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Thar She Blows! Two Points off the Larboard Bow!! Felix Salmon Tells Us John Carney May Have Spotted the London Whale Felix Salmon

Felix Salmon:

Bruno Iksil and the CHIPS trade: John Carney has been plugging away at what on earth Bruno Iskil, the so-called London Whale, might be doing with his reported $100 billion bet on an obscure off-the-run CDX index….

Carney’s CHIPS theory (for Corporate Hedging Inflation-Protected Securities) makes a certain amount of sense. Let’s say that Iksil… wants to make money in the fixed-income markets even as he sees inflation appearing…. It’s never easy for bond investors to make money in the face of inflation…. Most normal investors are faced with a choice: they can either get insanely low yields on TIPS, and protect themselves from inflation, or else they can get slightly higher yields on corporate bonds, but leave themselves open to having their money eroded by inflation.

Iksil, however… buys TIPS — say the 10-year series issued in January 2007, which matures in January 2017… now off the run… [and also] wants exposure to investment-grade corporate credit risk… [so he] sell[s] protection on a CDX index which matures at roughly the same time — in this case, Series 9 of the Markit CDX North America Investment Grade Index, which matures in September 2017….

[S]elling protection… costs you nothing up-front…. Iksil is cashing insurance premiums on a basket of corporate debt every six months, and he can add that cashflow to the much more modest cashflow he’s getting on his TIPS…. Put the TIPS and the CDX trade together into a package, and you get what Carney calls CHIPS….

What happens now if inflation picks up before 2017?… Iksil will make money on his TIPS…. Iksil will also make money on his CDX trade. The yield on a corporate bond is… called credit and rates. The rates part is the bit which goes up when inflation appears. But when you’re selling credit protection, you’re stripping out the rates part…. And when inflation appears, corporate credit risk actually goes down….

Iksil['s] mark-to-market P&L goes up when rates go up. For every basis point that rates rise, Iksil…. If yields go up by one percentage point, Iksil has made himself $65 million, just on the CDX part of the trade. Which is quite an achievement for a fixed-income investor in a rising-rates environment. Add in the profit on his TIPS, and he’s making even more.

It’s a big and risky trade — but it’s not one which he’s ever necessarily going to have to unwind. It has a maturity of about 5 years, and JP Morgan is more than big enough to hold a 5-year trade to maturity.

But is that really what he’s doing? There’s one very good reason to believe it’s much more complicated than I’ve laid out: if you look at those TIPS maturing in 2017, there were only $9 billion of them…. Iksil is doing here is basically replicating the kind of corporate credit exposure that JP Morgan has lots of already. This isn’t in any way a hedge of JP Morgan’s existing portfolio; it’s more of a doubling-down on it.

Still, looked at one way, Iksil’s job is to take the assets that JP Morgan hasn’t been able to loan out, and get the kind of return on those assets that JP Morgan would be seeing if it had been able to loan them out. So maybe it makes sense that he’s making a big bet on corporate credit. I just wonder where on earth he could possibly find $100 billion of inflation protection.

He better hope his TIPS counterparties who owe him TIPS that do not exist have low counterparty risk, is what I'm saying'...