On Wall Street, $3,500 goes further than anyone dared imagine in the 1980s when the predecessor to JPMorgan Chase & Co. charged the fee to trade each non-investment grade loan it sold.
That surcharge remains the same today and helps the biggest U.S. bank dominate the secretive $1.1 trillion junk-loan market while stifling profits for investors and rivals, which mostly stopped charging it years ago. The New York-based bank waives it for exclusive customers: trade with JPMorgan, no fee; trade one of its loans with anyone else, pay up.
JPMorgan can dictate terms because of its size, according to 12 people with knowledge of the matter who are concerned they’d jeopardize their business if their identities were revealed. The bank brings more corporate debt to market than anyone, and competitors and investors say they might be shut out of future deals if they don’t play by JPMorgan’s rules.
“This is one of the last frontiers of relatively unregulated, over-the-counter trading between financial giants,” said Jose Gabilondo, a law professor at Florida International University in Miami who focuses on corporate finance. “You’re dealing with a market that doesn’t have regulated disclosure requirements getting the information out in the market.”
The issue goes beyond pinched profits for rivals and investors such as pension plans and hedge funds that buy the loans. It’s also about what may happen when riskier investments lose their appeal. Since the fees make it unprofitable for JPMorgan competitors to trade loans made by the bank, buying and selling the debt may become difficult and put at risk individual investors, who own more of the loans through mutual funds than ever before.
Justin Perras, a spokesman for JPMorgan in New York, declined to comment on the bank’s practice of charging the trading fees or the way in which the charge affects how quickly investors can move in and out of the market. The bank has more than 1,200 predecessor institutions, according to its website, and became JPMorgan Chase in 2000 after J.P. Morgan & Co. merged with Chase Manhattan Corp., which had earlier combined with Chemical Banking Corp.
JPMorgan is at the center of an unprecedented expansion in global corporate debt markets, which have become more popular with investors seeking alternatives to government securities as central banks hold interest rates at record lows to spur growth.
The market value of bonds in the Bank of America Merrill Lynch Global Corporate & High Yield Index has soared to $10.5 trillion from $5.15 trillion in 2008. The market for institutional junk-rated loans, given to the most indebted companies, increased to $688.3 billion last year, exceeding the 2007 peak of $596 billion, according to data compiled by Bloomberg.
Led by Chief Executive Officer Jamie Dimon, JPMorgan was the biggest underwriter of corporate bonds last year, with a 6.8 percent share of the $3.27 trillion issued, compared with 6.1 percent for No. 2 Bank of America Corp., according to data compiled by Bloomberg. It was also the top-ranked manager of U.S. syndicated loan sales, the data show.
Since 2007, JPMorgan’s assets have grown 55 percent and its customer deposits have risen 74 percent. The bank ranks first in the U.S. in both categories.
Junk loans, also called high-yield or leveraged loans, are a lucrative business for banks at a time when new regulations designed to make the financial system safer are forcing them to cut back on businesses such as trading for their own accounts. Banks have typically earned 1 percent to 5 percent selling pieces of the debt to institutional investors such as pension plans and mutual funds, according to Standard & Poor’s data.
That compares with almost nothing to manage sales of investment-grade loans, given to companies with good credit, and an average 1.3 percent on sales of junk bonds last year, data compiled by Bloomberg show. Banks also earn an annual fee from borrowers to handle the paperwork, making sure everyone gets paid what they’re owed.
The $3,500 add-on might seem like a mote of dust on the $2.4 trillion balance sheet of a banking behemoth such as JPMorgan. Still, the fees add up because trades often consist of multiple transactions and JPMorgan charges for each.
For example, if an investment firm buys a $2 million slice of a loan administered by JPMorgan and then parcels it out to four of its funds, it would be forced to pay $14,000 if a dealer other than JPMorgan brokers the trade.
“It’s a nuisance and it creates additional inefficiencies,” David Breazzano, the president and chief investment officer of Waltham, Massachusetts-based DDJ Capital Management LLC, said in an interview. DDJ manages more than $7 billion in high-yield assets.
Rivals said they’re reluctant to trade many deals that JPMorgan helped to originally distribute because it’s too costly. Rather than finding ways to circumvent the biggest U.S. bank, investors usually give in and trade the debt only with JPMorgan, said the people who requested anonymity.
The rivals said they’re also concerned that if they don’t comply, JPMorgan may not give them opportunities to buy new deals the bank brings to market. That would hurt their business because their customers are giving them more cash to invest in high-yield loans than ever before, the people said. Perras, the JPMorgan spokesman, declined to comment.
The loans are widely traded. Last year’s $517 billion of transactions were within $3 billion of the all-time high in 2007, S&P and Loan Syndications and Trading Association data show.
