JPMorgan Losses Spark Frenzy in Swaps Indexes: Credit Markets

JPMorgan Says Ina Drew to Retire, Replaced by Zames as CIO
A pedestrian passes the offices of JPMorgan Chase & Co., center, in London. The entire London staff of JPMorgan Chase & Co.'s chief investment office is at risk of dismissal as a $2 billion trading loss prompts the first executive departures as soon as this week, a person familiar with the situation said. Photographer: Simon Dawson/Bloomberg

Signs are emerging that traders are already attempting to squeeze JPMorgan Chase & Co. after the biggest U.S. bank said it faced $2 billion in trading losses related to credit derivatives in the past six weeks.

The 10-year Markit CDX North America Investment Grade Index Series 9, an older, less-active benchmark for credit-default swaps created in 2007 in which JPMorgan trader Bruno Iksil in London was said to have amassed as much as a $100 billion position, jumped the most in almost eight months on May 11. Another index contract that takes more concentrated risks on the same companies recorded the biggest two-week surge in two years.

Hedge-fund managers and other investors are circling as speculation mounts over how and whether New York-based JPMorgan will unwind the trades. JPMorgan said May 10 in a regulatory filing that it may hold certain of its synthetic credit positions for the “longer term,” a scenario that may backfire on traders who have taken the opposite positions.

“We’re all trying to figure out what trade he had on,” Peter Tchir, founder of New York-based hedge fund TF Market Advisors, said in reference to Iksil. “It’s been nonstop. Everyone’s trying to get their hands around it.”

Trading volumes rose at the end of last week on contracts that Iksil, known as the London Whale for the size of his positions, is believed to have taken, according to market participants who asked not to be identified because their trading strategies aren’t public.

Narrowing Gap

Credit swaps on Series 9 of the Markit CDX index that expire in December 2017 jumped 12.3 basis points to 139.3 basis points on May 11, the biggest increase since Sept. 22, before reaching 145.9 today, according to data provider CMA. The difference between the index and the weighted average of its members, a gap that was said to have swelled from Iksil’s trades, shrank to 1.5 basis points today from 14 on May 10 and 18 on May 1, according to prices from two market participants.

A so-called tranche of the same index that covers the first 3 percent of losses, concentrating its risks in companies from distressed bond insurer MBIA Inc. to mortgage insurer Radian Group Inc., jumped to the highest since Jan. 5, climbing 2.6 percentage points to 71.9 percent upfront, CMA prices show.

The tranche, in which market participants familiar with trading flows said Iksil also took positions, has climbed 8.9 percentage points this month.

‘Egregious Mistakes’

JPMorgan is seeking to stem losses after its chief investment office took flawed positions on “synthetic credit” trades, which may cost the lender an additional $1 billion this quarter or next, Chief Executive Officer Jamie Dimon said May 10 on a conference call with analysts. The loss originated from the firm’s London CIO unit, an executive at the bank said.

“There were many errors, sloppiness and bad judgment,” Dimon said. “These were egregious mistakes, they were self-inflicted.”

JPMorgan said today Matt Zames will succeed Ina Drew as chief investment officer. The entire staff of the London CIO unit is at risk of dismissal as the trading loss prompts the first executive departures as soon as this week, a person familiar with the situation said. The firm is examining whether anyone in the unit, which employs a few dozen people in London, sought to hide risks, said the person, who requested anonymity because the deliberations are private.

‘Poorly Executed’

The losses stem from trades that were designed to hedge the bank’s overall credit risks, Dimon said on the conference call. The bank was reducing the hedge, he said, “but in hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed, and poorly monitored.”

“The portfolio has proven to be riskier, more volatile, and less effective as an economic hedge than we thought,” he said.

Dimon, 56, has been a critic of regulations including the so-called Volcker rule meant to bar proprietary trading by banks with federally insured deposits. He told analysts that the timing of the announcement “plays right into all the hands” of those pushing for a strict version of the restrictions.

“The chips at the poker table are in fewer and fewer hands because there are fewer firms with size balance sheets,” said Lawrence McDonald, senior director for credit, sales and trading at Newedge USA LLC and author of the book “A Colossal Failure of Common Sense” about the 2008 demise of Lehman Brothers Holdings Inc. “This is the product of the government’s regulation. It’s crazy. It puts some firms at greater risk.”

Multiple Traders

Bloomberg News first reported April 5 that Iksil had amassed positions that were so large he was driving price moves in the $10 trillion market for credit swaps indexes tied to corporate creditworthiness. The loss occurred in London under multiple traders, according to an executive at the bank, who spoke on the condition of anonymity.

A group of hedge funds and other money managers began looking to profit by betting distortions created by JPMorgan’s moves would normalize. The dislocations were so large that they were creating situations in which traders were able to effectively buy $1 of default protection for about 80 cents, the market participants said.

Series 9 of the Markit CDX index is tied to 121 companies, all of which were investment grade more than four years ago, including Armonk, New York-based MBIA’S now junk-rated MBIA Insurance Corp. unit and Philadelphia-based Radian.

Index Rolls

New versions of Markit Group Ltd.’s indexes are created every six months. Companies are replaced if they no longer have appropriate credit grades, aren’t among the most actively traded borrowers, or fail to meet other criteria. Four other companies initially included in Series 9, CIT Group Inc., Washington Mutual Inc., Fannie Mae and Freddie Mac, triggered credit events during or after the financial crisis.

The Series 9 contract expiring in 2017 climbed 27 basis points from the end of March through last week. JPMorgan’s trades probably aren’t one-way bets, market participants said in April. The bank may be offsetting the trades by buying protection on the same index with contracts that expire about seven months from now, the people said.

That strategy would pay JPMorgan the difference between the long-dated contracts and the short-dated ones, about 41 basis points at the end of March for Series 9, and the trade would gain when the gap narrows or lose when it widens. The hedge would end in December unless another trade is made to replace it.

The gap on the index soared 14 basis points on May 11 and has climbed 25 basis points since the end of March, a 61 percent increase, according to data from CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.

‘Blood In The Water’

The difference between the same maturities of the riskiest tranche contracts ballooned to 54.2 percentage points from 45.5 percentage points at the end of March, CMA prices show. It widened 3 percentage points on May 11.

“I know how Wall Street works. When there’s blood in the water, the sharks are going to attack that animal,” Charles Peabody, an analyst with Portales Partners LLC in New York who downgraded his recommendation on JPMorgan’s stock in March to “sector perform,” said in a telephone interview last week. “It could make it very difficult for them to unwind a trade.”

Elsewhere in credit markets, the current version of the Markit CDX Investment Grade Index, Series 18, climbed by 5.3 basis points to a mid-price of 113.9 basis points as of 12:07 p.m. in New York, according to prices compiled by Bloomberg.

That’s the highest level since Jan. 18 on an intra-day basis for the index, which typically rises as investor confidence deteriorates and falls as it improves. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Rate Swap Spreads

The U.S. two-year interest-rate swap spread, a measure of bond market stress, also reached the highest level since January, climbing 3.1 basis points to 37.78 basis points as of 11:51 a.m. in New York. The gauge, at the highest level since Jan. 12 on an intra-day basis, widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate bonds.

Bonds of Chesapeake Energy Corp. are the most actively traded dollar-denominated corporate securities by dealers today, with 218 trades of $1 million or more as of 11:52 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

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