"Either way, the incident underscored the basic problem. If J.P. Morgan Chase wants to act like a crazed cowboy hedge fund and make wild exacta bets on the derivatives market, they should be welcome to do so. But they shouldn’t get to do it with cheap cash from the Fed’s discount window, and they shouldn’t get to do it with money from the federally-insured bank accounts of teachers, firemen and other such real people. It’s a simple concept: you either get to be a bank, or you get to be a casino. But you can’t be both. If we don’t have rules to enforce that concept, we ought to get some."
Hamilton explains why this type of Casino betting creates systematic risk.
"How do you lose so much money so quickly? The short answer is, leverage. Although details are not known, one likely scenario (, ) involves derivatives constructed from the riskier components of some European corporate bonds. Using derivatives, you can buy or sell securities or pieces of securities that you do not yourself own, involving a potential promise to deliver more money than you even have. If the market moves against you, you'll have to deliver substantial real cash to unload your ommitment, and this process appears to be what produced the sudden losses. The Whale's notional exposure in one index was speculated to have been $100 billion in April.
The total notional exposure of all of JP Morgan's trades has been estimated to be $79 trillion. That's "trillion", with a "T", from a
company with an equity value of $140 billion, and falling quickly."
FT speculates on what happened:
"It’s an OTC market!!!
The hedge funds got angry.
They developed a theory that one trader was behind all of this. One trader, at one bank. One trader, at the CIO, at JP Morgan.
The hedge funds got more angry.
It dawned on the hedge funds that they had no one to complain to.
The hedge funds and banks had lobbied long and hard to keep this over-the-counter market in credit derivatives unregulated.
Thus it is unregulated, and they had no one to tell, officially, about what they suspected — that a single player had cornered, and distorted the market by putting on huge trades.
But the hedge funds were very, very angry that their trades were unprofitable while believing it was one bank’s fault.
They complained… to… journalists.
Now for something to go wrong
Our guess is that at some point, either the risk of the trades was spotted for real (see above, re: journalists) and/or, as previously mentioned, the CIO stopped managing the hedge ratio on the curve trades. Stop managing the ratio, and the trade will turn into an outright long or short position on credit."