By Walter Kurtz, Sober Look

As discussed earlier, we’ve had a substantial divergence between investment grade (IG) and high yield (HY) CDX spreads that started this year. These two indices historically move in tandem. There has been speculation in the market place that the JPMorgan CIO’s activities may be behind this trend. Based on the recent article by Euromoney, that indeed seems to be the case. Euromoney indicates that not only was JPMorgan selling IG CDX protection, it was buying HY CDX protection causing the two to diverge. Effectively JPM was long investment grade credit and short HY credit.

Euromoney: – It is clear that JPMorgan’s CIO sold substantial amounts of investment-grade credit default swap index exposure in the first quarter of the year; market participants maintain that it also bought high-yield default swap protection, with total notional trade sizes running to tens of billions of dollars.

Those trades were unusually large for the credit derivatives market, despite their concentration in indices, which are more liquid than single-name default swaps. The JPMorgan activity helped to fuel the global rally in investment-grade credit spreads in the first quarter and contributed to a widening in the ratio between investment-grade and high-yield spreads, taking the latter to a multiple of roughly six times the former.

This is not necessarily a bad position to hold, except for it’s size. The thinking probably was that if the economy stumbles, HY companies will get hurt first and their spreads will widen much faster than those of IG companies (making the spread between the two to widen). But liquidity in CDS markets has not been great in recent years and these large trades began to move the market earlier in the year – initially helping JPMorgan’s position.

IG vs HY CDX (Bloomberg)


But now that the market participants got a rough idea of what JPMorgan’s exposures are, they started putting on the opposite trades in anticipation of JPMorgan unwinding this book (which may already be taking place). The spread between HY and IG CDX has narrowed substantially since JPM’s announcement last week, causing the firm further pain (remember, JPM needs the spread to widen). The vultures are circling…

Euromoney: – The exact details of the trades put on by the JPMorgan CIO have not been disclosed. JPMorgan is understandably unwilling to shed additional light on its holdings, while its market counterparties such as hedge funds have limited visibility on offsets to individual trades, along with a strong motive to talk their own books by speculating about potential eventual deal unwinds.

And now everyone is asking the same question. JPMorgan had fairly thorough VAR models that should have shown a potential for a large loss on these positions. Why was this risk not flagged?

If you look at the chart above (IG vs. HY spreads), it is clear that the historical relationship (on which VAR models are based) has been broken by these outsize trades. Once you have a sudden change in correlation, the model needs to be re-calibrated. For spread positions this large and correlation that starts out close to one (which masks risks of large long/short positions), even a small change in correlation will have an enormous impact on the perceived amount of risk.

Illustration of how a spread position between two assets responds to changing correlation


As the mass media begins to pore over the issue of JPMorgan’s VAR models, the reporters will surely miss this one critical point. VAR models generally can not capture liquidity risk. In particular it is difficult to model how outsize trades can impact correlation. Once positions become too large and liquidity declines, even the most effective VAR models break down. And once others learn about your concentrated positions, no risk model stands a chance.


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Sober Look

Sober Look

Sober Look was founded by Walter Kurtz, a New York based hedge fund manager and credit markets specialist.

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  • whatisgoingon

    I’ve seen a few technical analysts note the divergence of the strong high yield bonds and weak stocks to be bullish for stocks.

  • Kobayachi

    Great post. The main question most investors have still remains though… why did JPM book this loss? (as opposed to why they didn’t push it off balance sheet as it so often happens or use some accounting trick to hide it)
    Do they expect more and bigger losses in the near future?

  • Andrea Malagoli

    It is time to drop the pseudo-scientific ‘quant’ approach and to re-instate the good-old-fashioned ‘common sense’ approach. Quantitative methods are a sophisticated way to predict the past, and often provide reassuring signals just before everything collapses.

    To think that the financial risk can be controlled in a scientific-looking way is an illusion perpetrated by many interested parties, including academic institutions affected by physics envy.

  • Johnny Evers


  • VII

    Don’t hate the players.
    The Fed and Policymakers in their hopes to get the economy lifted altered the rules and saved the banks. Right?
    Thus the only VAR model they were looking at is…take the risk. If they win they reap huge bonuses. If they don’t…they leave with a package and get fired? Moving on to KKR or whom ever. What better VAR analysis high probability does one need.
    They are not YOU or I they are different. The rules have been set to protect the banks. What does it matter if they lose share holder money? The reward is too high not to take the risk. Further let me play this out.
    Hmmm..I can take this risk and reap a 50m-100m bonus and if I don’t take this risk..I get fired. The money is not mine. The Fed will backstop any losses we take and too many policymakers are connected to ensuring a recover…no matter what. Should things get ugly…my long arms will drag many of my critics under the bus with me. They could pay me to keep quiet should I blow this trade up.
    …yep…nothing has changed. Hate the gamemakers…not the players.
    You want change…let those who should have failed fail! Dr. Hussman had this point made a long time ago. It’s too bad the regulators and Fed opted for the easy fix. If this wasn’t real..I’d think this whole 2009-2011 recover was a dateline bear trap.

  • Anonymous

    Sounds like the VAR model used in the first quarter was used to hide risk. They have since reverted to the old model. For accountability,I wonder who signed off on the new model??? Seems like a major decision.

    Quote from the Bloomberg article:

    JPMorgan also changed how it calculates so-called value at risk, or VAR, a measure of how much the company estimates it could lose on securities on 95 percent of days. The company restated its VAR for the first quarter, previously disclosed at $67 million, at $129 million. The bank used a new model for calculating its trading risk in the first quarter that Dimon said was “inadequate.” It is reverting to the old model.

  • AWF

    If the article is “Fact”
    It means JPM believes the economy is going in recession
    JD says JPM is going to hold

  • Mountaineer

    This is excellent.

  • JDM

    The trade is clearly not a hedge, but a bet on weaker borrowers caving while stronger ones remain. That is a mild recession.

    Given JPM’s dominance of the derivatives markets, I wonder what other “hedges” they have on — for example, those related to precious metals and miners, etc… Markets have been very odd in all of these.

  • Mr. Market

    Too much conspiracy thinking over here. I think the following happened. JPM took out these specific long & short positions. And as a result the divergence emerged. Other traders noticed this divergence and took out precisely opposite positions, reversing JPM’s profits and turned them into losses. Did they take on leverage to make these trades ?