Hedge funds and the Whale, credit index edition | FT Alphaville

Hedge funds and the Whale, credit index edition

What is this a story of? Bloomberg’s headline:

JPMorgan Trader’s Positions Said to Distort Credit Indexes

The WSJ’s:

‘London Whale’ Rattles Debt Market.

To summarise, a number of market participants are pointing their fingers at JP Morgan’s Bruno Iksil, who works for the bank’s “Chief Investment Office”.

It’s said that he’s on the other ends of so many large trades on the Markit CDX.NA.IG.9 credit index that it’s distorting the market. Now, if you want to avoid a brief bit of navel-gazing on our part, go straight to The details below.

Financial journalism

Stories like this remind us of the perils, and potential merits, of financial journalism. If you have a moment then, put yourself in the shoes of a journalist covering markets…

… now picture that someone, or maybe several someones, call you and claim that so-and-so is distorting the market. Now, this is something your readers would be no doubt interested to know. But of course, you need to do more research. Figure out who’s telling the truth. Is this just one angry person with a vendetta (and a trading position to match) or is this the tip of an iceberg?

If it turns out to be an iceberg, then it’s a matter of serious, justifiable interest. But what if there are only a few people who can verify the allegation? And what if they are only guessing anyway? Should you report on guesses when numbers of guessers are large enough? What is enough evidence, really?

In financial markets, when there are so many factors at play, how confident can one ever be about what caused a given movement in a stock, yield, or credit spread anyway?

Joe Weisenthal of Business Insider is also skeptical of what’s going on in this particular case:

One is that all of the sources on this seem to be from people trading against him/rivals. So presumably this kind of attention to his “book” if accurate is not very helpful. Nobody wants to be called a “whale.”

Alright, navel gaze over.

The details

Bloomberg:

The trader may have built a $100 billion position in contracts on Series 9 of the Markit CDX North America Investment Grade Index, according to the people, who said they based their estimates on the trades and price movements they witnessed as well as their understanding of the size and structure of the markets.

WSJ:

Mr. Iksil has turned more upbeat recently. He has been selling protection on an index of 125 companies in the form of credit-default swaps. That essentially means he is betting on the improving credit of those companies, which he does through the index—CDX IG 9—tracking these companies.

The Markit CDX.IG.NA (last letters = investment grade North America) is an index that one can buy or sell credit default swap protection on. When it first started trading, in September of 2007, it had 125 credits in it. Here’s the full list.

It had Fannie, Freddie, CIT Group, and WaMu, so now it actually trades with 121 reference entities, not 125.

Every 6 months, credit indices like this one “roll”, which just means that a new series of the index starts trading, and the names contained in it shuffle around so that they always meet the requirements of that index. For example, investment grade indices should contain investment grade names. The credits also need to meet certain standards of liquidity when trading on a standalone, single-name basis. And so on.

The most recent index is the CDX.NA.IG.18. Full list here. The most recent index is referred to as being “on-the-run” and it’s usually the most liquid of all the indices. All the old indices are “off-the-run”.

The CDX.NA.IG.9 (“the 9s”) are still somewhat liquid because there were in a lot of CDOs, used to hedge CDOs, the indices that came immediately after the 9s had their liquidity impeded by the crisis, etc, etc. Hence the 9s are a bit special. They are “off-the-run”.

Getting back to the Bloomberg and WSJ reports, they cite investors as being cross that there is seemingly a big index trader that is “distorting” its prices. Additionally, sources identify that trader as Mr Iksil at JP Morgan. Here’s the WSJ:

Kavi Gupta, a trader at Bank of America Merrill Lynch, wrote a message to investors Thursday about the mystery trader, saying hedge funds are accelerating wagers against “the large long,” or bullish investor. “Fast money has smelt blood,” he wrote. Bank of America declined to comment.

The hedge funds are wagering that the cost of default protection using the index will increase, potentially putting Mr. Iksil in a money-losing position and forcing him to reduce some of his holdings.

Buying protection on the index is currently cheaper than what it costs to protect the index’s component companies individually.

What the stories seem to be insinuating is this:

– The mystery trader, perhaps Mr Iksil, has gone long in a big way on the Markit CDX.NA.IG.9, i.e. sold large amounts of protection against the 121 credits contained therein.

– Hedge funds are aware of the big position.

– The hedge funds are using skew trades (we’ll explain shortly) to express this view.

Just above those paragraphs though:

J.P. Morgan said the CIO unit is “focused on managing the long-term structural assets and liabilities of the firm and is not focused on short-term profits.”

The bank added, “Our CIO activities hedge structural risks and invest to bring the company’s asset and liabilities into better alignment.”

So as far as JP Morgan is concerned, these are long-term hedges. So, reputational risk aside, are these really positions to bet against? After all, if the $100bn position that was referred to in the Bloomberg piece is gross notional, that sounds about right for the size of JP Morgan’s exposure anyway. As of March 30, 2012, there was $884bn gross in total on the index (untranched), and JP Morgan is a huge player in this space. So, whatever… big for sure, but not like crazy mental big.

Skew trading is where one buys or sells protection on the index, while simultaneously selling or buying an equivalent amount of exposure to the underlying credits. All 121 of them in the case of the CDX.NA.IG.9.

At the moment, what the hedge funds that spoke to the journalists are saying is that Iksil has supposedly sold so much protection on the index that its spread is a lot lower than it should be relative to the single-names. So they are betting that the skew will have to go back towards zero (it’s negative now).

A graphical investigation

The amount of net notional exposure to the CDX.NA.IG.9 index has increased an impressive amount lately, according to DTCC data:

That’s quite a lot for an off-the-run index. Especially since the CDOs which a lot of trades on the 9s involve are maturing.

Now about the skew and trading activity. Here are three charts:

That’s trading activity in the bottom two graphs. Terminations of old trades and the beginning of new trades count as activity. Skew is shown in the top chart. That’s the actual index spread, minus an estimate of how much the index spread should be based on single-name CDS spreads of the entities in the index.

(Note that the activity data only became available around December 2010, hence nothing showing up before that. Also there’s more than one way to calculate the skew, so different sources will have different numbers.)

A couple of things:

– There were some quite chunky trades — in notional terms — executed around the beginning of the year, that also seem to have resulted in net notional increases, i.e. someone was indeed piling on fresh risk.

– The skew seems to have gotten more negative, which is also consistent with the story of there being a big index protection seller in the market.

Outright skew trading is rather niche. Banks do it with their books around the margin, as part of hedging (old) CDO structures and the current book they are running, but the hedge fund players that just do this aren’t all that many.

Taking exposure to so many credits, and not getting killed on the bid/ask spread on the way out, is not for the faint-hearted. FT Alphaville can imagine why market players might be a bit sensitive to such a big play “distorting” prices. But is it distortion?

Let’s compare a bit:

This is the series before the most recent one. Its skew bounced around a fair amount, but never went that negative. So maybe the 9s are overly negative. Maybe.

It’ll be interesting to see how the skew on the 9s behaves the next couple of weeks, and if JP Morgan decides to comment on it more directly.

It’s thanks to some cross skew-trading hedge funds, and a note from a bank to said clients, that we ‘know’ about this at all. We’d welcome more information — on a postcard, email, or below.

Have a good Easter.

Related links:
Why part of the CDS market is stuck in time – FT Alphaville
Desert(ing) CDS – FT Alphaville