How Europe speared JPMorgan's whale
A complex bet on corporate bonds caused big losses for the bank after the eurozone crisis flared up in April.
Stocks were basically flat Friday as the market reacted to Thursday's bombshell announcement from JPMorgan Chase (JPM) that it suffered a $2 billion-plus loss on credit derivative positions taken by a trader in its London office.
This is a complex story, but the main takeaway is this: Wall Street banks are still making risky bets with their own money to compensate for a lack of profitable, traditional banking opportunities. This worked well for most of the year as risky assets moved higher on cheap-cash injections by the world's central banks. But as the eurozone crisis flared up in April, with new worries over Spain and Greece, the trade went wrong. Here's why and what it means.
The trader, identified in the press as Bruno Michel Iksil and dubbed a "whale" by hedge funds that caught the scent of blood months ago and started betting against him, was essentially selling "synthetic" insurance against default on a basket of investment-grade corporate bonds. So as bond prices moved higher, to reflect falling credit and default risks, his trade in "synthetic CDS" moved higher too.
Originally, this was done to hedge other credit market positions held by JPM. But eventually the trade got out of control and became speculative. That's when the hedge funds moved in.
Iksil was dabbling in what's known as the CDX.NA.IG.9 credit index, which is the main synthetic CDS index still trading after that market died down in the wake of the 2008 financial crisis. If you own the index, you get paid when companies within the index default. Alternatively, if you're selling the index, you make money when they don't.
So what went wrong? Details are still murky, but what we do know is that the index jumped in early April as high-yield corporate bonds came under pressure as the market freaked out over new problems in the eurozone -- from the collapse of the Dutch government over austerity measures to Spain's backsliding on closing its budget deficit to the rise of anti-bailout parties in Greece.
You can see this drop in the chart of the iShares High Yield Corporate Bond Fund (HYG) above. Compare this with the chart of Spain's 10-year bond yield below. Both events are saying the same thing: Risk off.
Back to Iksil.
The weakest links in the CDX.NA.IG.9 index include Radian Group (RDN), MBIA (MBI), Sprint (S) and R.R. Donnelley & Sons (RRD). All four stocks had excursions below their lower Bollinger Band in early April (a sign of an extended, persistent and unexpected decline) along with the rest of the market.
Radan's drop was particularly nasty and set off a decline that has taken the stock down nearly 50% from its March high.
I think there are three takeaways from all this. One, bank regulation remains in a sorry state, since a dramatic drop in a single stock put one of America's largest banks in a very bad spot. Two, the Federal Reserve's ultra-low interest rate policy is encouraging dangerously aggressive risk-taking behavior by a financial system desperate to maintain net interest margins in a low-rate environment. And three, this is just one example of why the situation in Europe, and in Greece, matters to the U.S. economy and its financial system.
This is the butterfly effect in action: A decision by politicians in Madrid to ease the tension of an angry electorate suffering 50% youth unemployment results in embarrassing losses for JPM and CEO Jamie Dimon, one of the most vocal critics of tighter regulation, via the synthetic CDS market, an artifact of the Fed-created housing bubble. What a mess.
JPM's misfortune is boosting the Edge Letter Sample Portfolio's short positions against the financial sector. Highlights include a 10.3% gain in Citigroup (C) and a 4% gain in the Direxion 3x Financial Bear (FAZ).
I found both C and FAZ with the help of technical screens developed with Fidelity's Wealth Lab Pro back-testing tools, which you can find here. (Fidelity sponsors the Investor Pro section on MSN Money.)
Check out Anthony's investment advisory service The Edge. A two-week free trial has been extended to MSN Money readers. Click here to sign up. Contact Anthony at firstname.lastname@example.org and follow him on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.
I don't know s--t about economics but my intuition is telling me us little people just got F---ed again somehow. Wall Street and other trading markets should be in hell. The rich get massaged while I get screwed as usual. I don't understand all this crap but somehow I can feel it, as the shaft get a little deeper in my ****. As for all you expert wannabes out there F off. I'm tired of your bulls—t rhetoric.. They will find some way to f us to make up the loss.
Two things are more apparent than ever:
1)Glass-Steagall needs to be reinstated.
Banks must register their charter as either a COMMERCIAL or INVESTMENT bank,they cannot be both as this represents a serious conflict of interest.For 66 years,Glass-Steagall provided the stability necessary to keep the banks from speculating with their own money and prevented the now unfortunate TOO-BIG-TO-FAIL fascist business model and culture.What ever happened to investing in capital goods,materials,equipment,and labor to fuel business/corporate growth to stimulate TANGIBLE,PRODUCTIVE GDP which enriches society?Clearly,speculative asset bubbles will continue to pop and prop trading like this will continue until ALL paper money is a smoldering ash heap.
2)This event is just part and parcel with Wall Street.MF Global,COMEX fraud,0% interest rates, high frequency trading,currency swaps,you name it,all of it is fraud,nothing more.And its exactly why the coming collapse will radically transform life as every American born after WWII has known.
The banking industry is already one of the most regulated industries there is. Look at how it has done over the past 50 years versus the computer industry which is largely unregulated. Government control doesn't work in banking any better than it works in any other industry.
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Stocks are facing some serious resistance as the bears tear into the market's respite.
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