Saturday, May 12, 2012

Details on the Losing JPMorgan Trade Emerge

Ben Protess, Andrew Ross Sorkin, Mark Scott and Nathaniel Popp at NYT have an exhausting detailed report on the losing trade that is costing JPMorgan Chase billions in losses.

Of note in their report, the point is made which I made in an earlier post:
 the loss is not a huge threat to a bank as large and powerful as JPMorgan.
Still the trade is fascinating. Here's what went down according to the NYT crew:
 Last summer the chief investment office began calling brokers at several Wall Street banks, the brokers say. The office was offering to sell insurance on an index of big American corporations like General Mills, Alcoa and McDonald’s — known as CDX IG Series 9. If the companies in the index went bankrupt, JPMorgan would have to pay out, but if the companies continued to do well JPMorgan could rake in the fees from financial firms that bought the insurance...

The strategy initially made money for JPMorgan and its position began to grow, as did an appetite for it among a tight-knit segment of hedge funds  focused on credit opportunities. The large scale of the trade was permitted as a result of an expansion in the limits placed on the size and the scope of securities the unit could trade in that were adopted after JPMorgan acquired Washington Mutual in the financial crisis. Those limits have now been scaled back.

By January, these hedge funds were getting calls nearly every day from brokers representing the chief investment office, according to hedge fund managers and brokers on the calls.

The seller’s identity was not supposed to be known, but the sheer volume of the trade made it hard to hide, and soon enough all fingers in the “small, clubby world” of credit hedge funds pointed to Mr. Iksil’s desk at JPMorgan, according to one fund manager.

“A bunch of us started looking at it and talking about it a lot,” the manager said. “There was agreement that Bruno [Iksil, JPMorgan’s London Whale] was selling.”

There were two ways that JPMorgan could win this bet. If the companies in the index did well, the bank’s cost of insuring the index would continue to fall. JPMorgan could also artificially drive the price lower by continuing to issue more and more insurance — a distinct possibility thanks to JPMorgan’s size and stature.

In January and February, as the price of the insurance continued to drop, lunch meetings and casual conversations between hedge fund managers swirled around the ability of JPMorgan to continue financing this bet.

“A lot of people told me it was a foolish trade,” said an official with a hedge fund that bet against JPMorgan. “The naysayers on this trade said, ‘Look, this guy has unlimited firepower, he can just keep selling and selling and make your life miserable.’ ”

Among the hedge funds that began taking positions against JPMorgan were Blue Mountain, a New York fund; Lucidus Capital Partners, a London fund; Hutchin Hill, a New York fund; and Bluecrest, a giant London hedge fund founded by two former traders on JPMorgan’s proprietary trading desk.

The trade did not at first make money for the hedge funds. In the improving economy early in the year, the hedge funds had to make regular insurance payments. But in late March, doubts about the economy began to swirl, and the index jumped.

JPMorgan began seeing losses by the end of the first quarter, on March 31, but they were not enormous, allowing bank executives to shrug off the early criticisms of the trade. But the trade drew increasing attention as the index continued to spike, multiplying JPMorgan’s potential losses if it had to pay out on the insurance...

In the case of the trade that generated the huge loss, the insurance on the contract does not come due until 2017, so JPMorgan could potentially hold off any actual losses until then. If the economy improves, the cost of insuring American companies could drop again. But now that the London Whale’s trade is public, hedge funds could force the cost of this specific insurance contract up, and with it JPMorgan’s paper losses. This is what appears to be happening now.

The list of the 129 companies in the CDX IG Series 9 index is here.

Bottom line: Given the mark-to-market requirements for banks and the capital requirements, this was an impossible trade for JPM to hide, once it started going against them. Now, it could be very tough for JPM to get out, far beyond the additional billion that is speculated it will cost JPM. This is going to be the mother of all short squeezes. What was The Whale thinking? What was Jamie Dimon thinking?

As a senior Wall Street executive quoted by NYT put it: “JPMorgan violated the cardinal rule of risk: Don’t become the market.”


  1. Kid Dynamite has a good post on the same subject:

  2. Bob, I did a post on this earlier today. FTAlphsville identified a few CDX IG Series 9 companies with credit issues.

    Keep up the good work.

  3. Too big to fail? Don't believe it. In the next crash some of the TBTF'ers will go down hard.