I’m almost obligated to get into this affair with Dimon & Co. However, I promise you I’ll save you the self-righteous lectures, which are so well versed and recorded at this point to fill a small history book or ten.
It’s not that I don’t agree with much of what’s being said. Or that I have anything against those of you who are saying it. More that, since you are all so on top of this, I don’t have to be.
Instead, let’s talk about something a little more practical.
Dimon mentioned that they have a $2 billion loss, presumably unrealized, over a 6 week period. We know that the position is composed largely of derivatives. So, we have a timeline, and we have a medium. But we are missing a quantity. That’s unfortunate, as it would be let us know how deep JPM is, and what they need to do or have happen in order to unwind it.
But hey, let’s just guess.
What do we know happened about 6 weeks ago? Well, looking at yields of major bonds, that was about when both Italian and Spanish 10 years reversed hard off their, up until then, descent from the ECB LTRO operation. We also know that buying those bonds, betting on further depressed yields was a VERY popular trade amongst the financier elite. Look at Corzine – who has deep ties to Dimon.
In fact, JPM was clearing Corzine’s trades in the MFGlobal affair, if I recall, so some of this position could even be a legacy. That would be fascinating. But that is WILD speculation on my part, so let’s get back on track…
It seems reasonable to guess that the culprit of this blow up is European debt. It was a popular target. The timeline’s right. So, assuming it is EU debt (specifically Spanish and Italian bonds), what does that tell us?
Well, Italian 10 years are currently trading up 50 basis points. Spanish 10 years are trading up 100 basis points. .5% and 1% – those are our defining numbers.
Rather than trying to blend them, let’s just assume that the entire position was either all Spanish 10 years, or all Italian 10 years, with the truth being somewhere in the middle.
Now, I know from looking them up that CDS coverage on an Italian 10 year will run you about $450 to insure a $10,000 notional bond. That’s a 1% profit spread for the bond holder. And I know that CDS coverage on a Spanish 10 year will run you about $500 – again a 1% profit spread for the bond holder.
So, if JPM had a prop position in Italian or Spanish CDS betting bonds were going to swing the other way, how big would it have to be to generate a $2 billion loss?
Well, for Spanish debt, which have rallied 1%, the move in CDS, assuming that same 1% profit spread for bond holders, would be from about $400 for coverage, to the current $500. That’s a 25% loss on any uncovered position JPM might be holding.
For Italian debt, which have rallied .5%, the move in CDS, assuming that same 1% profit spread for bond holders, would be from about $400 to $450. That’s a 12.5% loss on any uncovered position.
Now, in order to actually determine the size of the position, remember that their loss will be equal to the amount they’re losing on the mark-to-market aspect of the position, minus any positive carry trade they get up front for the CDS. The quickest way to do this is a solver method. I’m not going to bore you. I did it on the side.
For Spanish debt, the position would only have to be about $9.5 billion to generate these size losses. But, for Italian debt, the position would have to be much bigger – probably $23-24 billion in CDS.
So, I feel I can say pretty confidently that JPM has a $10-25 billion uncovered position in CDS, betting on better yields for EU bonds.
Now, JPM probably doesn’t feel very comfortable right now. Between the limited number of sizable buyers of CDS and the idiotic moves that EU countries have been making to restrict the rights of CDS holders, plus the fact that everyone knows JPM has this big position, the odds that they manage to unwind this thing at current prices are nil.
So Dimon says he’s going to offset the losses (which could still grow significantly, especially if EU bonds keep getting hit) by realizing some $1billion or so gains from equity markets.
Well, markets (were) up 10% in the first quarter of this year. So if Dimon thinks he has $1 billion in gains, just swinging with a wide guess here, that’s about $10 billion in assets he thinks he’s going to be able to sell.
To put things into perspective, if Dimon somehow managed to get on the sell side of 1 out of every 2 trades of a still very liquid stock like AAPL, it would still take him more than three days and 18 million shares to offset things. Assuming he somehow didn’t also collapse the market, which over a 3 day period he most certainly would.
Should Dimon manage to sell 1 in 10 shares of average trades in AAPL, keeping with our little game, it would take him more than 2 weeks to offset this.
And, being more reasonable still, if Dimon can only sell 1 in 100 shares of the average trade volumes of AAPL without risking collapsing that particular market, then it would take him over 4 months, in terms of AAPL, to cover his ass on this.
And if things get worse for JPM, with current estimates the losses could get as high as $4 billion, then naturally JPM would have to unload even greater equity positions to offset that. The total amount of assets they would need to sell, (and there by the expected reasonable time line for doing so), could triple, or even quadruple.
I know that $10 billion, $20 billion, or even $40 billion does not sound like that much in this day of trillion dollar bailouts that we live in. However, each of these is equivalent to a fairly large hedge fund entering a full-blown margin liquidation.
So, in summary, I would guess there’s going to be a powerful put over this market for at least a few months. Firstly because they will definitely have to be selling stock directly, which will lead to lots of momentum stocks like AAPL breaking down and lots of future setups that traders favor getting disappointed as “the JPM put” is in effect.
And secondly because, from the standpoint of the CDS, there are only two ways for JPM to get out – they can buy back the CDS directly, or they can go short the corresponding bonds to close the position. Well, $10-25 billion in CDS would be covering $200-600 billion in euro bonds, wouldn’t it?
Even if JPM only tries to close out a tenth of that, that’s still between 2-6 weeks worth of funding for a Spain or an Italy. They’re having enough time trying to sell their own debt directly; imagine having to compete with short sales by JPM?
So, what I’m saying here is this. This is not an LTCM “holy hell, we just destroyed the world with $1 trillion notional exposure” kind of event. But it is serious, and it does come at a most inopportune time. Particularly should equity markets begin to sell off, JPM might actually start to sink European bond auctions scrambling to save itself. This could at worst spark the next LTRO round, or on a lesser level the need for a $50 billion or so injection from the ECB.
6 Responses to Let’s Talk JPM’s Position Sizes, Coverage Options And “Offsetting Gains”
Great stuff Cain.
I don’t know enough about corporate governance to answer this question myself, but what are the chances that some of this 15 billion dollar buyback can be temporarily re-directed towards this problem?
When a company declares a buyback do they have to specify where that cash is coming from? They have 12 billion authorized up until the end of the year, so I assume some of that must already be sitting in cash and cash equivalents. Dimon wouldn’t be able to admit using such a method without sinking the share price, but I’m wondering if it could buy them some time here to liquidate other assets. Most people are saying they’ll need it all to support their share price, but the alternative of having a put under the entire market could be much worse for them.
Maybe I’m way off base here, but like I said, I don’t really know the specifics of how this all works.
I thought this was related to that stupid “London Whale” story from a few weeks back. Seems they were selling protection (CDS) on blue-chip bonds in one of the articles I read.
Can you find the article?
The only thing that makes me think it isn’t is that Dimon described being up at one point, then down a bunch starting 6 weeks ago.
Just everything about this makes me think “EU bonds”.
I found it. CDX.NA.IG.9 CDS Index.
It could certainly be; the timing looks right, with the index rolling over right about the same time that Dimon reported the losses.
Here’s the thing; no one has confirmed what the trade that blew up actually was, so this is just another theory.
Both the ig9 index and Italian/Spanish bonds seem to have inflected at around the same time, so difficult to say until the official disclosure comes out.
I’m not very familiar with the CDS indexes; I just learned about this today.
Well my theory’s been blown to shit. Too bad. I am shocked this is unrelated to direct exposure to EU sovereigns