Bruno Iksil, JPMorgan and the Real Conflict with Credit Default Swaps
We all have been watching the media fuss over the JPMorganChase (JPM) trader Bruno Iksil. Bloomberg News sums its up: “ Iksil’s outsized bets in credit derivatives are drawing attention to a little-known division that invests the company’s reserves and fueling a debate over whether banks are taking excessive risks with federally insured and subsidized money.”
For a number of months now, I have been listening to members of the Big Media wring their hands over the idea of bank holding companies using taxpayer-assured funds to trade OTC derivatives. But is this really the key problem with banks and CDS? IMHO, no.
Buried deep in the Bloomberg News story is a comment that indicates Iksil was betting American Airlines (AMR) would file while other hedge funds bet the other way. He won and made huge profits for JPM. “Surprise, surprise,” to quote Gomer Pyle.
BUT WE ALL KNOW THAT BY ITS CONTROL OF SYNDICATED LOANS, JPM CONTROLS WHEN ANY MAJOR ENTITY FILES CH. 11 (by controlling when the debtor-in-possession financing syndication will close). Thus the real question regarding Iksil and all large banks that trade CDS is whether the lending side of the house is speaking to the trading side of the house. My guess is “yes” based on observation of many default events and also conversations with people inside the largest banks.
I respect JPM CEO Jamie Dimon. He is a great operator and wouldn't likely know if Iskil was using back-door contacts to learn about (and even influence) when the DIP syndication gets done. But that timing is precisely how the large dealer banks that issue all the CDS effectively control when an entity files bankruptcy.
From the start of the CDS market, we saw this as a phenomenon where the bonds of a cash-short debtor fall as CDS spreads rise when "shorts" take a run at an entity by bidding up the CDS values when the short, naked, bonds by buying CDS. Then "magically" the bond market "opens" and the debtor's bonds skyrocket in value just before the Ch. 11 occurs. Think GM and Delphi, for those of you with short memories.
The bond rally before the CH 11 is a "standard" pattern seen many times. As CDS rise with increasing shorts, the debtor is increasingly barred from selling new debt to avoid a crisis because the big banks "naturally" price new debt based on the implied price shown by rising CDS values for that debtor.
Then, as a bankruptcy filing is being negotiated, "strangely" the timing of filing relates to the expiration of some batch of CDS contrcts (when major banks are "off the hook"). As the DIP financing is syndicated, there's suddenly a surge in the value of the debtor's bonds as hedge funds that are "naked" (lacking bonds to deliver with their CDSs on default) try like heck to buy bonds (in order to match them to the "naked" CDSs which results in 100% recovery).
As readers of ZH may recall, in the last week before Delphi filed, its bonds jumped 25% in value as naked hedge funds sought to cover their CDS contracts. Does that help jog your collective memories?
People like Iksil are not dumb and one would have to be REALLY dumb to do what he does without seeing the pattern between an approaching default event and the movement of bond prices. Obviously federal regulators have no idea, but the Iksil matter is a near-perfect example of why we need to limit CDS. How? To (i) demonstrable "matching" (to back owned risk positions), (ii) time for unwinding the CDS after selling the matched position and (iii) some reasonable inventory level for those that deal in the underlying bonds. That is, if you don’t own the underlying, no buying of CDS, period.
So please, my dear friends in the Big Media, it is time to get a collective clue. The real problem with CDS trading by large banks such as JPM is not the speculative positions taken by traders like Bruno Iksil, but instead the vast conflict of interest between the lending side of the house and the trading side, whether the trader is on the arb desk or, in the case of Iksil, working for the CIO trading for the bank’s treasury. Keep in mind that all of Iksil’s colleagues in New York who traded for the JPM treasury have been fired due to the Volcker Rule. More on that in a future rant.
What is the answer? We need to focus on the Volcker Rule in Dodd-Frank and take the process the next, logical step, namely to separate completely the lending side of the house from the trading side of the house. We can do this through a complete, physical separation of the two business units. Or you could simply enact a law that prevents banks from trading any security or derivative where the bank has a lending relationship with the issuer.
The latter course is draconian, but only recognizes what we all used to know instinctively before the creation of the CDS market; namely that lenders have a duty of care to borrowers and should not take any action that would prejudice the interests of their customers. How’s that for an old fashioned idea? I’ll bet my friend Chairman Volcker would agree.