JP Morgan loss was bungled attempt to cut Basel III RWAs, says Dimon

Loss-making unit's RWAs would have tripled under Basel III, JP Morgan chief executive says - but attempting to cut capital burden made its hedges more complex

An attempt to reduce risk-weighted assets (RWAs), coupled with a change to a value-at-risk model, was behind the $2 billion credit trading loss reported by JP Morgan last month, the bank's chief executive testified yesterday.

Appearing before the Senate Committee on Banking, Housing and Urban Affairs in Washington, DC, Jamie Dimon claimed the trading strategy – described as a hedge – changed in nature as the bank tried to cut RWA numbers at the loss-making chief investment office (CIO).

"Under Basel I, the risk-weighted assets of these positions in the fourth quarter of 2011 were around $20 billion. Under Basel III, those [risk-weighted assets] were estimated to be around $60 billion. We thought this was an ineffective use of risk-weighted assets and our intent was to bring that down over time," Dimon stated.

That may help to explain why the losses emerged when credit spreads widened – a subject of intense speculation since the announcement was made on May 10. If the strategy was intended as a hedge for the bank's structural exposure to corporate credit, the CIO should have been a net buyer of protection, a position that would have gained in value as credit deteriorated. Instead, the CIO ended up a net seller, and Dimon implied this was a bungled attempt to offset existing bought protection and reduce the prospective capital consumption.

"In January, February and March, we asked [the CIO] to reduce this risk. You can do that by going long [credit] or by just selling the [short] positions you have. They actually created a far larger portfolio that had far more complex risks in it. The way [this hedge position] was contrived between January, February and March, it changed in a way I cannot publicly defend," he added.

We thought this was an ineffective use of risk-weighted assets and our intent was to bring that down over time

The adoption of the new VAR model allowed the CIO to take this extra risk, but Dimon said he did not believe the model had been changed in a deliberate attempt to disguise the activity, as one senator suggested.

"It seems that [the CIO's] VAR model was loosened up significantly to allow them to engage in more risky activities," said Senator Jack Reed.

Dimon disputed this suggestion. "In January, a new [VAR] model was put in place that allowed them to take more risk, and that contributed to what happened. I don't, as of today, believe that was done for nefarious purposes. We believe that was done properly by the independent model review group. There may be flaws in how it was implemented, but as soon as we realised the new model did not reflect reality, we went back to the old model," he said.

At that point, the VAR numbers reported by the model almost doubled, from the $67 million reported in its first-quarter earnings report to $129 million. Market experts have speculated that the new model failed to incorporate a key risk factor, making it relatively insensitive to the market conditions prevailing during the first quarter. Regulators, meanwhile, have said they are looking at whether the bank had an obligation to disclose the change to the model – and the bank's supervisor, the Office of the Comptroller of the Currency, is also facing awkward questions about whether it knew about and approved the change.

Dimon's frank testimony, and his insistence that he bears ultimate responsibility for the losses, was well received by the committee, but he refused to go into details about the specifics of the CIO's trading strategy, or discuss the activities of Bruno Iksil – the so-called London Whale, who is thought to be most directly involved.

Reed suggested the strategy had stopped being a hedge and became a proprietary bet, which would be banned under the Dodd-Frank Act. "These credit default swaps were first made to protect against loans outstanding, particularly in Europe. That was in the 2007–08 time period. But then in 2011–2012, at some point the bet was switched, and now rather than protecting your credit exposure, you were selling credit protection, which seems to be a bet on the direction of the market unrelated to your credit exposure in Europe. That looks a lot like proprietary trading designed to generate as much profit as possible," Reed said.

"I think the original intent was good," Dimon responded. "What it morphed into, I'm not going to try and defend. Under any name, whatever you call it, I will not defend it because it violated common sense. I do believe the people doing it thought they were maintaining a short against high-yield credit that would protect the company in a crisis. We now know they were wrong."