Friday, May 11, 2012


Nice glass frames lady!
What beached the London whale? Credit Indices
By Charles Forelle
Friday, May 11, 2012
J.P. Morgan’s blown trade, and its $2 billion bill, has everyone’s attention. At its core was a bet on an abstruse corner of the credit market. Here’s a quick guide to the credit indices that beached the London Whale.

The Wall Street Journal has reported that the trader, Bruno Iksil, had been placing bets on an index called “CDX.NA.IG.9″–the largest of a panoply of credit indices produced by data provider Markit.

The indices track the prices of credit-default swaps, insurance-like contracts between two parties in which the contract’s seller agrees to pay the buyer if a particular debt issuer defaults. Credit-default swaps are popular because they let investors easily take positions on the changing health of a country or company.
By selling a CDS contract, for instance, an investor profits from the improvement in the credit profile of a company or a country. Buying a bond would accomplish a similar goal, but that exposes the investor to the risk that interest rates will rise, hurting the bond’s value. The CDS is, in a sense, a “purer” bet. It’s also a useful tool for hedging bond portfolios–buying CDS will provide comfort in case an issuer whose bond you’re holding defaults.

Credit indices take these synthetic instruments one step further: They let investors place bets on the health of entire swaths of the economy.

The CDX.NA.IG.9 index comprises CDS values on 121 investment-grade (“IG”) companies in North America (“NA”). It’s the ninth series of this index–every six months, the index is adjusted and a new series is produced. The current series is 18. But No. 9 is the big kahuna. Despite not being current, that series is the most bought and sold of any credit index, according to the Depository Trust & Clearing Corp. DTCC says there is $146 billion in “net notional” exposure on CDX.NA.IG.9 outstanding. That’s the maximum amount of payouts that could change hands.

By trading the index, in effect, you are speculating on what speculators think about the creditworthiness of 121 companies. Sellers of protection on the index are making a bullish bet: The buyers pay them a fixed premium quarterly (similar to an insurance premium); if any of the companies in the index defaults or has another “credit event,” the protection seller compensates the buyer and the companies are removed from the index. CDS.NA.IG.9 originally had 125 members, but credit events of CIT Group, Fannie Mae, Freddie Mac and Washington Mutual shrunk it to 121.

At the crux of the J.P. Morgan debacle is just what Mr. Iksil and his group were doing with these synthetic credit indices. The bank insists the group was making trades to hedge its exposure to the defaults in the broader economy. The precise mechanics of what Mr. Iksil did, and what the bank did to try to unwind his position isn’t clear, but one thing is: If the trades were a hedge, they were an evidently bad one.

That points up the danger of large losses in such broad indices. A CDS contract on a single issuer is (or should be, see our reporting on Greece here) a simple hedge against default. If you hold the bond, and the issuer defaults, you should be paid.

Trying to hedge an entire economy with a synthetic index is much less simple.

Follow @charlesforelle on Twitter.


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