Shares of JPMorgan Chase (JPM) rose nearly 5% Tuesday, a welcome rally as the stock has fallen over 20% since May 1. By now, the general public is well aware that the firm lost over $2 billion dollars on a 'hedge' gone bad in its CIO unit. However, by virtue of its complexity, the trade at the heart of the controversy is still not very well understood by most. The public's ignorance regarding exactly what happened in London (where the drama that is the Bruno Iksil trade took place), could very well cause some investors to believe that, after the recent sell-off, shares of JPMorgan are a bargain. In fact, speculating on the stock can be likened to trying to catch the proverbial falling knife, as even a basic understanding of what happened is quite enough to indicate the extent to which the situation could harm the firm
First it is critical to understand what exactly was being traded. The Markit CDX NA IG Series 9 index is an obscure portfolio of credit default swaps "tied to the credit quality of over a hundred North American investment grade bond issuers...including such names as Kraft Foods and Wal-Mart Stores." (KFT, WMT) Iksil was selling protection on this index. In and of itself, this was a bullish bet--the seller of protection is essentially betting the index's constituents will not default, as a 'credit event' would trigger a payment from the seller to the buyer of the protection.
The reason for selling the protection: JPM had overhedged its exposure to the corporate debt it owned--in other words, in order to right its Value at Risk, the firm set out to hedge its hedges by selling protection on IG.9. This was a bullish bet on credit designed to offset the firm's purchase of CDX (senior) tranche. The CDX tranche purchase was the firm's way of protecting itself against rapidly rising systemic risk (from the European debt crisis) which, in extreme cases, can cause 'correlation' to rise sharply, sinking the senior parts of a credit portfolio, an event which would cause the CDX to pay off, mitigating the losses suffered from a wave of defaults. Here is the critical part of the story: when the ECB implemented the LTRO in December, it effectively removed systemic risk from the system, thereby causing the aforementioned 'correlation' to plummet, and forcing Iksil to sell massive amounts of protection on the IG.9 to maintain the model's risk neutrality.
The amount of protection he sold (the size of his long position) caused the market to become disconnected from its fundamentals, a state of affairs several hedge funds sought to exploit to no avail (Iksil's willingness to sell unlimited amounts of protection meant the discrepancy simply would not disappear). When the hedge funds complained, the veil was lifted, and JPMorgan was exposed as the one on the other side of the trade.
Due to the stubborn rally in credit and equity markets during the first half of the year, Iksil found himself increasingly 'long' as he was forced to sell more and more protection. When reality kicked in last month and fears began to resurface about Europe and stocks began to stumble, the trade began to reverse itself and a nightmare scenario unfolded: Iksil found himself in the unenviable position of being the biggest long player in a market that was finally behaving the way it should have back in December before the LTRO. That is, last fall, the CIO office had an entirely sensible CDX tranche hedge in place designed to profit from rising systemic risk. The ECB crushed systemic risk, blew up Iksil's model causing him to take a bigger and bigger long position in the IG.9, then, when systemic risk finally returned, Iksil found himself on the opposite side of the trade from where he set out to be in November: he is the biggest long in a market he desperately wants to be short. From ZeroHedge:
"The key factor is that if systemic risk had remained in even a 'normal' range of possible regions based on history, then the JPM CIO office would have had no need to over-hedge their tail-risk hedge position, no greed-driven need to press the momentum, and no need for such an epic collapse as we are seeing now."
Prospective investors in shares of JPMorgan should ask themselves the following two questions: 1) How much of the position has been unwound and, relatedly, how much is it going to cost to unwind the entire trade in an illiquid market, and 2) Assuming the entire trade is not unwound, do you really want to be long JPMorgan when their CIO is (accidentally) betting that systemic risk will not rise?
Perhaps more frightening than not knowing how much of the trade has been unwound since it began to move against the firm, is not knowing what kind of losses JPM has incurred on the parts of the trade it has unwound. Additionally, if things in Europe get worse and systemic risk rises quicker than the firm can unwind the long leg of the trade, losses could mount quickly. Also, if the firm insists on not selling at fire sale prices, the drama could drag on for several quarters--a dark cloud I would not want hovering over a stock in my portfolio.
Investors do have at least one clue as to how bad things could potentially get. JPM suspended its stock buyback program Monday, an ominous sign given that the NY Fed estimated that the amount of securities/trading/counterparty losses that would need to be incurred to make the buyback program a threat to the firm's capital structure was $31.5 billion.
With no clarity as to exactly how big the losses on JPM's 'hedging mistake' could be, investors would do well to avoid JPM shares for the time being. Additionally, if you own the shares currently and you suspect systemic risk may rise as events in Europe bring about more uncertainty, you should keep in mind that JPM's CIO position might still be net-long (i.e. you might consider selling the shares on any strength). Another way to play is to buy puts on JPM when the stock pops on supposedly 'oversold' conditions.
Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in JPM over the next 72 hours.