Huge swings in CDS positions as JPM stems 'Whale' losses

Aug 22 (IFR) - JP Morgan unwound billions of dollars worth of credit default swap positions in the second quarter of the year in an effort to manage a damaging trading blunder at the bank's chief investment office that has already inflicted losses of US$5.8bn and spurred a re-organisation of the bank's senior management.

Winding down the bungled strategy put in place by a trader dubbed the "London Whale" caused JP Morgan to move from being a net seller of US$148bn of credit protection at the end of March to US$12bn at the end of June, according to official data from the US Federal Reserve.

There was a concerted effort to cut risk in investment-grade CDS, with the bank halving its net short position from US$84bn to US$40bn. Despite this dramatic cut, though, JP Morgan remains a notable outlier among its Wall Street peers in being heavily short investment-grade credit protection. Other major US banks hold an average of US$50bn of protection in expectation of the rocky market environment persisting.

The most striking change to JP Morgan's positioning was a significant U-turn in high-yield CDS, which wasn't thought to make up a large part of the Whale trade. The bank switched from being a net seller of US$65bn of high-yield credit protection in Q1 to owning US$28bn of protection by the end of June.

The huge swings in the bank's CDS positions give an idea of the drastic measures needed to stem losses from the Whale trade, which JP Morgan chief executive Jamie Dimon admitted could reach US$7.5bn based on extreme scenarios.

The CIO's short position in investment-grade credit protection had leapt eightfold to US$84bn during the first quarter as the Whale trade was put on. A curve-flattener formed the centrepiece of the strategy, which caused JP Morgan's holding of IG credit protection with a maturity of one year or less to balloon to US$54bn at the end of Q1 from US$3.6bn six months before. The amount of protection it sold over five years in tenor jumped fivefold to US$102bn.

The Fed data show the bank has made significant progress in reversing both positions, with its long position in short-dated protection falling 59% back to US$22bn and its short position in long-dated protection dropping 30% to US$71bn. JP Morgan also became a net holder of IG protection between one and five years in maturity to the tune of US$8.7bn, having previously been a net seller of US$36bn.

Traders say the CIO activity has created huge distortions in even the most liquid credit indices over the past few months as JP Morgan removed 70% of the basis risk between European and US indices and dampened sensitivity to moves in credit spreads from US$51m per basis point in April to US$7m in July.

Demand for iTraxx Main index shot through the roof, while the basis between Markit's CDX IG index and the off-the-run Series 9 - which the CIO held a large position in - more than doubled from late March to early June

REVENUES HIT

The Fed data also illustrate how the eye-watering losses are weighing on the firm's usually robust credit trading revenues. JP Morgan's credit market-making operation is widely recognised as one of the best on the Street, raking in average revenues of US$3bn per quarter over 2010 and 2011, with a high of US$4.1bn in the third quarter of 2010.

By contrast, the Fed filing shows that the US bank had negative trading revenues from credit exposures of US$984m in Q1 and US$4.6bn in Q2. Traders at rival firms say the wider macroeconomic environment, including ongoing tensions in the eurozone, would have made unwinding the Whale trade particularly expensive.

Dimon announced in the bank's Q2 earnings call that a residual delta-hedged tranche portfolio with risk-weighted assets of more than US$30bn would be moved to the investment bank, while the CIO would maintain a short position in liquid credit indices with a notional of US$11bn to hedge available-for-sale securities held in the unit.

The data cited in this article come from financial reports that US banks are obliged to submit to the US Federal Reserve on a quarterly basis. A JP Morgan spokesman declined to comment.

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