More plentiful trading has “dramatically increased the financial burden that assignment fees have imposed,” said Barry Zamore, the head of U.S. non-distressed, leveraged-loan trading for Credit Suisse Group AG in New York. “Assignment fees were meant for the manual processes in the year 1995, not 2014.”
After the 2008 financial crisis, international rules penalized financial institutions for keeping the loans on their books by requiring them to hold more capital in case the debt goes bad. Banks found ready buyers in an economy distorted by the Federal Reserve’s near-zero benchmark interest rate.
Leveraged loans have returned 81 percent in the past five years through January, about five times the 16.6 percent return of the Bank of America Merrill Lynch U.S. Treasury Index.
Junk loans differ from junk bonds even though many investors buy both. Finance laws drafted after the Great Depression of the 1930s didn’t consider junk loans to be securities because they were mostly private transactions between one bank and one borrower. Since the government already supervised banks, lawmakers saw no need to double up by regulating their loans, too. Today, banks sell most of the loans to institutions.
It’s impossible to estimate from public regulatory filings how much JPMorgan earns from the fees. Trading data isn’t available on a loan-specific level. Banks don’t disclose such detailed earnings, nor are they legally required to.
The lack of transparency allows the trading of leveraged loans to go on in relative darkness, said Elisabeth de Fontenay, a Duke Law School professor in Durham, North Carolina, who previously worked as a corporate lawyer at Ropes & Gray LLP.
“The leveraged-loan market is at once the most dynamic and the least visible capital market in the U.S., which is exactly how its participants like it,” de Fontenay said in an academic article presented at the 2013 Law and Society Association conference.
While the U.S. Securities and Exchange Commission hasn’t tried to regulate the loans as securities, such oversight would lead to pressure to lower or eliminate fees, de Fontenay said in a telephone interview this month.
The market will be tested when sentiment deteriorates, she said. It’s happened before. Prices fell as low as 59.2 cents on the dollar during the 2008 credit crisis, S&P and LSTA data show. They hit a high of 98.9 cents on Jan. 17.
JPMorgan’s fee is a relic from a time when clerks used Lotus spreadsheets to track transactions and the market for junk loans was less than 2 percent the size it is now.
Loan trades can still take weeks to settle, and until 2012 traders relied on fax machines to place orders. In contrast, junk bonds are increasingly traded electronically and have prices that are publicly reported through Trace, run by the Financial Industry Regulatory Authority.
The bank’s dominance dates from 1982, when banker James B. Lee Jr. created a loan syndication unit to sell pieces of debt for JPMorgan predecessor Chemical Bank, according to a press release for a New York Public Library event honoring Lee in
2008. Lee is now a JPMorgan vice chairman.
By 1999, another JPMorgan predecessor, Chase Manhattan, handled 44 percent of the $22 billion of loans to the least creditworthy companies, according to data compiled by Bloomberg.
Last year, JPMorgan managed the distribution of $133.7 billion of junk-rated loans, the second-biggest share among banks. Bank of America has been the top underwriter since 2008 after combining with Merrill Lynch & Co.
Bank of America charges the $3,500 fee to JPMorgan, Royal Bank of Canada and Jefferies Group LLC, according to two people familiar with the trades. The Charlotte, North Carolina-based bank waives the fee for most of its rivals.
By 2005, Credit Suisse, Deutsche Bank AG, Royal Bank of Scotland Group Plc, Morgan Stanley, Goldman Sachs Group Inc. and 10 other banks agreed to mostly stop charging each other’s clients the standard $3,500 fee to trade loans.
Investors are still protesting 10 years after an August 2004 LSTA survey in which market participants said the surcharges are “an impediment for the loan market.” The fee reduced competition, making it cost more to enter and exit the growing market, investors said at the time.
“These fees are associated with froth,” said Gabilondo of Florida International University. “The bank probably feels that it can skim a little bit off because there’s some investor on the other side who’s so willing to hold these that they’re willing to pay a transaction fee.”
Mutual funds, whose investors are often quick to buy and sell, account for about 33 percent of the market, according to data from S&P and the LSTA. They channeled a record $63 billion into the debt last year, compared with net withdrawals in 2007. Retirees and pensioners are turning to leveraged loans, which pay more when benchmark interest rates rise, instead of junk bonds, which are tied to fixed benchmark rates.
Yields on junk loans issued this year are an average 5.03 percent, according to S&P’s Capital IQ Leveraged Commentary & Data. That compares with the yield on 10-year Treasury bond of
“It’s a surprisingly concentrated market,” said de Fontenay of Duke Law School. “Right now there’s so much artificial demand for loans. In the long run it will be an issue.”