Credit Default Swaps: Still Here, Still Able to Wreak Havoc

JP MorganJPMorgan Chase (JPM), the country's biggest bank, is reporting a $2 billion trading loss that occurred in the space of just six weeks. The loss reportedly involved the investments in "credit default swaps" -- yes, those same complicated investments that played such a large role in the financial crisis.

Here's what we know so far, and why credit default swaps still pose such a threat to the U.S. economy.

The tale of the London whale

The loss occurred in JPMorgan's chief investment office, or CIO, the unit in the bank assigned with hedging the bank's own investments.

In the last month, the CIO had been the subject of intense speculation in the markets, with rumors that a single trader in the bank's London office, nicknamed "the London whale," was placing enormous bets in the derivatives markets -- bets so big they were moving the markets themselves.

JPMorgan CEO Jamie Dimon had written these rumors off as a "tempest in a teapot," but as it turns out, they were true. The New York Times is reporting that Bruno Iksil, a French trader based in London, was responsible for taking the derivatives positions.

JP Morgan Chase is the biggest bank in the U.S., with a very strong balance sheet. As such, the $2 billion dollar write-off won't cripple the bank. But it raises concerns that these kinds of derivatives trades -- despite a raft of post-crisis regulation -- still have the potential to wreak great economic havoc.

How investment banks buy insurance

A derivative is a type of security whose price is dependent on -- or "derived" from -- one or more underlying assets, like stocks, bonds, or currencies. The specific type of derivative Iksil was reportedly using in his trades was a credit default swap.

Credit default swaps are used to protect against the default of an underlying asset. As with an insurance policy that insures you against a house fire, with a credit default swap you pay a premium and are insured against the default of a debt instrument.

A simple way to think about credit default swaps is as "counter bets" to the bets you've already made. Investment banks and hedge funds commonly use credit default swaps as investments in and of themselves, or to hedge against their own portfolio of investments.

Here we go again

Credit default swaps were at the heart of the financial crisis. They were dreamed up by Wall Street in the late 1990s and became popular fast. In 2000, the market was $900 billion. By 2008, it was more than $30 trillion.


The problem was that as everyone and their mothers began taking out these credit default swaps, no one was keeping track of who owed what to whom. That is, there was no central clearinghouse that was keeping track of all those insurance policies out there.

As it turned out, many institutions had taken derivative positions against the mortgage-backed securities that became so ubiquitous in the early to mid-2000s.

When the mortgage-backed securities started to go south and the "insurance policies" started coming due, many institutions, like insurer American International Group (AIG), realized they couldn't cover their bets. Consequently, they would have gone bust -- taking the rest of the financial system down with them -- if they hadn't been bailed out by the federal government.

Waking Up and Smelling the Derivatives

For all the post-crisis hand-wringing over the behavior of the banks and other "too-big-to-fail" institutions that found themselves in mortal danger from the use of unregulated financial instruments like credit default swaps, very little has changed.

The Dodd-Frank reform bill was supposed to set up a derivatives clearinghouse, but that has been slow in coming. The Volker Rule, intended to stop banks from trading with their own money, is still two years away from implementation, and it's not clear that this trading loss would have been covered by it.

The call for stronger regulation in the wake of JPMorgan's massive trading loss has already begun. Jamie Dimon himself admitted that this event would play right into the hands of his critics. For everyone's sake, let's hope so.

Motley Fool contributor John Grgurich owns no shares of any of the companies mentioned in this article. The Motley Fool owns shares of JPMorgan Chase.

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114 Comments

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Dodd Frank

Great article - really well written and clearly outlined.

