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
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
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
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.
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
|How big is JPMorgan’s tempest
in a teapot’?
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
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.