Macaskill on markets: Rivals hover over JPMorgan as farce threatens to turn into tragedy
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Macaskill on markets: Rivals hover over JPMorgan as farce threatens to turn into tragedy

The JPMorgan credit derivatives trading farce is set to extend its run. Rival market players will have plenty of tactical opportunities for profits, but a bigger question for peer-group banks is whether they will be able to win back investment banking market share that was lost to JPMorgan after 2008.

JPMorgan’s investment bank generated $26.3 billion of revenue last year, including $19.3 billion from trading, so there is a big pie to target.

Goldman Sachs was quick to sound a dog-whistle signal that it intends to capitalize on JPMorgan’s weakness.

Goldman president Gary Cohn and CFO David Viniar visited bank stock analysts just before the bank’s May 24 AGM. They reiterated Goldman’s stated intention to win market share in Europe in cash equities, derivatives and selected fixed-income markets. They added, though, that winning business with corporate clients from JPMorgan was also a priority.

The message was couched in the context of a contest for dull but worthy corporate finance business, but the subtext was clear: Goldman intends to push the argument that JPMorgan’s reputation for superior risk management was vastly overblown.

This could be described as the "Jamie Dimon is full of it" line of attack and it is one that has been getting a lot of play since the JPMorgan chief executive was forced to admit that what he initially described as a "tempest in a teapot" was in fact a trading blunder of epic proportions by his chief investment office.

The sheer size of the positions held by the CIOvirtually guarantees that there will be opportunities for rivals to push JPMorgan’s eventual loss well beyond the initial $2 billion estimate and the decision to place close to half the office’s $382 billion of assets in risky holdings ranging from corporate bonds and default swaps to mortgage-backed debt does not look very smart as fears of a global downturn revive.

The process of unwinding the credit derivatives trades put on by the CIO might cause unexpected market disruptions, beyond the simple effect on spread direction caused by trade reversals. This could extend the trading opportunities for hedge funds and rival dealers looking to exploit market anomalies, and it also risks alienating clients of JPMorgan’s investment bank.

One example of a potential second-order effect of unwinds might be seen in the basis between single-name default swaps and the off-the-run CDX IG9 index where JPMorgan CIO trader Bruno Iksilwent in for his most unhinged protection selling.

The sales of protection pushed the spread of the index well below the levels implied by default swaps for its constituents, causing short-term losses for hedge funds that trade credit index arbitrage and prompting fund managers to start complaining about the trading tactics.

Some funds are sitting on paper profits from the reversal of the IG9 index from a spread of 125 basis points just before JPMorgan announced it had botched its CIO turbo-charged hedging on May 10 to 160bp at the end of May. A few funds could have 50% profits from select trades in March, when the IG9 was as tight as 105bp. But to realize profits on related credit index arbitrage trades the funds will have to both reverse their index protection buying and unwind the associated single-name deals by buying protection on the individual components of the index.

This could shift the basis, or skew, back into positive territory, as single-name default swap markets are far less liquid than indices.

Estimates of the outstanding JPMorgan trades are just that, given that the most recent disclosure of just over $100 billion of net long credit derivatives is valid only as of the end of March, but it is conceivable that the bank still has as much as $70 billion of notional IG9 credit index trades to unwind. One hedge fund manager, with an apparent eye to making sure that this is the unwind that just keeps giving, estimates that credit index skew trades from other funds active in the field, such as BlueMountain Capital, could account for around $35 billion of the trades put on with JPMorgan. That in turn implies that there is more than $300 million of protection buying in each component name of the index to come in the form of unwinds, which could easily take the skew into positive territory.

While hedge funds try to milk the JPMorgan unwinds for as much profit as possible, rival bank dealers have a dual opportunity. They too can try to turn a tactical profit, but they also have a market-making platform to help key clients get in on the fun and hopefully build some enduring customer loyalty.

JPMorgan’s investment bank obviously cannot trade against its own CIO (although some of its more experienced staff must have wished that they could at times) and its position as the leading credit trading bank by revenue has been undermined by a dealing fiasco that has become one of the dominant themes of the year.

Whether this proves to be a temporary reverse for JPMorgan’s credit trading group or the beginning of an erosion of its recent global dominance in overall fixed-income revenue generation is not yet clear.

Rivals such as Goldman Sachs and Morgan Stanley can certainly be expected to push hard to win fixed-income market share while JPMorgan is on the defensive. But the after-effects of the JPMorgan scandal have already undermined a key competitive barometer for the pure-play investment banks by contributing to a sharp widening in their own credit spreads. Renewed regulatory scrutiny and a reduction in client and shareholder confidence in the risk management ability of banks is not a conducive environment for growth at any of the main dealers.

European universal banks will also try to win some fixed-income share, but given the backdrop of renewed eurozone tensions the best they can probably hope for is a respite from JPMorgan’s recent incursions in their own backyard.

These factors might give Jamie Dimon some breathing space as he prepares for a congressional appearance and then a second-quarter earnings announcement that will be crucial to JPMorgan’s future. If he can announce that the trading losses have been cauterized without undermining investment banking performance then he stands a chance of moving past the scandal. Otherwise the value of the franchise could slide. JPMorgan announced its second-quarter earnings last year on July 14, Bastille Day. Dimon must hope his equivalent 2012 earnings day does not turn out to mark the storming of Fortress JPMorgan.

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