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American Airlines Bankruptcy Helped JPMorgan To $6 Billion Loss

Updated to include testimony from former JPMorgan CFO Douglas Braunstein.

NEW YORK ( TheStreet) -- In the ever more twisted tale of JPMorgan's (JPM - Get Report) risky trading activities, a Senate report released on Thursday indicates that the bankruptcy of American Airlines (AMRPQ) helped the bank to an over $6 billion loss, known as the "London Whale" trade.

The Senate subcommittee on investigations report -- titled JPMorgan Chase Whale Trades: A Case History of Derivatives Risks and Abuses -- makes the case that the bank's backfired trading strategy escalated on the heels of a $400 million payout from the bankruptcy of American Airlines in late November 2011.

Had American Airlines fallen into bankruptcy just a few weeks later, JPMorgan stood to lose on a trade in complicated credit derivative instruments, potentially exposing a flawed strategy undertaken by the bank, according to the Senate report.

Instead, American Airlines declared bankruptcy on November 29, netting JPMorgan between $400 million to $550 million in trading profits that the Senate report says gave traders and risk managers the confidence to grow the risky "London Whale" trade from about $51 billion in notional value at the end of 2011 to $157 billion by early 2012.

The move proved to be disastrous, eventually causing JPMorgan to hold an unwieldy trading position that has led to over $6 billion in losses, puts the banks ability to manage risk in question and has caused the biggest blemish in CEO James Dimon's career.

Media reports and corporate filings indicate some JPMorgan employees involved in the trade may face criminal probes, while others such as Ina Drew, a well-respected risk manager, have been forced out of the firm.

A Senate hearing on Friday will stoke further inquiry into the failed "London Whale" trade as advocates for Wall Street reform use JPMorgan's surprising loss to make the case for the Volcker Rule, a yet-to-be-finalized a piece of the 2010 Dodd-Frank Act that prohibits banks from making proprietary trades.

"The 'Whale' trades expose problems that reach far beyond one London trading desk," said Subcommittee Chairman Carl Levin, a Democrat from Michigan, in Friday testimony.

The genesis of JPMorgan's "London Whale" trading loss began with the creation of its 'Chief Investment Office' in 2006, a unit set up to hedge the bank from various interest rate, macroeconomic and credit risks.

During the financial crisis of 2008, CIO helped insulate JPMorgan from what was an historic credit crunch, as risk managers such as unit head Drew managed effective hedges to risks ranging from rising and falling interest rates and exposures the bank faced on servicing failed mortgages, according to the Senate report.

In 2011, however, the CIO took on a new dimension, investing heavily in a portfolio of structured credit products such as illiquid credit default swap indices. Those trades, the Senate subcommittee says, turned the CIO unit from a hedge to one making directional bets on markets, with disastrous results.

Starting at just $4 billion in notional value in 2008, JPMorgan's structured credit portfolio grew to $51 billion by the end of 2011 and to $157 billion by April 2012, when escalating losses on the poorly managed credit trades forced CEO Jamie Dimon to come clean to investors over the size and scope of the CIO unit.

The Senate report questions whether top JPMorgan executives such as then-CFO Douglas Braunstein were misleading in their disclosure to investors of the banks grip on its trading loss -- an allegation the bank denies.

In Friday testimony, committee chair Levin reasserted claims that JPMorgan misrepresented the risks of the trade or the deterioration of the position to its regulator and in an April disclosure to the investing public.

"The failure of regulators to act sooner can't be excused by the banks behavior," Levin said, in comments that put some blame on the Office of the Comptroller of the Currency, JPMorgan's regulator for riskier derivatives trading activities.

While former CFO Braunstein conceded in afternoon testimony that some information of the trade did not make it to the OCC, he stuck by public disclosures made in April. Braunstein also couldn't recall specific interaction with CEO Jamie Dimon, after the Senate report alleged full disclosure of the trading position to the OCC upset the bank head.

According to information gleaned by the OCC's investigation of the loss, the CIO during the fall of 2011 placed a massive bet on a high yield credit index that tracked credit default swaps for 100 junk-rated companies.

In September 2011, the CIO, through its trader Bruno Iksil, began to buy a short side position against the index by way of "tranches," building trades that would only pay off if at least two companies defaulted before the position expired on December 20, 2011.

JPMorgan is said to have spent about $1 billion building up the short side of the structured credit trading position, while also making additional bets to offset the costs of what was a growing trade.

The structured credit trade could have all come crashing down, had no defaults occurred by Dec. 20 2012, exposing what turned out to be a flawed strategy of investing long some credit indices, while growing ever-larger short positions against illiquid tranche trades.

Instead, American's bankruptcy gave JPMorgan a profit of $400 million -- nearly 90% of the CIO's 2011 revenue -- in a move that the Senate report says gave unit head Ina Drew confidence in the strategy and that gave traders Achilles Macris and Bruno Iksil the green light to rebuild an even larger structured credit position that swelled to $157 billion.

"If American Airlines had defaulted three weeks later, the SCP's short position would have already expired, and the SCP would not have reaped its "massive" profit," the Senate report states.

Drew, "told the CIO traders to try to repeat their performance in 2012," the report adds.

According to the Senate subcommittee report, "Mr. Macris told the JPMorgan Chase Task Force investigation that he viewed the 2011 gain as a great event for the CIO. Mr. Iksil told that investigation that kind of gain was 'unprecedented' within the CIO, and that he had just 'reset' the position the month before because it was 'cheap.' Several JPMorgan Chase personnel told the Subcommittee that, but for that $400 million gain, the SCP would have lost money in 2011."

In Friday testimony to the Senate subcommittee, Drew said "the book was positioned to generate significant returns during stressed or difficult credit environments and modest returns during more benign credit environments," and noted $2 billion in returns between 2007 and 2011, a stretch that included a severe financial downturn.

"[Valuations] for many of the book's positions were inflated and not calculated or reported in good faith," Drew added in testimony referring to the structured credit trades put on by JPMorgan's London-based CIO team.

Traders Macris, Iksil and credit trading head Javier Martin-Artajo will not participate in Friday's hearing as the Senate subcommittee subpoena authority doesn't extend to London.
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