The Real Story Behind JPMorgan Chase & Co.’s (JPM) Infamous Whale-Sized Trade In Credit Derivatives

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February 4, 2013 5:08pm NYSE:FAS NYSE:FAZ

jpmorganShah Gilani: Here’s an insight for you – along with a trademark indictment, of course.

Take it with a grain of salt, because it’s just an educated guess on my part.

It’s about how the infamous London Whale may have been harpooned by spawn from his own pod.

For those who haven’t heard, the London Whale is one of the latest traders to make the headlines. Bruno Iksil was the top trader at the JPMorgan Chase & Co.’s (NYSE:JPM) Chief Investment Office (CIO) in London.

He got the nickname “the London Whale” for the outsized bets he became known for.

But this is no fish story…

Last year JP Morgan’s Chief Investment Office bet the house. They invested untold billions of dollars of the bank’s excess money – mostly depositors’ dough it hadn’t lent out – by putting on a whale-sized trade in credit derivatives.

The bank’s loss on that trade is over $6.2 billion… and counting.

Now, it appears that, besides the lucky hedge funds on the other side of the Whale’s bleeding bet, there were JPMorgan traders elsewhere in the bank betting against the Whale’s position.

According to Reuters on Tuesday, “The U.S. Senate Permanent Committee on Investigations, which launched an inquiry into the trading loss last fall, is looking into the how different divisions of the bank wound up on opposite sides of the same trade, said one of the people familiar with the matter.”

Now, here’s where my educated guess comes in: It’s highly unlikely – near impossible – for a desk to allow a big dog trader’s big positions to be offset by any other trader(s) on the same desk – or under the same boss – unless it is agreed on that they work together to hedge the position.

Small opposing positions might be taken by traders on the same desk, sure, because traders make their own profit and loss (P/L) on the desk. But offsetting, or “netting” out, the big dog’s play? No way.

That never happens – unless it happens by agreement.

For example: In the mid-eighties I was hired out of Chicago – because of my reputation as a hedge trader – by Lloyds Bank to hedge the Bank’s government desk, their currency desk and their special products (derivatives) desk.

One by one, in succession, the heads of the government desk, then the currency desk, then the derivatives desk, all took me out to lunch. They said, “Sorry, nothing personal, but we’re not going to work with you, ever. We will shut down the Treasury Department (meaning they had all decided to leave and cripple the Bank!) before we do that. We run our own books, and if we think we’re overexposed, we’ll sell our positions or do what we want to do. We’re not going to have our bonuses subjected to the idiots in management.”

They won. That tells you about where the power really resides in banks. Management apologized to me for putting me in the middle of their power struggle and gave me my own desk and said, “Trade whatever you want. You have your own P/L.”

What appears to have happened at JPMorgan Chase is that the counter trades took place in a separate area (desk) with its own P/L, where those traders “faded” the Whale – whose positions they should never have been privy to.

In other words, they were padding their own P/L for their bonus pool (probably) by leaking the Whale’s position to Blue Mountain, Saba, etc. Then, they could bet against the Whale’s position and actually bust his book to make a ton of money on their trades.

Now that is unusual – at least to the degree that it “might” have happened.

But it goes to show how cutthroat Wall Street can be – and that it’s every man for himself.

I’d be willing to bet (well, maybe not after this article), that if any of those JPM traders gets fired, they’re going to Blue Mountain or Saba or any of the other six or so desks they helped make a profit on the fade trade.

Welcome to Too Big To Be Legit.

Did I say that I was just guessing? Well, I am. I’m a trader. I’m just “speculating.”

But, if it walks like a duck…

Related: Direxion Daily Financial Bear 3X Shares ETF (NYSEARCA:FAZ), Direxion Daily Financial Bull 3X Shares ETF (NYSEARCA:FAS), Financial ETF (NYSEARCA:XLF).

Shah GilaniWritten By Shah Gilani From Money Morning

Shah Gilani is the editor of the highly successful trading research service, The Capital Wave Forecast, and a contributing editor to both Money Morning and The Money Map Report.  He is considered one of the world’s foremost experts on the credit crisis. His published open letters to the White House, Congress and U.S. Treasury secretaries have outlined detailed alternative policy options  that have been lauded by academics and legislators.

His experience and knowledge uniquely qualify him as an expert.  Gilani ran his first hedge fund in 1982 from his seat on the floor of  the Chicago Board of Options Exchange. When the OEX  (options on the Standard & Poor’s 100) began trading on March 11,  1983, Gilani was working in the pit as a market maker, and along with other traders popularized what later became known as the VIX (volatility  index). He left Chicago to run the futures and options division of the  British banking giant Lloyds TSB. Gilani went on to  originate and run a packaged fixed-income trading desk for Roosevelt  & Cross Inc., an old line New York boutique bond firm, and  established that company’s listed and OTC trading desks. Gilani started  another hedge fund in 1999, which he ran until 2003, when he retired to develop land holdings with partners.

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