FT Alphaville " The high yield tranche piece Coverage of the $2bn $3bn loss emanating from JPMorgan's Chief Investment Office on its synthetic credit portfolio continues a pace, and FT Alphaville's tour continues too. The desire to understand what the trade was and the rationale behind it continues to bug us and many others. Interestingly, some of the discussion of late has come full circle. Bloomberg kicked off the London Whale saga on April 6th, and their follow-up on April 9th contained a detail that has now come back into the narrative. This time, though, it's more than a mere sidenote - more on this in a minute. While these more recent explanations are satisfying, we're still scratching our heads a bit. The challenge remains: to find trades that have managed to deteriorate with the speed that CEO Jamie Dimon has claimed they have - small in the first quarter, $2bn "all in the second quarter," and "it kind of grew as the quarter went on." Now, credit tranches, which are leveraged positions on credit indices that themselves already involve a lot of leverage, could do this if the model used to determine hedge ratios wasn't up to the task or if the trades were just outright foolish. There's also this, as Tracy Alloway and Sam Jones in wrote in Thursday's FT: Makes you go hmmm, doesn't it? Back to some of that original Bloomberg coverage for a moment, when the "London Whale" was first brought to the world's attention. There was a snippet in their report about the CIO making a profitable call in the fall of 2011 on Markit CDX.NA.HY tranches (NA = North America, HY = High Yield). These trades paid out when Dynegy and American Airlines" parent, AMR Corp, defaulted: When a group of hedge-fund traders last year bet that a cluster of companies in one of the indexes wouldn't default before contracts expired in December, Iksil was taking the opposite view, according to four market participants at hedge funds and banks, who spoke on condition of anonymity because they aren't authorized to discuss the transactions. Iksil's bet won out, and the hedge funds faced losses of 25 percent, when American Airlines parent AMR Corp. filed for bankruptcy less than a month before the insurance-like swaps matured, the market participants said. The trades were made in so-called tranches of the index, which take concentrated risks on the member companies. The WSJ is saying the same in their story this Thursday, May 17th - that the contracts expired in December. The FT story doesn't say when the contracts expired. The gist of all the stories is that the CIO was selling protection on the CDX.NA.IG.9 (going long) to balance out the tranches on the high yield index that they'd bought (going short, which turned out to be profitable when Dynegy and AMR Corp defaulted). In this way the trade would be both a curve play and across indices - one high yield, one investment grade, with the high yield play levered further because it was a tranche. The long on the IG.9 also would have helped to fund the rather expensive short on the high yield tranches. It's possible that not all of the CIO's tranches, on which they bought protection, matured in December. There's no way to know, as one has to rely on the veracity of reports from market participants. The WSJ story does, however, point the finger at the CDX.NA.HY.11, and from the DTCC data it looks like they have a point: That's quite a big drop in the week ending December 23rd. However, the companies that defaulted are in other high yield indices too. The Series 10 of the same index did not have a similar drop. It's clear that something motivated the CIO to continue to sell protection on the investment grade index, with a maturity in December 2017 (the "10-year" because of when the index launched, in September 2009), into this year, which kept the index cheap compared to its underlying constituents. But if there is one thing that is clear, it's that it is impossible for the CIO to have lost $2bn $3bn on that index position alone. Furthermore if the CIO actually did still have short high yield positions on right now, they'd likely be performing well, not poorly, given the increase in systemic risk out of Europe and deteriorating credit environment generally. But, as the FT pointed out on Wednesday, it may well be the case that the hedge ratio between the index and tranches wasn't correct or that it simply became impossible for the CIO to rebalance. Show me the losses Calculators out. The Markit CDX.NA.IG.9 currently has a gross notional outstanding of $795bn (which is $32bn less than it was a week before so someone might have taken some trades off, cough, cough) and a net notional of $146bn (constant on the week). To be generous, let's say JPMorgan has a fifth of the gross notional number, $160bn. This might not be generous enough but, hell, we're all guessing here. Give $80bn to the credit desk, which leaves $80bn for the CIO. Then assume something like the following, which is effectively a net long North American credit because the buy position on the short end is too small to be anything like hedged (you may imagine it's high yield instead of investment grade at the 5-year which would serve to amplify the gains): Sell $30bn of 10-year From the March 21st low of 106bps to the April 10th high of 130bps, this position would have lost roughly $400m. From the same March 21st low to Wednesday's close of 150bp, this position would have lost roughly $700m. "Rough" because we're just using durations. Buy $50bn of 5-year* Even with raging incompetence on one's side, there has to be some other side to the trade. It could all be in tranches, but for the sake of argument - and stubbornly in keeping with our curve-flattener-hedge-turned-bullish-long theory - let's say there was some short position on the short end of the index. This position would have been up roughly $54m from March 21st to April 10th, and up $68m by May 16th. For reference: As can been seen from the above cowboy math, there is something else going on here as it would be pretty hard to impossible for JPMorgan's CIO to amass a big enough sell position at the 10-year point on the index alone to get to $2bn of losses. Hence one has to look to other indices, e.g. high yield; and/or tranches on those. What were these "flawed, complex, poorly reviewed, poorly executed and poorly monitored" strategies that were meant to re-hedge the CIO's insurance against fat tails? Back to Jamie Dimon, on the May 10th call: I know it was done with the intention to hedge the tail risk for JPMorgan, but I am telling you, it morphed over time and the new strategy which was meant to reduce the hedge overall made it more complex, more risky and it was unbelievably ineffective. So we are back to where a lot of the hedge funds are: as Tracy and Sam reported, "JPMorgan's loss remains something of a mystery." More to follow on Friday. _______ $50bn on the 5-year to $30bn 10-year is a woefully pathetic ratio, i.e. this is way too small to be called a delta hedge, i.e. a hedge that would immunise the overall trade to small changes in index levels. This supports two theories: 1) the buy was really just a tail-hedge for jump-to-default risk and wasn't meant to be a hedge against index movements at all, and 2) this leg was indeed more about tranches but, again, those would perform well, and so make it harder to get to the $2bn loss number. This entry was posted by Lisa Pollack on Thursday, May 17th, 2012 at 20:03 and is filed under Capital markets. Tagged with cdx, Chief investment office, credit derivatives, JP morgan, OTC derivatives.