JP Morgan Chase’s $2 billion mark-to-market trading loss stemmed from some fundamental mistakes by risk managers: particularly the notion that a hedge on credit exposures could reduce the bank’s risk but at the same time earn billions of dollars.

That’s what experts are saying about a trading loss that has knocked billions off the bank’s market share, sparked probes by the Justice Department and the Securities and Exchange Commission, forced credit-rating firms to issue negative outlooks for the bank, and turned the spotlight on a bank unit that was set up to invest excess deposits but also generate a sizable profit.

According to JP Morgan, the bank’s chief investment office was investing in a benchmark for credit-default swaps designed to mitigate the bank’s overall credit exposure, in particular the possibility of higher interest rates and inflation. But the hedge was risky itself and the positions in derivatives so large that they distorted the market, experts say. JP Morgan also may have failed to fully understand its exposure because it was relying too heavily on Value at Risk (VaR), a common risk model that estimates the potential loss in value of a risky asset or portfolio over a certain number of trading days.

Last Friday JP Morgan stated that the trading positions, reportedly on a series of the 10-year Markit CDX North American Investment Grade index, were “riskier, more volatile, and less effective as an economic hedge than the firm previously believed.” JP Morgan CEO Jamie Dimon admitted that they were “flawed, complex, poorly reviewed, poorly executed, and poorly monitored.” At the bank’s Tampa shareholder meeting on Tuesday, Dimon added that he couldn’t justify the mistake.

“It screamed improper credit-risk management to us from the very beginning,” says Matthew Streeter, a product manager at FINCAD, speaking of when he heard about the incident. (FINCAD is a developer of derivatives risk-management software.)

For one, the credit index bets introduced secondary risk exposures that JP Morgan executives apparently didn’t take into account, says Streeter. But a key question to ask about hedging, he says, is whether the hedge is exposing the insured to risk above and beyond the risk it is trying to mitigate with the hedge.

Second, the size of the trades JP Morgan was making were so large they were moving the market for the hedging instrument, concentrating a lot of risk on one side of the trade. “Any hedge on a $650 billion book will absolutely drive the market,” Streeter says.

Third, JP Morgan’s chief investment office was doing what Streeter calls “speculative hedging”: hedging with the intention of making a profit. As Ryan Gibbons, managing partner of GPS Capital Markets, told CFO in 2011, big gains and losses from hedging spell trouble. When companies make money off hedging, they tend to forget what their core businesses are, said Gibbons. At the high point of the chief investment office’s performance, in 2009, it managed nearly 17% of the bank’s assets and generated $3.1 billion in yearly income.

But a former finance chief at JP Morgan says hedging is inherently risky, and if JP Morgan was taking a risk it should expect to get paid for it. “Who says you don’t earn money on a hedge?” said Dina Dublon, CFO of JP Morgan Chase from 1998 to 2004, prior to taking the podium at CFO’s Women in Finance conference in New York Tuesday. “The only time hedging is not risk-taking is when you sell the position you are trying to hedge; anything else, you’re taking risk.”

A risk-management consultant who didn’t want his name used agreed with Dublon. “No matter [how well] you are managing assets, sometimes you are going to get nailed,” he said. “This is what happens on the downside of risk. No system is perfect.”

Dublon also pointed out that JP Morgan’s $2 billion mistake was not an accounting loss. “There is a difference between accounting and economic valuations,” she said. “You have a mark-to-market hedge against an accrual exposure that is not being marked to market. So you can have a gain or loss on the hedge, but you will not recognize the change in value of the loan portfolio, which is on an accrual accounting basis.”

JP Morgan’s chief investment office was not a separate entity when Dublon was finance chief, but was housed within the bank’s treasury function, she said. Whether or not her finance department hedged credit risk depended on the price of the hedge. “Sometimes you do, sometimes you don’t,” Dublon said.

A Higher VaR
When JP Morgan revealed the loss last Friday, it said its risk measure had underestimated the portfolio’s volatility. In the first quarter, JP Morgan was monitoring its positions using a new VaR model, which was indicating the chief investment office unit VaR was $67 million. But JP Morgan scrapped that model and returned to an older version once the loss was discovered. It restated the VaR for its first quarter as $129 million.

“A VaR of $67 million at a 95% confidence level implies the [chief investment office] should not incur losses of more than $67 million on more than three business days during the quarter,” wrote CreditSights analyst David Hendler in a report last Friday. But the restatement means that the office “may have incurred losses in excess of $129 million on three days.” Hendler concluded that the losses put in question not only the accuracy of JP Morgan’s VaR models but also the data being input into those models.

A March 2008 report by a group of senior global-banking regulators, “Observations on Risk Management Practices During the Recent Market Turbulence,” found that “firms that avoided significant unexpected losses used a wide range of risk measures to discuss and challenge views on credit and market risk.” The regulators noted that many banks used VaR, but did so in conjunction with notional limits, stress tests, and forward-looking scenario analysis.

Despite all the tools available, regulators and large, complex banking organizations face a tough task in judging the riskiness of many nontraditional commercial-banking activities, said Federal Deposit Insurance Corp. vice chair Thomas Hoenig in testimony before a Senate committee last week. “Trading and market-making are high-frequency activities that can take place between [regulator] exams with little evidence that they ever occurred. As a result, a snapshot of positions of these activities on one day has no predicative value for the positions, for example, a week later.” Monitoring trading on a “high-frequency basis” would be costly for banks and regulators, he said. “Moreover, it requires substantial transparency that banks are likely to strongly oppose.”

Hoenig is proposing a strict division of some of the banking functions conducted by the big universal banks like JP Morgan. Under his proposal, commercial banks would be allowed to perform some investment-banking activities but would be prevented from making markets in derivatives or securities and trading securities or derivatives for their own account or a customer’s.