J.P. Morgan Chase & Co. (JPM) sold $101.3 billion more
long-dated derivatives insuring against defaults by
investment-grade companies as of March 31 than it had bought back,
according to quarterly data from the Federal Reserve.
The amount of insurance-like credit-default swaps the bank sold
was double its $50.2 billion net position at the end of December
and more than four times its $23.6 billion net position as of Sept.
30, 2011.
The Federal Reserve data, first reported Wednesday by Reuters,
validate earlier reports by The Wall Street Journal that positions
by traders at the bank, including one dubbed "the London whale,"
had reached a face value of $100 billion or more.
Those trades were part of a complicated three-step strategy,
previously reported by Dow Jones Newswires and The Wall Street
Journal, that have raised questions about whether the bank was
hedging its risks or making big bets on the direction of CDS
prices.
The bank is a member of a CDS clearinghouse run by
IntercontinentalExchange Inc. (ICE), which it pays to guarantee
such trades. That offers some hope the risks of the bank's losses
to broader markets will be contained. While it couldn't be
determined how many CDS trades J.P. Morgan had cleared, ICE had
$914 billion of open CDS in its U.S. clearinghouse as of May
18.
People familiar with J.P. Morgan's strategy have said the bank
has been hurt most by long-term CDS protection it sold against
defaults by investment-grade companies, with many contracts tied to
an index of CDS expiring in 2017.
The bank hasn't disclosed the exact trades that caused it to
announce a $2 billion loss on May 10, but it said in a filing that
since March 31, it had seen "significant mark-to-market losses in
its synthetic credit portfolio," a reference to CDS trades.
People familiar with the losing trades said one of the firm's
biggest positions was to have sold CDS protection on a basket of
bonds from 121 investment-grade U.S. companies.
Protection expiring in 2017 using that index, called the
CDX.IG9, currently costs $160,000 a year to cover $10 million of
bonds, according to data provider Markit. If the bank had sold the
index CDS March 31, however, it would be paid only $112,000 a year
in premium, meaning the CDS it wrote would have lost money.
Worse, the move between May 10 and Thursday was double the
initial move from March 31 to May 10--the period in which the bank
said it took the $2 billion loss--suggesting its losses on IG9
trades may have doubled, assuming no change in its positions.
A spokesman for J.P. Morgan declined to comment.
Traders estimate for every $1,000 increase in the annual cost of
protection for the IG9 index, the bank would have lost as much as
$490,000 per $1 billion of net CDS it sold. Those estimates
ironically are based on a CDS calculator developed by J.P. Morgan
and later made available to the wider derivatives industry.
Selling CDS is akin to making a bullish bet, or "going long" on
the underlying bonds. Buying CDS is what a firm would do when it
wanted to express a bearish view, or a "short position," betting
the underlying bonds would weaken and potentially move closer to
default. When a firm is "net long," it has sold more protection
than it has purchased.
While J.P. Morgan was increasing its net long--or CDS
selling--in investment-grade protection over the long term, it
simultaneously held a bearish position over the short term, helping
to offset some of its losses, Fed data show. It increased its net
short position by owning $53.8 billion of investment-grade CDS
protection lasting one year or less as of March 31, compared with
$3.64 billion as of Sept. 30. The Journal previously reported that
some of the firm's coverage expires in December this year.
This protection was designed as a hedge in case the bullish
positions soured, said people familiar with the bank's strategy.
But at least as of March 31, the firm didn't appear to be holding
enough of the offsetting trades because the amount of protection it
sold dwarfed what it had purchased.
As of March 31, the firm had net sold $36 billion of CDS lasting
more than one year but less than five years, the Fed data show,
whereas by the end of September, it had bought more protection than
it had sold, with a net short position of $16.3 billion.
While J.P. Morgan works its way out from underneath the losses,
the potential risks to the broader financial markets are hard to
quantify. The trades were made by the firm's Chief Investment
Office in London, but the CDX.IG9 index trades it made were likely
put into ICE's clearinghouse in the U.S.
Dealers like J.P. Morgan have been clearing their CDS for a few
years, and they mostly use ICE to do so. Clearinghouses take fees
for mutualizing risks among their members and guaranteeing trades
in the event of member defaults; J.P. Morgan Chase Bank is one of
27 members of ICE Clear Credit; all are banks or bank
affiliates.
Data suggest dealers--possibly including J.P. Morgan--have
increased their clearing of trades in the IG9 index. ICE's clearing
volumes show IG9 trades expiring in 2017 are around $73 billion of
the total $914 billion of CDS sitting in the clearinghouse, double
the volume as of year-end 2011.
The increase is even more starkly illustrated by looking only at
CDS written on indexes: IG9 trades expiring in 2017 account for a
15% share of all index CDS now, compared with 8.76% as of Dec. 30,
2011.
J.P. Morgan may not have been clearing all of its CDS trades,
and there is no way to attribute the volumes to any single firm.
But an unusual amount of IG9 trades expiring in 2017 were cleared
at various points in the first quarter, contributing to its rising
volumes in the clearinghouse.
About $20 billion of IG9 trades were cleared in the week ended
Feb. 3, $16 billion in the week ended March 9, and $15 billion the
week ended March 30; for most of this year, the weekly volume added
in IG9 trades of that maturity was less than $10 billion.
-By Katy Burne, Dow Jones Newswires; 212-416-3084;
katy.burne@dowjones.com
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