How do we explain the devastating mess JP Morgan is in?
All of the sudden, around 4:30 pm today, everyone started buzzing about JP Morgan’s recent 10-Q report, which detailed massive losses in its chief investment office, an unforeseen $2 billion loss related to derivatives. Then the bank held a surprise conference call at 5:00 pm, where they said simply — we screwed up, bad.
How could the bank not have seen this coming when they’re supposed to be managing risk?
The truth may lie in VaR, or Value at Risk. Here’s how we explained it a few months ago:
VaR is one of the most common ways to measure how much money a bank has at risk. In a nutshell, VaR is the maximum amount of money one could lose over a certain period of time given a certain level of confidence.
For example, if you had a one day VaR of $100 at a 95% level of confidence, then there is a 95% chance you won’t lose more than $100 in one day.
However, this doesn’t mean that the worst-case-scenario loss in a given day is capped at $100. In fact, thanks to the existence of derivatives and the ability to short, the maximum loss for a trading department can be unknown. Such weaknesses have drawn criticism from the likes of hedge fund manager David Einhorn and The Black Swan author Nassim Taleb, who calls VaR a “fraud.”
Basically, you never no for sure what your worst case scenario may be.JP Morgan seemed to have recently adjusted their models that they used to calculate VaR. During the conference call, CEO Jamie Dimon said that they had reported the VaR within the CIO as around 67 based on their models. But they’ve recently realised flaws in the new model, and going back to the new model, their VaR was calculated out to be 129. Oof.
So basically, VaR is just the tip of the iceberg, but at least it gives you some idea right? So in that spirit, here’s a chart that shows us just how much the JP Morgan CIO’s VaR has shot up over the last year.
You’ll note that in 2011, max VaR was 64, now we’re talking about a VaR of 187.