapot.”

Clearly, they hoped that the story would fizzle out with their announcements. Their hopes were dashed, however, because the London Whale story continued to gain traction. On April 27, JP Morgan’s senior management, who were collectively growing tired of the accusations that they were hiding losses, asked a senior trader in their investment bank to value the CIO’s positions. The results were staggering. The trader found that the quarter-end marks were at least $275 million higher than the real numbers, and the loss was at least $767 million greater than Iksil’s spreadsheet.

When the truth came to light, JP Morgan’s management immediately removed the mark-to-market pricing responsibilities from the CIO office and reassigned the entire SCP portfolio. Then, an unnamed JP Morgan executive issued a directive to all staff members not “to discuss [their work] with people outside the immediate group.” The firm was in heavy damage-control mode.

On May 10, JP Morgan was forced to revise their earlier earnings report. They reported a $2 billion loss on the SCP portfolio, attributed to the now-notorious London Whale. Dimon, in a rare example of self-effacement, said, “There were many errors, sloppiness and bad judgment. These were egregious mistakes. They were self-inflicted.” 

He would later have to defend himself before Congress as the final tally reached $6.2 billion. 

Ed. note: This article is taken from a chapter of Scott Skyrm’s soon to be published sequel to Rogue Traders.

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