Cliff Notes: JP Morgan Whale Trade

JP Morgan’s has a Central Investment Office (CIO) that manages the overall investment and hedging of the bank. The total assets that they manage is about $360B which is roughly the difference between JPM’s deposits ($1.1 Trillion) and Loans ($720B). The group, of about 40 people, is headed globally by Ina Drew based out of New York. Bruno Iskill who initiated the London Whale Trade reports to Achilles Macris in the London office.
Bruno Iskill initiated a curve trade on the CDX.NA.IG.9 Credit Index. This index represents the CDS spreads of 125 US corporate bonds. This particular Index was chosen because it had the most liquidity since it was initiated in 2007 and a lot of structured products launched in that timeframe had elements of CDX.NA.IG.9 embedded in those deals. The rumored trade initiated approximately in Jan 2011 was:
  1. Selling protection on the 10-year contract of the CDX.NA.IG.9 (that matures in December 2017)
  2. Buying three times the notional amount on the 5-year tenor (that matures in December 2012).
For a visualization of the curve- click here .

The proportions were supposed to be such that the overall trade was CV/DV01 neutral which means that regardless of the movement of the overall credit yields that trade would not have lost money IF the change in spreads happened in the same quantities across the curve (i.e. for both the 5 yr & 10 yr). The trade was supposed to be also “rebalanced regularly” as prices change so that the proportions between the 5yr and 10yr cotinued to be CV/DV01 neutral. The trade could also make money in a somewhat bearish environment if the shorter maturity (5Yr- 2012) CDS spreads moved up more than the longer maturity (10yr-2017) which in effect would have “flattened the curve”. They initiated this curve trade instead of buying the CDS protection outright because it would have been money out of thier pocket and a negative carry trade. The curve trade achieves a short credit bearish view without money out of the pocket.

There were two problems with the trade:
1) JPM recently updated thier risk and VAR models which got the math wrong on the hedge proportions for the 5yr & 10yr contracts that they were supposed to buy & sell.
2) They sold 10 yr protection in such large quantities that they themselves became the market (See this chart for an increase in the market). In effect, that created a skew i.e. a difference in value between the Index and the 125 underlying bonds (see this chart for the skew).

Several credit focused hedge funds such as Blue Mountain Capital, Lucidus Capital Partners, Hutchin Hill and Bluecrest saw the arbitrage opportunities and started exploiting it. However, JPM had such unlimited fire power that the market distortion did not close for a long time. Frustrated by JPM’s power, the hedge funds leaked the story of the “London whale” to Bloomberg to force JPM’s hand.

No original research & reporting. Summarized from the following posts & articles:

  1. The Original Bloomberg Article
  2. Thar she blows!
  3. The curve trade
  4. Shamu in the swimming pool
  5. Too Big To Hedge
  6. What position transparency?




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