Friday, April 6, 2012

The "London Whale" is likely hedging JPMorgan's own bonds

The financial media has had a field day with the recent story about the so called "London Whale". Apparently a trader out of JPMorgan's office of the CIO has been a seller of the Investment Grade (IG) CDX (an index of investment grade corporate CDS).
WSJ: Mr. Iksil has taken large positions for the bank in insurance-like products called credit-default swaps. Lately, partly in reaction to market movements possibly resulting from Mr. Iksil's trades, some hedge funds and others have made heavy opposing bets, according to people close to the matter.
According to the story these trades have been so large that they are distorting the market. A few comments on this situation:

1. The story of large sales of protection are in fact true as evidenced by the recent divergence of the IG CDX and the HY CDX spreads which are generally highly correlated. The selling pressure from the "Whale" or whoever has tightened IG spreads disproportionately to HY CDX.

IG anf HY CDX spreads (Bloomberg)

Note that the spike in both spreads today is due to the relatively bad employment numbers out of the US, as we continue to see more negative economic surprises.

2. The story about hedge funds taking the other side is probably true as well, simply because hedge funds use IG CDX as a general hedge against negative market events. And given the relative divergence here, they saw this index as a fairly cheap hedge/market short. But they clearly have not traded enough to bring the two indices back in line.

3. As IG CDX widened today, it is premature to conclude that JPMorgan has taken a large loss. Let's just put some numbers on it. Let's say JPM is short $5bn of  IG CDX protection. The index has widened 15bp from the lows (85 to 100). That translates into $37mm of losses, barely a blip for JPM's earnings.

4. In general JPM would not do an outright trade like this. Most likely they have something on the other side of the trade that the market doesn't see. It is in fact highly possible that the bank is hedging the volatility in its own bonds. Well publicized accounting rules have banks mark their own debt to market. In difficult times their debt drops in value, and because the bank is effectively short its own debt, it records a gain. What JPMorgan may be doing is protecting itself from the rise in its debt value, which would force them to record a loss. If JPMorgan's credit spread tightens, the firm takes a loss on its own bonds but would make a gain on the bank's IG CDX position as an offset. IG CDX is highly correlated to the CDS of financial companies and is liquid enough for JPMorgan to execute in size. It is well known that Goldman for example has been quite active in hedging its bonds, and is therefore not unreasonable to assume that JPMorgan is doing the same using IG CDX.
Reuters: ... Morgan Stanley reported $3.6 billion worth of debt valuation gains in the last half of 2011, as its credit default swap prices more than doubled. The bank is likely to report a charge of hundreds of millions of dollars in the first quarter if its bond and CDS prices remain stable, analysts said. Goldman hedges its debt valuation risk, so its gains and losses are smaller and harder to predict.
For those interested in this topic, here is a great detailed write-up on the IG CDX recent dynamics and a discussion of the infamous London Whale from Lisa Pollack .
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