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?

We’ll get to these questions a bit later, as we would first like to review how the $2bn mark-to-market loss announced on Thursday may have happened…

A curve trade with the best of intentions

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.

While it’s impossible to know what the CIO did without further disclosure from JP Morgan, FT Alphaville thought they had entered into a curve trade, based on market data and what statements the bank did make about what sort of thing the CIO does.

In short, we thought this particular curve trade was a flattener, that being a type of trade which allows one to take a bearish view. If you had such a trade in place in the fall of 2011, you would have done well for yourself, thanks to general turmoil in the markets. What followed after that though, in 2012, is all together different.

To get a sense of curve trading, consider this curve, which is for the most recent incarnation of the Markit CDX.NA.IG, an investment grade credit index that contains 125 North American corporates:

The whole curve moving down would mean that these corporates are regarded as more creditworthy, i.e. spreads have tightened. The curve being more steep is also generally good because it means that the near term is less risky, the longer term is more risky — primarily because there’s more time for things to go wrong.

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.

To give a specific example, FT Alphaville discussed back in November how anyone who placed a flattener on Italy, even just a few months beforehand, would have made some serious money when the curve flattened and then inverted:

Again, our 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.

Shamu rebalances

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, due to spread movements and the passage of time. “Rebalancing” here means 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 — as it seems JP Morgan has recently discovered. But before talk about recent events, let’s look at the build up to it.

Judging from the total net notional amounts outstanding in the market for the CDX.NA.IG.9, it looks like the CIO (or whoever else was doing something similar) may have really screwed the pooch in terms of managing this trade, possibly increasing its overall size too in a fit of doubling down. That large size meant that rebalancing in order to keep the trade on in its true form would ultimately become impossible. Which is what we think led to this Thursday’s announcement.

Note, however, that again, we are looking at the data, what JP Morgan has said, and making an educated guess. Here’s the chart:

Here’s the context, to show how the increase in this specific index stands out compared to other indices of the same type, but different vintages (look for the dark purple line):

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. Here’s the raw measure of skew (the theoretical value of the index based on the spreads of the underlying single-name constituents less the actual traded value of the index):

To really get a sense of this though, one has to look at the skew as a percentage of the index:

It’s also possible that some recent trends in tranche trading were contributing to this.

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. The pressure was too much for the arbitrage to make profits. The trades sat in the loss position while the selling pressure making the index cheap, stayed on.

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.

It’s an OTC market!!!

The hedge funds got angry.

They developed a theory that one trader was behind all of this. One trader, at one bank. One trader, at the CIO, at JP Morgan.

The hedge funds got more angry.

It dawned on the hedge funds that they had no one to complain to.

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.

Now for something to go wrong

Our guess is that at some point, either the risk of the trades was spotted for real (see above, re: journalists) and/or, as previously mentioned, the CIO stopped managing the hedge ratio on the curve trades. Stop managing the ratio, and the trade will turn into an outright long or short position on credit.

There’s another problem too. There are four credits in the Markit CDX.NA.IG.9 that are especially wide: Radian, MBIA, Sprint Nextel, and R.R. Donnelley & Sons. If one is outright long or short, the idiosyncratic risk around these names would have to be actively (expensively) managed.

More to the point, what business does a Volckered bank have taking an outright view on these credits?

Whither the regulators

99 per cent of all CDS trades live in an information warehouse called DTCC, to which the regulators of the banks have access in however much detail they want!!! What kind of regulator doesn’t go and look at the that, when the mere public, aggregated info shows this?

It baffles us. Absolutely baffles us.

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.

Related links:
JPM Whale-Watching Tour – FT Alphaville
You Say “Voldemort” Like That’s A Bad Thing – Dealbreaker
JP Morgan’s giant unwitting catalyst trade - FT Alphaville
The remarkable resurgence in synthetic credit tranches – FT Alphaville
Stardate April 13, CIO sector, JP Morgan reporting VaR - FT Alphaville