NEW YORK The $2 billion-and-counting trading loss at JPMorgan Chase & Co rattled investors on Monday, raising fears of more trouble to come from a possible wave of ratings downgrades of major global banks.
Market participants said the mismanaged derivatives trade at JPMorgan, regarded as the best-run large U.S. bank, raised concern about other banks' derivatives strategies.
"You have seen risk coming off here," said MacNeil Curry, chief rates and currency technical strategist at Bank of America Merrill Lynch. "It raises the question that if JPMorgan is the best of the breed, what are the other guys doing?"
That's a question Moody's Investors Service is likely to ask as it reviews the business models and risk management systems of 15 global banks and securities firms.
On Friday Fitch Ratings cut JPMorgan's credit rating one notch to A-plus from AA-minus.
Some fear JPMorgan's loss highlights how opaque over-the-counter derivatives trades are and how big losses at one bank could spark losses at its counterparties and feed systemic risk.
Moody's has said it will conclude its review of financial institutions by the end of June. In February, it said it may cut JPMorgan's Aa3 long-term rating by two notches.
Downgrades would likely raise banks' cost of funding and for the lowest rated banks may make some investors reticent to trade with the firms.
"Moody's argument was that there were structural issues in the sector, including greater volatility, higher funding costs, and that in a revenue-challenged environment, banks were having to stretch for yield in order to generate earnings, which is what you saw here," said John Guarnera, U.S. bank credit analyst at Societe Generale.
"Moody's may now think that their process has been validated, and that may mean that they are unlikely to be lenient and will downgrade to the full extent that they have indicated," he said.
For now, JPMorgan's strong reputation, huge deposit base and limited reliance on short-term cash have kept a lid on three-month interbank borrowing costs, which fell Monday.
But there were signs of rising stress elsewhere.
The risk premium on U.S. interest rate swaps over Treasuries, to hedge their interest rate risk, flirted with its highest level since early January at 39 basis points.
Front-month Eurodollar futures fell 1.5 basis points to 5.00 basis points on the day with the December 2013 contract falling to its lowest level in about five weeks. Analysts said this reflects concern that investors may cut back on short-term loans to banks in the future.
The cost to insure JPMorgan's debt in the credit default swap market rose 13 basis points on Monday to 139 basis points, the highest level since January 2. That's up from 110 basis points on Wednesday before JPMorgan announced the loss, according to data by Markit.
That means it would cost $139,000 per year for five years to insure $10 million in debt.
The bank still trades at much lower cost than competitors, with Citigroup trading at 247 basis points, Bank of America at 292 basis points, Goldman Sachs at 313 basis points and Morgan Stanley at 410 basis points, according to Markit data.
Analysts at the TABB Group said the sheer size of JPMorgan's trade all but guaranteed it would end in disaster. That's because the group estimates the average credit default swap trade is around $70 million; JPMorgan had entered into credit derivatives positions estimated to be as large as $100 billion.
"How JPMorgan planned on finding liquidity to unwind its alleged position is a mystery," TABB analyst Will Rhode said in a note.
Investors turned negative on financial services in the second quarter, according to Thomson Reuters Lipper service, which tracks the weekly flow of cash moving in and out of U.S.-domiciled mutual funds and exchange traded funds.
In the first quarter, net inflows reached $2.556 billion, the best quarterly performance since the fourth quarter of 2010. However, there have been net outflows of $1.373 billion since April, with redemptions in five of the last six weeks.