JP Morgan gives hedging a black eye

by Wayne Ferbert on May 16th, 2012

JP Morgan’s loss last week of $2 billion was reported by the company to have occurred in an account used for hedging. That is quite a loss in a short time frame for an account that was supposed to be the hedging vehicle. Seems unlikely, even.

So, what do we make of it? JP Morgan has promised more information at the end of the quarter on the trade. But the Wall Street Journal is reporting some details on the three legs of the trade that caused the loss.

The first leg was a protective position. It was a derivative that would have paid off if the index it was based on went lower. The index was a high yield corporate bond index. Given JP Morgan’s rather large exposure to corporate bonds, such a position would make a lot of sense as a hedge. The Buy & Hedge investor should recognize this – it would look like a married put. You would own the underlying (ie, the high yield corporate bonds) and then have protection on the index (ie, the put). Together, they create a married put.

If JP Morgan had just stopped there, they would certainly have been in a traditional hedged position. But they didn’t stop there.

The second leg of the trade, according to the Wall Street Journal, was a position in which they SOLD protection on another bond index. This index was for investment grade corporate bonds. The protection they sold to others were in the form of credit default swaps (CDS). These are protection from default. But in this case, since it was sold on an index, it really is like selling protection to someone else that guarantees that the index won’t drop. That is effectively the same as being bullish the investment grade bonds. In fact, typically for selling the CDS, the seller would collect the interest on the bonds as the on-going payment for the CDS protection. That trade was set to expire in 2017.

So, JP Morgan for the CDS that it sold, created a bullish position on Investment grade corporate bonds. So, let’s recap: JP Morgan owned high yield bonds. Check. They bought protection for those bonds. Check. They then complicated matters by selling the CDS protection on investment grade bonds. Check???

At this point, they are bullish high yield bonds. And they have a spread trade of long investment grade bonds and short high yield bonds. Now, it is starting to look like they made a bet – not a hedge.

Then came the third leg of the trade. They bought protection for the investment grade bonds – but the protection expired at the end of 2012. But indications are that they mixed different indexes in trying to build this last position. In other words, it may not have been a perfect hedge for the investment grade position. After all, if it was, then JP Morgan would have had two nicely hedged positions: A married put on its High Yield Bond portfolio AND a market neutral investment grade hedge that was neutral thru 2012 and biased long from 2013-2017.

But since the indexes they used to hedge did not correlate as well as they had hoped to the investment it was meant to hedge, the investments did not act as expected. It all seems very confusing – but in the end it seems as if JP Morgan was timing its bets based on market moves, it was reactionary to short-term market swings, and they were using indexes that were not perfectly correlated. The result: a big black eye.

The lesson for Buy & Hedge investors: don’t time the market. Don’t time your hedges. Make sure your hedges are well correlated with the underlying investments. And if they aren’t well correlated, monitor it very closely as you might have to make a quick exit after a brutal loss!



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