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Credit derivatives were the brainchild of savvy bankers at JPMorgan in the 1990s. Now the bank and one of Wall Street’s most controversial products are under intense scrutiny in what will be a crucial period for the market.
As JPMorgan reels from a complicated hedging strategy, one that misfired to the tune of at least $2.3bn in losses, derivatives-market participants worried about new rules on trading fear it will be harder to argue for more lenient treatment.
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The loss is also a reminder of the dangers of seeking bigger profits by minimising the cost of hedging.
While credit derivatives were created to allow lenders to offset the threat of a default by a borrower, the product has been associated with a number of blow-ups in recent years.
These include the effect on many Wall Street trading books in 2005 when US carmakers lost their investment-grade rating. Then came AIG’s huge losses from writing credit insurance on mortgage bonds to major banks in 2008, which precipitated a bailout from the Federal Reserve. Also at that time, Deutsche Bank lost more than $1bn from credit derivative trading as the financial crisis intensified.
“It is an indictment of risk management,” says Ed Grebeck, chief executive of Tempus Advisors, a global debt management strategy group. “What has happened in the last several years is that every time everybody says everything is OK, another one of these situations happens. And there are more coming.”
While the specific details of JPMorgan’s strategy are unclear, traders say the bank created a large portfolio of swaps over underlying holdings of bonds that involved selling protection on one credit index, the so-called CDX North American investment-grade index series 9, while purchasing insurance on other contracts. Income from writing insurance on one index helps pay for buying insurance on other indices.
Such positioning reflects how much of Wall Street’s hedging activity is actually based on assumptions about the future changes in the relationship between different indices and their constituents. As such, it relies heavily on models that look to economise the costs of hedging and allow profits to run.
“All financial institutions are only profitable if they take risk, if you hedge away all risk, there is no return,” says Andrew Lo, professor at MIT.
Trading in the credit default swaps market is conducted on a bilateral basis between two counterparties. This means the market still operates in the dark, with trades privately negotiated between two parties and with no public record of transactions for each day. Within this opaque world, banks and investors that amass large positions can become vulnerable to a so-called “squeeze”.
That is the situation JPMorgan found itself in as hedge funds sensed strains in the bank’s management of its huge positions and began to trade aggressively against the bank.
“Trading in size in a bilaterally negotiated world can put you in the worst position you can be in: the trade going against you and the Street knows,” says Christian Martin, a former swaps trader at Merrill Lynch and co-founder of TeraExchange, a nascent electronic CDS market platform.
Major dealers dislike the idea of trading derivatives on an exchange type platform, as it stands to substantially reduce their profit margins. But a public record of real-time transactions would mean a more transparent market that is less prone to being dominated by a single player.
While JPMorgan’s losses to date are a fraction of its balance sheet and it is believed the trades were centrally cleared, satisfying one key area of derivatives reform, there is nevertheless much at stake for the industry and swaps trading.
Wall Street has resisted efforts to reform the trading of derivatives since the signing of the Dodd Frank Act in 2010. The industry has warned tough rules for derivatives trading could harm liquidity and impair the ability of banks to hedge loan and bond risk, ultimately raising the cost of financing for a swath of companies.
Over the past year, moreover, outstanding CDS trades have fallen by a fifth as the market has reduced risk and banks grapple with the prospect of higher capital charges.
The credit derivatives index in which JPMorgan is believed to have amassed a large position initially moved higher on the news of its losing position, an indication that the losses could be higher than the bank reported (though the bank is thought to have moved to neutralise its positions). Therein resides a risk for the wider market.
JPMorgan “is a major player in credit derivatives and by no means the worst managed or the most aggressive in risk taking”, says Satyajit Das, a derivatives trader turned consultant. “If it curtails its activities then the loss of liquidity may affect other players and result in unrelated losses.”