Unreliable Guesswork in Valuing Murky Trades

On Wall Street, bets worth hundreds of billions of dollars are valued using a considerable amount of guesswork.

The dangers of that approach were revealed on Wednesday in the government’s criminal complaints against two former JPMorgan Chase traders.

The traders, Javier Martin-Artajo and Julien G. Grout, may eventually be absolved of all the charges against them. But there is now enough material in the public domain to conclude that a cadre of JPMorgan employees embarked on a foolhardy quest to trade their way out of trouble, and left the bank with $6 billion of losses in the process.

Their trading didn’t take place in a market where large numbers of transactions produced transparent and public prices through the day, like the stock market. Instead, the traders made bets with derivatives, financial contracts that often trade sporadically and in the shadows of Wall Street. They focused on so-called credit derivatives, which allow traders to bet on the perceived creditworthiness of companies. In particular, they took large positions in a credit derivatives product called CDX. NA. IG9, which represents a basket of companies.

In its lawsuits, the government says that the traders deliberately valued such bets to make their losses look lower than they actually were in the early months of 2012.

One way that traders value their holdings is to use pricing data from a range of banks.

If Wall Street brokers are offering to buy a derivative contract at 100 and sell it at 104, the trader might value that contract on his own books at 102, the midpoint between the two numbers.

Prosecutors say that the JPMorgan traders did two things when using this so-called bid-offer spread to value trades. They stopped using the midprice, opting instead to use values closer to the edge of the pricing range when it suited them, according to the lawsuits. In one case, the government says the traders even marked a position in the CDX. NA. IG9 outside the range.

The problem with using this approach is that it may not be fully based on prices that occurred in actual transactions. Instead, it may rely heavily on indicative prices, which is the term Wall Street gives to the price quotes that a broker puts out to the market but isn’t obligated to use in a transaction.

When markets dry up in times of stress, the indicative prices may be far removed from the actual trading prices.

The lawyers defending the two JPMorgan traders may use the fuzziness of the derivatives market to their advantage. They might ask: How can the government argue that the traders’ valuations were off when there it’s difficult to know what the “right” price is? In addition, they might argue that rival banks deliberately moved their indicative prices in a direction that would make the JPMorgan traders’ losses larger. In early 2012, word had gotten out that the bank was struggling to deal with an overly large derivatives bet.

But a defense of the JPMorgan traders that homes in on the unreliability of prices would have to deal with an eye-catching episode on March 16 last year that the government claims took place. It is described in item No. 46 in a list of bullet points in the lawsuits against Mr. Martin-Artajo and Mr. Grout.

Mr. Martin-Artajo directed and pressured Mr. Grout to set advantageous valuations in JPMorgan’s books, the complaints say. But sometimes another trader, Bruno Iksil, tried to persuade both Mr. Martin-Artajo and Mr. Grout to opt for valuations he thought were more realistic, prosecutors claim.

What’s interesting about Bullet Point 46 is how Mr. Iksil, who wasn’t named in the suits, went about making his case to Mr. Grout. He said to Mr. Grout that he had just completed some actual trades in the derivatives that were contributing to the losses. It appears that these were hard prices based on real-world transactions, not indicative prices.

Mr. Grout did not end up using these prices to help value the other derivatives holdings, the government said. It seems from the complaint that, if Mr. Grout had used these fresh prices to value their overall positions, their losses would have been bigger.

Defenders of the JPMorgan employees might then argue that Mr. Iksil’s trades on that day may only have been small and not representative of what prices really were in the wider market. And there may be more to March 16 episode than appears in the government lawsuits.

Still, the episode raises a wider point. The unit of JPMorgan where Mr. Grout and Mr. Martin-Artejo worked was amassing huge amounts of credit derivatives at this time, giving the bank a wealth of real prices to use when calculating the size of its loss. In fact, in the first quarter of 2012 alone, JPMorgan added more than $390 billion of such derivatives, according to regulatory filings.

JPMorgan was effectively the market at the time. In theory, then, its traders should have had no problem finding market prices to value the size of their loss.