DealBreaker, Matt Levine, You Say “Voldemort” Like That’s A Bad Thing, here. Levine plays who’s the narc:
What is going on here? Like, for one thing: who narc’ed on him? And why? The most sensible account as always comes from Lisa Pollack; her take is basically that (1) a bunch of hedge funds are betting that the skew between spreads on the individual names in the CDX.IG.NA.9 (which names they are long) and spreads on the actual index (which they are short) will converge, (2) Iksil recently got massively long the index, blowing out that skew and losing them money on a mark-to-market basis, and (3) the hedge funds are mad and sad and going to the press to embarrass and/or regulate JPMorgan out of this market? This seems fine except that except it’s hard to see the hedge funds making money on an actual skew trade; Markit shows a -12bps skew and my sense is that after bid/ask you just can’t make a living on 12bps of convergence.
There’s a part of me that wants the narc to be JPMorgan itself, calling attention to its brilliant risk management, spooky nicknames, and ability to move markets with one flick of a London-based Frenchman. Also perhaps to provide a platform for its anti-regulatory case.
Levine seems to get a handle on the moment and the Lisa Pollack reference seems valuable long term.
But realistically, the press has been bad, with Bloomberg going so far as to say “Neither Iksil nor JPMorgan have been accused of wrongdoing,” which, ouch! So maybe it’s other banks, jealous of how good JPMorgan’s hedging is, calling attention to the Very Important Issue of how un-Volckery and maybe-market-manipulative it is?
If so I feel like they’re … doing kind of a weak job? I will be surprised if anyone gets worked up about the market manipulation angle given that (1) the losers are eeeeevil hedge funds and (2) it’s having a fairly small effect on the market for one off-the-run CDX index. And for the Volcker Rule angle … I am serenely untroubled by JPMorgan risking $100bn on US investment grade credit, and everyone else is similarly untroubled given that there’s no real evidence that this trade (arguably a hedge, arguably long-term, etc.) would actually violate the Volcker Rule. Regardless of how you get there, though, if your model of bank regulation prohibits JPMorgan from risking $100bn on diversifid US investment grade credit, your model is wrong.
If I were writing the anti-JPMorgan PR campaign here I might come at it differently. If you take these reports at face value – and you can’t entirely; I don’t believe that JPM is long all this credit risk unhedged and neither does anyone who talked to the Journal or Bloomberg – then JPMorgan has invested $100bn of its huuuuge but finite balance sheet in US corporate credit via this trade. Unlike its loans, this extension of credit is unfunded, but still – JPMorgan is not exactly short of cash, as they’d be the first to tell you, and they can always get more if they need it. So it’s reasonable to think that JPMorgan’s ability to extend credit is finite and that is due to capital, not funding. But that $100bn of credit risk has been extended not to the 121 actual businesses in the CDX.IG.NA.9 index, many of whom probably also have too much cash but some of whom could presumably use the money to like Build A Factory or Hire Some Workers or Buy An Instagram or whatever. Instead it’s being extended to … well, indirectly, to eeeeevil hedge funds who are short the credits and churlish enough to complain about it to the press. If you’re a regulator or politician whose complaint about banks is that they aren’t doing enough lending to support the real economy, news that 5% of JPMorgan’s balance sheet is in the form of synthetic corporate lending that doesn’t actually go to those corporates might be enough to get you mad.
Trading environment seems a little more toxic than usual. Levine gives it all a gritty early 70s Popeye Doyle, French Connection feel.
Ft.com/alphaville, Lisa Pollack, Hedge funds and the Whale, credit index edition, here. Lisa Pollack is publishing this reasonably early, 6 Apr. Look at the charts in “A graphical investigation” toward the end of the piece to get some sense of how the IG9 market has moved and on what volumes.
Zerohedge, Behind ‘The Iksil Trade’ – IG9 Tranches Explained, here.
So what was once a 3%-7% tranche is now roughly a 2.4% – 6.4% tranche.
So if you sell protection on this tranche, you need further cumulative defaults of 2.4% before you make any payments, and then you make payments until 6.4% of the notional has had losses. If there is a 0% recovery on each default, you could have 3 defaults before having to make any payment (each name is 1/125 or 0.8%). If recovery was 40% then you have no payments until the 6th default.
The big question is, what do you get paid on this tranche? 20 points up-front and 500 bps running. So if you sell $1 billion of this tranche, you receive $200 million up front and $50 million per annum. In a relatively tight credit spread environment, this is a lot of money. If you use the upfront payment to “defease” losses, the $1 billion of exposure has a maximum loss of $800 million, and would require 4 defaults at 0% recovery before actually having a loss, and more realistically, would only take a loss on the 8th default with a 40% recovery. Suddenly the trade seems less scary, as least to me.
But how do people come up with a number of a “100 billion”? That comes down to “deltas”. The delta on this tranche is about 7.5 times. So if someone wanted to take this risk, without delta (just sell the tranche and not have a “correlation” bet), every $1 billion would create $7.5 billion of index trading.
You could sell this “no delta” and the buyer would pay you for the tranche, but then have to go and sell 7.5 times that amount of index out to the market so they could manage their “correlation” risk – a giant model based book. Some dealers are very good at tranches, but are weak at trading the underlying index. In those cases, you might sell the tranche “with delta” and sell the index position yourself because you can get better execution that way. So you sell the tranche and buy 7.5 times the index from the correlation desk (the with delta trade). Then you sell the straight index into the market. It would explain why you are seen as a seller of index when the real trade is actually being a seller of the tranche.
Morgan Stanley, 2012 Handbook of Credit Derivatives and Structured Credit Strategies, here. 250+ page doc on credit derivatives via Levine at DealBreaker. I’ll take a look at it today.
Ft.com/alphaville, Lisa Pollack, The mystery of Morgan Stanley’s footnote unravels Part 1, here. Part 2, here. MS reduced exposure to Italy by $3.4bn while benefiting from a positive hit to net revenue of $600m. How did that work? Alternative Termination Event clauses – just like they teach in the CVA courses.