JP Morgan Chase concedes failures in loan hedging programme

Hit by increased loan loss provisions, credit rating downgrades and a below-book-value market capitalisation, JP Morgan Chase is conceding that a plan to reduce concentrations of credit risk in the firm’s loan and derivatives portfolio has been overtaken by market events. This plan was put in place in November 2001, but it appears that the firm was unable to hedge the exposures that mattered most.

Speaking to Risk in March 2002, Blythe Masters, JP Morgan Chase's head of loan portfolio risk management, said: “We are overexposed to event risk – we need to manage down key concentrations of single-name risk that exist in the portfolio.” Masters went on to explain that credit default swaps were her primary risk management tool, remarking: “We have very substantial credit derivatives positions [hedging both loan and derivatives exposures].” Also speaking in March 2002, JP Morgan Chase’s co-chief credit officer, David Pflug, told Risk: “You can assume that we have default protection on all the big telcos.”

However, JP Morgan Chase’s position now appears to have changed. Speaking to Risk this week, Masters said: “We have $12 billion exposure to telecom and cable as well as exposure to merchant energy companies, three sectors that have deteriorated significantly. The risks that led to the recent charge-offs were unhedgeable during the period since the first quarter of this year.” Questioned whether buying additional protection in the market since late 2001 might have avoided the need for increased loan-loss reserves in the third quarter of 2002, Masters responded: “To suggest that we could or should have hedged all these exposures is unrealistic.”

Some market observers have suggested that the cost of buying protection in the market may have contributed to JP Morgan Chase’s weak trading performance, but Masters denied this, saying that the mark-to-market valuation of loan hedges had made a positive contribution to trading revenues. “There have been material gains in connection with the $40 billion-45 billion of hedges on our loans and derivatives exposures,” she said. Asked to quantify the meaning of ‘material’ with respect to JP Morgan Chase’s 2002 earnings, Masters declined to comment further.

In a statement accompanying JP Morgan Chase’s pre-announcement of its weak third-quarter results last week, the firm’s chief executive, William Harrison, said: “As much as we have focused on reducing credit portfolio concentrations in recent years, it is clear that further reductions are necessary.” But Harrison’s hopes may prove to be in vain in the current credit environment. According to Masters: “We are not prepared to hedge indiscriminately at any price – the costs would be dire.”