By John Balassi and Melissa Mott
In the end, it might come down to a battle between a whale and the other big fish in the sea.
Reports that a London-based JP Morgan trader dubbed “the whale” has single handedly moved an index of credit default swaps by building a massive $100 billion position appear overdone.
On Tuesday, senior credit traders said they were likely inspired by leaks from hedge funds and other “big fish” fast money accounts, caught on the wrong side of the trade.
The stories said JP Morgan’s Bruno Iksil had sold so much protection on the Series 9 of the Markit CDX North America Investment Grade Index (CDX.IG. NA.9) that the index is now trading rich to its intrinsic value. Investors look at intrinsic value compared to the traded spread of the index to gauge whether an opportunity for an arbitrage exists.
The reports are speculative and do not take all the facts into account. For one, Iksil, who works in the bank’s Chief Investment Office in London, is unlikely to have amassed a net CDS position that is greater than the combined derivative holdings of all but six banks, and equal to about two thirds of JP Morgan’s total market capitalization.
However, if the $100 billion is a gross and not a net notional position, it may be appropriate to hedge the bank’s credit risk exposure or its liquid asset portfolio for risk management purposes.
Equally, since bank loan demand is down, the trade could be an attractive and cheap way for JP Morgan to collect a premium to bolster its net interest margins. CDS buyers pay a premium to sellers to insure their bonds against default.
Series 9, which comprised 125 credits when it started trading in 2007, is significant in its own right given the timeframe in which it was the on-the-run contract. First, some of its original constituents, including Fannie Mae, Freddie Mac, CIT Group and Washington Mutual, eventually defaulted and were not included in the rollover into Series 10. Others that are still constituents are currently trading in distressed territory, including RR Donnelley & Sons, iStar Financial, MBIA and Radian Group.
Then there’s the fact that Series 9 was the “on the run” index heading into the credit crisis, when it was used to hedge synthetic CDOs and tranches. This type of tranche market trading fell apart when Lehman went bankrupt in September 2008, but the index remains the benchmark.
The aggregate CDO market was $338 billion in 2006, according to Thomson Reuters data. Prior to the decline of the CDO market, it was common for desks, such as bespoke desks, to hedge correlation exposure by using standardized index tranches.
Ultimately the index will start to trade towards fair value.
Since JP Morgan’s position has been made publicâ€”accurately or notâ€”it’s unlikely that Iksil will be adding to this trade. Moreover, if he took the position for hedging reasons, he is unlikely to be forced out of it, although other recent longs who jumped in to play the momentum will likely exit their positions.
The absence of a big seller should be enough to push it towards fair value.