JPMorgan chief executive Jamie Dimon was keen to dismiss reports of hefty credit derivatives trades placed by his chief investment office as a "tempest in a teapot" on the bank’s quarterly results conference call in April.
There was certainly no sign that the hedge funds that ushered the details of the position-taking into the public domain had managed to score a quick result by forcing JPMorgan to unwind its trades.
But the publicity about the deals does create some problems for JPMorgan. The bank is clearly too big to fail without creating systemic chaos. The recent attention to its derivatives trades suggests that it might also be too big to hedge, at least in terms of balancing its exposure with deals that are designed to create a profit in relatively likely market situations.
The exact details of the trades put on by the JPMorgan CIO have not been disclosed. JPMorgan is understandably unwilling to shed additional light on its holdings, while its market counterparties such as hedge funds have limited visibility on offsets to individual trades, along with a strong motive to talk their own books by speculating about potential eventual deal unwinds.
It is clear that JPMorgan’s CIO sold substantial amounts of investment-grade credit default swap index exposure in the first quarter of the year; market participants maintain that it also bought high-yield default swap protection, with total notional trade sizes running to tens of billions of dollars.
Those trades were unusually large for the credit derivatives market, despite their concentration in indices, which are more liquid than single-name default swaps. The JPMorgan activity helped to fuel the global rally in investment-grade credit spreads in the first quarter and contributed to a widening in the ratio between investment-grade and high-yield spreads, taking the latter to a multiple of roughly six times the former.
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| How big is JPMorgan’s ‘tempest in a teapot’? |
A dream scenario for hedge funds and rival dealers on the other side of the JPMorgan trades would be a repeat of the Morgan Stanley credit derivatives trading debacle of 2007. A group of proprietary dealers at Morgan Stanley led by Howie Hubler sold derivatives protection on CDOs at the end of 2006 with supposed embedded hedges that became less effective as market conditions deteriorated during 2007. As the exposure became widely known on Wall Street, rival traders were able to squeeze Morgan Stanley with a combination of opposing deals and collateral demands; eventually the bank lost roughly $10 billion on notional derivatives exposure of around $16 billion.
JPMorgan is less likely to buckle, even though its CIO is running positions that are much larger on a notional basis than the default swaps that drove Morgan Stanley to what is still the biggest single trading loss ever recorded.
For one thing, JPMorgan’s CIO trades really do serve a hedging function, unless detailed assertions made by Dimon and his CFO, Doug Braunstein, on the recent public results call were untrue, which would be an oddly reckless approach to take.
Braunstein said that the firm invests the difference between its deposits and loans – a portfolio of around $360 billion – in order to hedge the interest rate risk of this asset and liability mismatch. He noted that the firm hedges basis risk, convexity risk, foreign exchange risk and mortgage servicing risk through the CIO, while also looking to turn a profit from its activity.
The sheer size of the portfolio indicates that JPMorgan’s CIO could be difficult to drive out of a position that it feels it can leave on for a medium-term basis. And there is a difference between the Morgan Stanley trades that were a pure proprietary bet with some embedded hedges that failed and JPMorgan’s deals that serve an underlying hedging function, while also including a proprietary element.
But there are also intriguing similarities between the Morgan Stanley and JPMorgan trades, not least in the role played in their adoption by the respective chief executives at the two firms.
John Mack, chief executive of Morgan Stanley at the time, was not directly involved in the complex trades created by Hubler and his team. But Mack fostered a culture of increased risk-taking at the firm in an open attempt to catch up with the proprietary dealing revenues generated by Goldman Sachs. This led directly to the Hubler trading loss, which in turn undermined counterparty confidence in Morgan Stanley as the credit crisis worsened during 2008.
Jamie Dimon at JPMorgan is similarly unlikely to have been involved in the details of the recent hike in the CIO’s exposure in credit derivatives trading. It is hard to believe that a notoriously hands-on chief executive like Dimon did not give his approval to the broader expansion in the footprint of the bank’s CIO, however.
The size of the value at risk of the CIO portfolio is startling and has exceeded the VAR in JPMorgan’s investment bank in each of the past two quarters, which indicates that Dimon must have approved the risk levels being run by the unit. The CIO had average VAR of $69 million in the fourth quarter of 2011 and $67 million in the first quarter of this year. JPMorgan’s investment bank – nowadays the most successful in the world in terms of revenue generation – managed to get by with VAR of $57 million in the fourth quarter of 2011 and $63 million in the first quarter of 2012.
Braunstein, appearing alongside Dimon on the recent quarterly earnings call, read out the firm’s line on whether or not the profit-seeking element of the CIO’s mandate is likely to be in breach of the Volcker Rule.
Braunstein said that based on what JPMorgan believes to be the spirit of the legislation and the long-term investing philosophy followed by the CIO, its action is consistent with what the bank believes the ultimate outcome will be related to Volcker.
It was a highly convoluted statement, and no wonder. It is a deeply dubious assertion that the CIO’s activity falls within the spirit of the Volcker Rule and although JPMorgan might well be right in assuming that its activity will not be penalized when a diluted version of the rule is finally enforced, the bank is probably wise not to flaunt this view in public.
The oxygen of publicity now threatens to ignite fires for JPMorgan on various fronts. Funds and rival dealers will be keen to exaggerate positions taken by the bank’s CIO in the hope of profiting from either momentum or trade reversals. And questions about whether a trade is a hedge are likely to multiply, even if regulators and politicians are slow to make a push for any detailed information.
