JPMORGAN CHASE WHALE TRADES: A CASE HISTORY OF DERIVATIVES RISKS AND ABUSES

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(3) Ignoring Repeated Breaches of Credit Spread Risk Limits
The VaR and CRM results were not the only risk metrics that warned the CIO of
increasing risk in the Synthetic Credit Portfolio. So did two additional risk metrics that
JPMorgan Chase used to track how its portfolios would perform based on changes in “credit
spreads,” meaning risks linked to changes in credit derivative premiums. The credit spread risk
limits were repeatedly breached in January and February 2012, with the SCP exceeding the limit
by 100% in January, by 270% in early February, and by more than 1,000% in mid-April. But
instead of heeding those risk warnings, which came on top of the VaR and CRM warnings, the
CIO traders, risk managers, and management criticized the credit spread risk metrics as faulty
and pushed for them to be replaced.
The two credit spread risk metrics were known within the bank as, first, “Credit Spread
Widening 01” (CS01), also often referred to as “Credit Spread Basis Point Value” (CSBPV) or
Spr01; and second, the “Credit Spread Widening 10%” (CSW10%). As with VaR, each of these
metrics produced a dollar value signifying the amount of money that could be lost by a portfolio
in a single day under specified market conditions. The bank established the CS01 and CSW10%
risk limits for the CIO. 1106
(a) Breaching CS01 Risk Limit
The Synthetic Credit Portfolio first breached the CS01 risk limit in January 2012. 1107 To
understand how the CS01 works, it helps to understand how positions on a credit index are
priced. Most credit positions operate somewhat like insurance. 1108
The “short” party makes
periodic premium payments to the “long” party over a specified period of time to obtain credit
protection. If a “credit event” like a bankruptcy or loan default takes place during the covered
period, the long party is required to make a sizeable payment to the short party.
The amount of the premium payments paid by the short party is typically expressed in
basis points. A basis point is equal to one-hundredth of one percent. So if the CIO purchased a
$1 billion short position in a credit index for 150 basis points, the CIO was required to pay its
long counterparty $15 million per year (1.5% of $1 billion) for the credit protection.
Credit positions are often priced by looking at the amount of position’s premium
payment, also called the “coupon” payment or “credit spread.” If the credit spread “widens,” as
happens in a worsening credit environment, it means the value of the existing short position
increases, because the premium amount that was contractually agreed to be paid for the existing
position will be less than the premium required to obtain the same credit protection in the
worsening marketplace. If the credit spread “narrows,” as happens in an improving credit
environment, the value of the existing short position falls. That’s because the premium amount
paid for that existing short position will likely be greater than the premium that could be paid to
obtain the same type of credit protection in the improving market. In addition, because credit
1106
Subcommittee interviews of Ina Drew, CIO (9/7/2012, 12/11/2012).
1107
See 1/20/2012 email from Keith Stephan, CIO, to Irvin Goldman, CIO, and others, “Breach of firm var,” JPM-
CIO-PSI 0000141.
1108
For more information about credit products, see Chapter II.