Boaz Weinstein stepped up to the microphone.
The former Deutsche Bank trader – now a hedge fund manager and one of the world’s most prominent credit investors – was about to reveal his big investment idea to an audience that had paid as much as $1,500 a head to hear from him.
And he was doing it in JPMorgan Chase’s Madison Avenue office.
“Buy CDX.NA.IG.9,” Mr Weinstein said at the charity investment conference in February. It could be bought at a “very good discount”, he explained.
It was perhaps the first time some of the investors had heard of the IG.9 – an index comprised of derivatives called “credit default swaps” linked to the credit quality of more than a hundred investment-grade companies in North America.
It would certainly not be the last.
Mr Weinstein is believed to be among the first to notice disturbing oddities in the way the index was trading. Last week, three months after Mr Weinstein’s tip, the IG.9 has become the unlikely talk of Wall Street after JPMorgan revealed a shock $2bn loss believed to stem from its outsized trading of the derivatives index.
The bank has kept details of its trading activity tightly under wraps, but hedge funds have developed their own theories. The positions were taken within a little-understood fiefdom of the bank, the chief investment office.
Run by Ina Drew, one of the most powerful women on Wall Street, the CIO was often ignored because it looked dull compared with the racy world of trading in the investment bank. It was charged with hedging the vast amounts of credit exposure arising from the bank’s daily business and managing its “excess deposits”.
Now the division was about to become infamous.
In mid-2011, with no end in sight to the eurozone crisis, as well as simmering concerns about the US economy, the CIO began looking at a big way to hedge JPMorgan’s overall credit risk and existing trading positions.
Two problems faced the bank. First, simply shorting credit was an expensive affair: JPMorgan was not the only institution with concerns about the future. And second, market volatility promised to make any directional position – short or long – punishing in the short term.
The trades the CIO embarked on, it hoped, would overcome both problems.
Consistent with the view that credit was due a correction, CIO traders looked to “short” credit indices. Rather than short the indices as a whole, however, they bought credit protection on specially constructed baskets of subordinated credits known as tranches, say people familiar with the supposed trade.
Buying such protection was expensive and prone to volatility. So for the second part of the trade, JPMorgan hedged by selling protection on the IG.9 as a whole.
Because of the mechanics of the trade, in order to achieve a “market neutral” position, whereby JPMorgan hedged the bet against volatility as best it could and offset the cost of its short positions, the bank had to sell far more units of cheap protection on the IG.9 as a whole than it bought on short, more expensive tranches.
Taken as a whole, the trade would pay off if a credit market correction damaged some investment-grade companies but was not so severe to dramatically impact them all.
For a while, the trade worked well. In the second half of 2011, investment-grade companies such as American Airlines went into bankruptcy, benefiting the short legs of the JPMorgan trades, specifically designed to profit from idiosyncratic failures.
But then in December, the European Central Bank unleashed a tidal wave of liquidity into markets, triggering what some analysts called the “mother of all credit rallies”.
The two legs of JPMorgan’s trade did not move according to the relationship the bank had expected, meaning the position became imperfectly hedged. Like many credit models before it, JPMorgan appeared to misjudge correlation – one of the hardest market phenomena to accurately capture in mathematics.
In order to try and stay risk neutral, the dynamic hedge required even more long protection to be sold. The bank continued to write swaps on the IG.9, causing a pricing distortion that was spotted by more and more hedge funds seeking profit.
Hedge funds such as BlueCrest Capital, BlueMountain, Lucidus and CQS tried to arbitrage the discrepancy, but to their frustration, it would not disappear.
Someone was willing – and able – to continue selling protection on the IG.9, they realised. By the start of 2012 it was clear that there was a gargantuan opponent willing to sell them protection at what looked like uneconomic levels.
“For the last nine months the main reason to not buy something for 72 cents that was really worth a dollar was the idea that there was this guy with infinite capacity on the other side [of the trade],” lamented one prominent hedge fund manager.
Fingers were quickly pointed at JPMorgan and in early April the funds squealed.
In articles in Bloomberg and the Wall Street Journal, anonymous fund managers complained of the massive positions JPMorgan was taking in the derivatives market. They pinpointed Bruno Iksil, a French trader in JPMorgan’s CIO office in London, as the mastermind behind the trades. He was dubbed “the London whale” for his colossal clout in the market.
A few days later on an earnings conference call with analysts, Jamie Dimon, the bank’s chief executive, dismissed the stories as a “complete tempest in a teapot”.
It was not an offhand remark. In JPMorgan’s New York offices, executives had discussed the whale stories with Ms Drew. The CIO boss briefed the operating committee in early April that there was nothing out of the normal and the situation was under control, according to people familiar with those conversations.
But the trade was growing more unwieldy as credit markets took a turn for the worse in April, hedge funds say. With the size of JPMorgan’s long leg continuing to build, it eventually overwhelmed the market. The legs of the trade could no longer be balanced.
The bank soon parachuted in top risk managers from its investment bank, to help evaluate the trade and the models and assumptions underpinning it: what they discovered forced an embarrassing about-face.
Last week Mr Dimon revealed the $2bn mark-to-market loss and said that a key risk management model in the CIO had been “inadequate.”
Even now, the magnitude of JPMorgan’s loss remains something of a mystery to hedge funds. There are rumours that Mr Iksil’s positions may be masking other losses elsewhere within the CIO.
Meanwhile, the hedge that went spectacularly wrong has become something of an epic tale for hedge fund managers. One said: “It wasn’t just a giant whale, it was the size of the Atlantic Ocean.”
With additional reporting by Tom Braithwaite, Telis Demos and Ajay Makan in New York.
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