FT Alphaville » Too Big To Hedge: Throughout FT Alphaville’s coverage of the credit trades of JP Morgan’s Chief Investment Office, there were two thoughts that kept nagging us. We’d think about them whenever we wrote about the technicals the trades might be creating. One was: could this really happen under CEO Jamie Dimon’s watch? The other was: where the hell are the regulators in all of this?…
Like most trades, it probably started harmless enough, or it least it seemed that way. After all, no one enters into a trade to lose money….FT Alphaville thought they had entered into a curve trade…. The whole curve moving down would mean that these corporates are regarded as more creditworthy, i.e. spreads have tightened…. The curve flattens when things look bad even in the near term. Curves can completely invert when the view is that if the corporate (or sovereign) can manage to survive some immediate obstacles and not implode, things will probably get better or at least less bad…. [O]ur theory was that the CIO had put on a trade that bet that the CDX.NA.IG.9 — a credit index that was launched in 2007 which has decent liquidity due to the legacy of the CDO boom — would flatten. With such a trade, JP Morgan could say things like this (from the WSJ):
On a conference call with analysts, [J.P. Morgan Chief Financial Officer Doug] Braunstein said the positions are meant to hedge investments the bank makes in “very high grade” securities with excess deposits. (J.P. Morgan has some $1.1 trillion in worldwide deposits.) Braunstein said the CIO positions are meant to offset the risk of a “stress-loss” in that credit portfolio. He added the CIO position is made in line with the bank’s overall risk strategy. Which is a good thing to answer with when Paul Volcker comes knocking on your door, inquiring about any proprietary trading going on under your roof.
A flattener trade is just fine in reasonable doses, i.e. if there’s enough liquidity in the market to support it. Unfortunately, with curve trades, you have to rebalance them reasonably actively… keeping the ratio of protection bought at the short end to protection sold at the long end just right. Get this wrong and your position will start to look even more risky and volatile…. [I]t looks like the CIO… may have really screwed the pooch in terms of managing this trade, possibly increasing its overall size too in a fit of doubling down….
The consequence of this build-up of net notional, whoever is behind it, is that the CDX.NA.IG.9 index became very cheap compared to its underlying constituents. Hedge funds and others saw that and started putting on trades to arbitrage the difference…. So the trades to take advantage of the technical (cheap index) were on and hedge funds gleefully waited for the market to correct back to fundamentals, turning a handsome profit in the process. Only the market didn’t correct. Someone, or several someones, were selling so much protection and sitting on it, that the market couldn’t correct….
Meanwhile, whoever was doing the selling was probably getting cold feet. As we mentioned, they probably stopped rebalancing the hedge, which probably let to increased risk and losses. From JP Morgan’s 10-Q:
Since March 31, 2012, CIO has had significant mark-to-market losses in its synthetic credit portfolio, and this portfolio has proven to be riskier, more volatile and less effective as an economic hedge than the Firm previously believed.
More on that below, but first, back to those hedge funds…. The hedge funds got angry…. The hedge funds and banks had lobbied long and hard to keep this over-the-counter market in credit derivatives unregulated. Thus it is unregulated, and they had no one to tell, officially, about what they suspected — that a single player had cornered, and distorted the market by putting on huge trades. But the hedge funds were very, very angry that their trades were unprofitable while believing it was one bank’s fault. They complained… to… journalists….
As for Mr Dimon… actually we’re still wondering about that. He seems mighty upset though. He even saw this post coming, didn’t he? Not to mention the hundreds of others out today, and tomorrow, and next week, and possibly after that to, when he said this: ”[the $2bn trading loss] plays right into the hands of a whole bunch of pundits out there.”
He’s right. On that point anyway.