If you still don't get it this article I wrote I have been told is on the money. I have used examples to simplify:

http://elementaryguidetofinancialmarkets.blogspot.co.uk/2012/05/jpmcios-aka-london-whales-2bn-loss-what.html

and part 2:

http://elementaryguidetofinancialmarkets.blogspot.co.uk/2012/06/london-whale-v-2-trading-out-of-line.html

or here for the main blog 'financial concepts explained simply':

http://elementaryguidetofinancialmarkets.blogspot.co.uk/

June 05 2012 at 11:18 AM Report abuse rate up rate down Reply
santiamman

Of COURSE they're still around, and of COURSE they're still wreaking havoc! What else would you expect? Despite being at the core of the collapse, Congress, ever at the beck and call of their Wall Street owners, has done nothing to change them. They remain off the record. Critically, they remain specifically exempted from being identified as the insurance instruments they are, and thus exempt from any financial backing normally required for insurance policies. They weren't worth the paper they were printed on 4 years ago, and they aren't worth the paper they're printed on today. Thank you, Congress. Thank you White House, and most of all, thank you, Phil Gramm.

May 14 2012 at 1:05 PM Report abuse rate up rate down Reply
nl1952

Thanks Barney.

May 14 2012 at 7:56 AM Report abuse +1 rate up rate down Reply
kafienkarl

free market and capitalism are never at fault it's always the government's fault. pathetic. a big part of this mess is due to the banks and mortgage companies. all happened prior to Obama. wait and see what happens when RomneyCare gets in office.

May 14 2012 at 2:38 AM Report abuse -1 rate up rate down Reply
icemanbill23

Is GW Bush still to blame for this too?

May 14 2012 at 2:11 AM Report abuse +3 rate up rate down Reply
1 reply to icemanbill23's comment
kafienkarl

yup

May 14 2012 at 2:44 AM Report abuse -1 rate up rate down Reply
talari

Do you mean to say, we can't borrow money to fund prosperity?? Earth shattering news! With no plan or intention of paying back the 'bailout money' I thought our government knew what they were doing.

May 14 2012 at 1:48 AM Report abuse +1 rate up rate down Reply
barblc210

And the banks are making it really difficult to refinance our homes. Before you could buy a mansion if you delivered pizza. Now you can't even refinance with a good income and a high credit score. Yet we bailed out the banks. What gives?

May 14 2012 at 1:21 AM Report abuse +1 rate up rate down Reply
ricringer2

I owe chase a bunch, I hope they would go bankrupt and maybe they wouldn't collect any of the credit card billions america owes these greedy B-s-t-d-s, let all these bad bank decisions be their downfall. Why do we have to bail these jerks out all the time. Let them fail!

May 13 2012 at 8:59 PM Report abuse rate up rate down Reply
drbuckles

Just think if the founding fathers were taking lobby money from the King of England while they were discussing the Constitution or the Declaration of Independence how things would have turned out? We’d still be under the corporate boot of England. The too large to fail banks are now our new boot masters, so where is that government of the people for the people and by the people? All of the Republicans and most of the Democrats are their shills doing their bidding to make sure we pay their debts for them. Obama has done a lot for his 3 years but when history writes itself his failure will be not breaking up too big to fail banks. And waiting for congress to do it is like herding cats. These people are so disconnected and paid off it would be like asking JP Morgan’s Jamie Dimon of the banking cartel what do you think we should do? With the loss of 2 billion under his nose and the MF Global fraud of $1.2 billion out of customer accounts, under John Corzine, an Obama contributor, disappearing into thin air, it makes you wonder if the mob now rules our Nation State. Moreover, the House tea party Repubicons reduced down the $55 million requested by the Obama administration to investigate the fraudulent banking activity. So much for all their liberty talk from these future plutocrats. Wealth corrupts and absolute wealth corrupts absolutely.

May 13 2012 at 7:51 PM Report abuse rate up rate down Reply
1 reply to drbuckles's comment
theycallmeroy3

It's so interesting you brought up the " corporate boot of England." Because that's exactly who kicked the pants and socks off of J.P Morgan and MFG. These losses didn't come off a US trading desk. The losses came off the Square Mile, located in London.
We've all heard the saying, " truth is stranger than fiction?" Well, this is a prime example.
JPM and MFG got taken to the woodshed by a guy form London named, Bruno. AKA, The London Whale.
In the Square Mile, one is allowed to releverage...unlimited.

May 13 2012 at 8:25 PM Report abuse rate up rate down Reply
marosh23

credit default swaps are based on trust but as Reagan said trust but verify but there is no trustworhy source to oversee these transactions

May 13 2012 at 7:48 PM Report abuse rate up rate down Reply