--Additional Losses Possible As J.P. Morgan seeks exit from complex derivatives trade
--CEO Dimon pegs downside at $1 billion, but analysts say cost could go higher
--Bank's outsize stake in market is key issue
By Christian Berthelsen Of DOW JONES NEWSWIRES
NEW YORK (Dow Jones)--J.P. Morgan Chase & Co. (JPM) stunned Wall Street late Thursday, admitting it suffered $2 billion in losses in just six weeks stemming from large, opaque and complicated derivatives trades put on by a little-known unit within the bank.
Now comes the hard part: unwinding the volatile position without incurring additional extraordinary damage.
J.P. Morgan chief executive James Dimon said during a conference call with analysts that the bank could suffer an additional $1 billion in losses as it tries to exit the trade.
But he cautioned it could be more. Asked if that was his maximum loss estimate, he simply said: "No," adding that volatility would be high and could last through the current quarter and next quarter. Oppenheimer said in a note that it estimates the losses could double to $4 billion by the end of the second quarter alone.
The trades were made by the bank's Chief Investment Office, which is tasked with investing surplus assets to hedge against the risks of rising inflation and interest rates. Though all large banks have such a function in one form or another, they say in financial filings that their holdings are concentrated in low-risk, low-return assets such as Treasurys, government-backed mortgages and corporate and municipal bonds.
A central issue is the size of J.P. Morgan's position: It reportedly sold as much as $100 billion in notional value of credit default swaps on an index that tracks North American corporate debt, according to The Wall Street Journal and other media outlets.
The trade amounted to a bullish bet on the health of corporate America, by selling insurance that would pay out in the event of a default or other credit event by companies included in the index.
But the total amount invested in CDS on the index is just under $150 billion, according to data from the Depository Trust & Clearing Corp., meaning J.P. Morgan's trades make up about one-third to two-thirds of the market. On top of that, according to research from TABB Group, the size of the average trade in index credit swaps is $70 million, with the biggest being $500 million.
"The mystery," TABB Group said, is "how J.P. Morgan planned on finding counterparties and the liquidity to unwind its alleged position."
Research firm CreditSights seconded that, saying: "This position could be difficult to exit in an orderly fashion given its potentially large size in relation to the overall specific market and the potential need to reverse it for some reason in quick fashion."
Dimon said the bank would not engage in a fire sale that would flood the market and drive down the value of its holdings. "We're not going to do something stupid," he said. "We're willing to hold as long as necessary inventory, and we're willing to bear volatility."
Though the loss was startling, J.P. Morgan said it expects the bank to be profitable nonetheless in the second quarter, and that capital levels and other cushions would absorb the blow. The bank booked $5.2 billion in profits in the first quarter, $19 billion last year and holds $190 billion in shareholder equity.
Still, much remains unclear about the size of the position, the precise nature of the investment and the bigger picture into which it fits.
Dimon described the trade as a hedge against the firm's overall credit exposure. But as it was essentially a bet in favor of corporate credit, which it already does through lending, analysts questioned whether it amounted to a doubling down rather than a protection against risk.
CreditSights noted the value of investments on the credit index, Markit's CDX North America Investment Grade Series 9, increased $58 billion from the beginning of the year to $148 billion in early April, and questioned how the moves in the index could have led to such losses. "While prices did increase noticeably in early April, there is little indication of a major market reversal which could have led to such large positional losses," the firm said.
Two analysts questioned whether the purpose of the trade was truly a hedge or a directional bet designed to profit. While offering little detail, Dimon said the trade was intended to hedge but that "it morphed over time and the new strategy which was meant to reduce the hedge overall made it more complex, more risky and it was unbelievably ineffective."
-By Christian Berthelsen, Dow Jones Newswires; 212-416-2381; christian.berthelsen@dowjones.com.
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