What May Have Happened at JPMorgan?

Let me start with a disclaimer: I have no privileged information about the USD 2B trading loss at JPMorgan. The reasoning in this post is purely speculation on my part.

How could a firm with a long history of conservative, commercial banking practice make a USD 2B error investing its own capital? The error is not the loss itself. The error was the size of positions taken in the markets based on measures of JPM’s balance sheet exposures. These measurements appear to have been incorrect by an order of magnitude.

Who makes the measurements? In banks like JPM there are two competing sources for measurement, (i) traditional approach as practised by accountants and actuaries, and (ii) the modern finance approach. The traditional approach focuses on dollar-value amounts generated by historical cost based accounting systems. For example, these systems can quantify the total amount of loans as, say, USD 500B. The finance approach speaks in terms of risk, volatility and market value. For example, these systems may estimate the loan book as having a six year duration and market value of USD 700B due to lower interest rates….

….so imagine a person like Jamie Dimon’s confusion when he asks for an estimate of his firm’s loan outstandings? In the example above, his accountants say USD 500B, while his risk-unit says USD 700B. Who is he to believe? … He then learns that his internal investment team has been basing its decision off the USD 700Bn number which means they have USD 200B more exposure than were they to use the USD 500B number…

…then, Dimon’s CFO tells him that the USD 700B is only an attempt at mark-to-market since none of the loan book actually trades. For accounting purposes, therefore, USD 500B is the number that must be used…

Get the picture? My guess is that something like this has happened with the accountants assailing the risk managers. The irony under this scenario is that the risk unit is probably right and there is no loss at all! The truth, however, lies somewhere in between.