A Message To JPMorgan Shareholders: The Whale Trade Has Probably Not Been Unwound

| About: JPMorgan Chase (JPM)

In the unscheduled conference call held to disclose the massive trading loss at its CIO desk in London, a noticeably perturbed Jamie Dimon said the following about the firm's plans to manage the position responsible for the loss:

"The Firm is currently repositioning CIO's synthetic credit portfolio, which it is doing in conjunction with its assessment of the Firm's overall credit exposure. As this repositioning is being effected in a manner designed to maximize economic value, CIO may hold certain of its current synthetic credit positions for the longer term."

Now either the public did not understand exactly what that statement was meant to convey or investors simply chose not to believe that Mr. Dimon could possibly be considering holding onto parts of the position, because just a little over a month later, almost no one questioned the validity of a CNBC report which claimed JP Morgan (NYSE:JPM) had unwound two thirds of the losing position. The report (released on June 20) cited no sources but had the following to say in support of the contention that the firm was indeed getting out from under the whale:

"The market [is] very talkative about this this morning. Part of it is that the DTCC released some data within the past day or so showing that there has been a lot of activity around this--I believe it is 31 billion in notional value"

Bloomberg's interpretation of the volume spike in the IG9 on June 18 and 19 mirrored that of CNBC:

"Trading in the credit derivatives index that contributed to JPMorgan Chase & Co. losses in its London chief investment office soared to a record yesterday in a sign that the biggest U.S. bank may be unwinding its position, according to data cited by Credit Suisse Group AG"

The whole story then, is based on extrapolation: a spike in volume must mean the trade is being unwound. What both reports fail to mention is that June 20 is index credit option and single-name CDS expiration. It doesn't take a leap of logic to surmise that the heavy volume was almost certainly attributable to the IMM date. In other words, the hedge funds on the other side of the trade (the funds who bought all the protection JP Morgan was selling presumably as part of a skew trade wherein cheap protection on the IG9 was bought and expensive protection on the index's individual components was sold) all closed-out their positions as the skew hit zero causing the spike in activity which the media attributed to JP Morgan's efforts to unwind its trade. Indeed this was partially confirmed by a report that Boaz Weinstein and Saba Capital had recently exited their position. The drop in IG9 index net notionals then, can quite plausibly be attributed to hedge funds taking profits before the IMM date.

Perhaps the most disconcerting and relevant consideration for JP Morgan shareholders is the fact that 'tranched' IG9 net notionals are little changed this month. Recall that JP Morgan's CIO desk began selling protection on the IG9

"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 fact that tranched IG9 net notionals are little changed seems to indicate that JP Morgan is still holding its original hedge. One way to look at this is that it is a good thing as it theoretically protects the firm from a spike in systemic risk (a so-called 'fat tail' event). Another way to look at it is that the whole ridiculous situation has now come full circle: JP Morgan is right back where it was in November, sitting on a hedge which could easily be blown-up by any event which eliminates systemic risk such as more quantitative easing by the Fed or an LTRO 3 by the ECB.

In short, a close examination of the situation certainly suggests that JP Morgan is still sitting on the 'Whale' bet in one form or another. The idea that the trade is 65-70% unwound is absurd, as it isn't even clear from the reports which part of the trade is being referred to: is the hedge or the hedge of the hedge? If it turns out JP Morgan still has its CDX tranche position, the firm could end up incurring substantial losses should central banks make a big move to reduce systemic risk. Short JPM or long JPM puts.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.