RUMOURS were already circulating that the world's most admired bank, JPMorgan Chase, was sitting on a proprietary trading derivatives time bomb a month ago when the New York-based group announced a $US5.4 billion March-quarter profit.
The bomb detonated yesterday when JPM announced a loss of more than $US2 billion that will almost certainly grow, and it may be a game-changer: the US creates banking and investment banking templates for the world and its politicians and regulators will figure that if JPMorgan and its boss, Jamie Dimon, can rack up huge losses in the derivatives market, anybody can: calls from the biggest banks for further weakening of the ''Volcker Rule'' that will limit their ability to trade on their own account are likely to fall on deaf ears.
Bloomberg revealed early in April that very large credit derivative positions had been acquired by Bruno Iksil, a little-known London-based trader inside JPM's Chief Investment Office (CIO), a unit that operates as a global treasury for the giant group. The positions were so large they were influencing credit yields, and speculation that JPM was exposed to losses spread like wildfire.
JPM says on its website that the CIO manages ''structural risks which arise out of the various business activities of the firm''. Dimon said it managed all of the group's exposures when he announced yesterday a $US2 billion-plus pre-tax mark-to-market loss on credit derivatives, and an offsetting $US1 billion pre-tax profit on the sale of a profitable part of the CIO's investment portfolio.
The group's chief financial officer, Doug Braunstein, told the first-quarter profit conference a month ago that JPM had liabilities, deposits mainly, of $US1.1 trillion, and had lent about $US720 billion. The $US360 billion mismatch left the group at risk to changing prices in fixed interest, currency and other markets, and the CIO brought JPM back into balance and earned income in the process by investing the deposit surplus ''in high-grade, low-risk securities'' including mortgage securities, shares, debt and derivatives, he said.
Braunstein also said, however, that the CIO needed to hedge its portfolio against market-wide shocks of the kind that are still occurring in the wake of the global crisis, and it is a proprietary trading hedging attempt that has backfired.
The credit default swap positions that Iksil acquired for JPM opened up a potentially profitable arbitrage between elevated default insurance prices that implied relatively high corporate and banking bond yields, and lower yields on the bonds themselves, which trade separately.
JPM's judgment call appears to have been that the credit default swaps were out of kilter - too high - and its punt was that they would come back into line with the physical corporate and banking bond market. It would have generated big profits if that occurred. Instead, Europe's sovereign debt crisis continued to percolate, and credit default swap prices continued to rise.
The CIO unit reported profits of $453 million in the March quarter, and had been expected to earn $US200 million in the three months to June. It is now expected to post a quarterly loss of $US800 million now, and JPM can digest that easily. It had $US2.32 trillion of assets and $US190 billion of shareholders' funds at the end of March, and should still post a $US3 billion-plus June-quarter profit.
Additional financial losses could top $US1 billion, however, and the final tally is dependent on how badly trapped JPM is: its position in the credit default swap market is known, and is too big to be liquidated painlessly.
That puts it in a similar position, albeit for a smaller amount relative to its balance sheet size, as John Meriwether's Long Term Capital Management group was in 2008.
LTCM was also caught with arbitrage positions that went onto losses when prices did not converge. The losses multiplied as rival firms traded against its positions, and it was eventually subjected to a $US3.6 billion Wall Street bailout that was co-ordinated by the US Federal Reserve.
JPM will also pay a reputational price. It was not untouched by the 2007-09 financial crisis but it was strong enough to acquire two of the crisis casualties, Bear Stearns and Washington Mutual, and overtook Bank of America as the largest US bank late last year.
Its record of sound management is tarnished by the derivatives loss, which Dimon said flowed from a hedging strategy that was flawed, complex, poorly reviewed, poorly executed, and poorly monitored.
''These were egregious mistakes, they were self-inflicted [and] we are accountable,'' he said yesterday. ''What happened violates our own standards and principles for how we want to run the company.''
There is also likely to be a regulatory price for banks. The banks have already compartmentalised their proprietary, in-house trading activities, but Dimon has been prominent in a push by the big US banks against the ''Volcker Rule'', which will further restrict proprietary trading when it is introduced by US regulators in July.
The banks argue that proprietary trading is an essential market-making process and liquidity generator, and they have already successfully lobbied for hedging of the kind undertaken by JPM to be exempted.
JPM's loss-making credit default arbitrage nevertheless violated ''the Dimon principle'', Jamie Dimon said yesterday, and regulators will probably agree.
The Volcker rule is unlikely to be further watered down now, and the odds on it being strengthened have come in.