Net Notional

Yesterday, when we first presented our calculation of what the Fed's balance sheet would look like through the end of 2013, some were confused why we assumed that the Fed would continue monetizing the long-end beyond the end of 2012. Simple: in its statement, the FOMC said that "If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability." Therefore, the only question is by what point the labor market would have improved sufficiently to satisfy the Fed with its "improvement" (all else equal, which however - and here's looking at you inflation - will not be). Conservatively, we assumed that it would take at the lest until December 2014 for unemployment to cross the Fed's "all clear threshold." As it turns out we were optimistic. Bank of America's Priya Misra has just released an analysis which is identical to ours in all other respects, except for when the latest QE version would end. BofA's take: "We do not believe there will be “substantial” improvement in the labor market for the next 1.5-2 years and foresee the Fed buying Treasuries after the end of Operation Twist." What does this mean for total Fed purchases? Again, simple. Add $1 trillion to the Zero Hedge total of $4TRN. In other words, Bank of America just predicted at least 2 years and change of constant monetization, which would send the Fed's balance sheet to grand total of just over $5,000,000,000,000 as the Fed adds another $2.2 trillion MBS and Treasury notional to the current total of $2.8 trillion.

For those strapped for time, here are the key charts from the numerous JPM slidepacks just released.

The full set of DTCC data is in (that is the repository for reporting CDS data) and reading between the lines provides us with some significant color on what was occurring at JPM's CIO office. First things first, JPM has derisked some/all of the tranche position but remains (we suspect) long IG9 credit hedged by a plethora of liquid on-the-run credit hedges. There appears to have been a delta-neutral HY short credit unwind (in mid-Feb) but no HY9 tranche positioning and nothing since then. However, when we look into IG9 gross and net notionals between tranched (the tail-risk hedge we believe they put on originally) and UnTranched (the index market where the whale managed to delta of the tail-risk hedge) the story becomes both confirming of our hunches and also very concerning. The charts below tell the story of an early unwind of the Fed-induced-failure tail-risk hedge but an arrogant momentum chaser that left the massive long credit index position (hedge of a hedge) that had been the cause of dislocations in the Index-arb business (that other media entities have focused on) flapping into and after LTRO2 into around early-to-mid April (when we are sure Jamie got the call). The changes in gross notional suggest a $120bn tranche position - which adjusted for leverage and the unhedged 'hedge' left on through March adds up to a $2.5bn loss. Add to this the guesstimate cost of 10% of notional (based on mezz price moves) to unwind the remaining tranche position ($5.5bn further losses) and the total could be around $8bn loss on this mess. However, there has been huge 'technical flow' in almost every liquid credit index (IG18, HY18, HYG, and JNK for example) which would have reduced the loss - though left considerable basis risk (hedging the loss with an imperfect hedge). Perhaps given the tranche unwind last week (and the skew compression), the rally in credit indices this week reflects some more unwinds of the tail-risk's hedge and a slowing of the technicals in the market - leaving just weak fundamentals - though we note IG9 index notionals did not shift much meaning they will likely try and unwind this position against the random market hedges they picked up in the last month (leaving huge basis risks for anyone who cares to press).

You know I saw this one coming 3 years ago, didn't you??? This ain't the end of the story either. You heard it hear first, again!

There are a lot of moving parts in the Dismal tale of Dimon's demise... Iksil' large size in the market left a mark that hedge funds tried to fix - that was his index trading was making the index extremely rich (expensive) relative to intrinsics (fair-value). That is where the media picked up the story and as we detail below leads us to today. Attempts to hedge his over-hedged positions and/or unwind them impacted the market too much and we suspect created the need for today's admission of guilt. And so, we find ourselves with - net CDS/CDO notionals remain huge (and implicitly on JPM's shoulders), his very recent lack of selling has left the credit index maybe 20bps rich to where it might trade given its rough correlation with the S&P 500 and this would imply at least $3bn of losses already in addition at fair-value. Of course, the situation is far worse because 1) any efforts to unwind such a huge position will lead to the market yawning wide and swallowing him in illiquid bid-ask spreads; and 2) the rest of the world knows their position - so why would the hedge funds not push their position. Note, it is not the instrument that caused this - it is the trader as "you don't hedge risk when you bet on momentum continuing you idiot!"

Out of nowehere, JPM announced 40 minutes ago that it would hold an unscheduled 5pm call to coincide with the release of its 10-Q. Rumors were swirling as to why. The reason is as follows:

• JPMORGAN SAYS CIO UNIT HAS SIGNIFICANT MARK-TO-MARKET LOSSES - "Fortress balance sheet" at least until Bruno Iskil gets done with it.
  
• JPMORGAN SAYS LOSSES ARE IN SYNTHETIC CREDIT PORTFOLIO - but, but, net is NEVER, EVER Gross.
• JPM WOULD NEED $971M ADDED COLLATERAL IF RATINGS CUT ONE-NOTCH
• JPM WOULD NEED $1.7B ADDED COLLATERAL IF RATINGS CUT 2 NOTCHES - how about three notches?
• JPMORGAN: MAY HOLD SOME SYNTHETIC CREDIT POSITIONS LONG TERM - "Level 3 CDS FTW"
• "As of March 31, 2012, the value of CIO's total AFS securities portfolio exceeded its cost by approximately $8 billion"

As a reminder, the CIO unit is where Bruno Iksil was making $200 billion-sized bets. Basically JPM has suffered massive losses at its CIO group most likely due to its IG/HY positions held by Iksil.

Presented with little comment but given the seemingly unlimited balance sheet of the JPMorgan CIO office and the ability to sell as much protection (implicitly bullish) and gather premium as credit derivative index notionals soared at an incredible rate, are we stretching the point a little too far to claim that perhaps, just perhaps, one of the new transmission mechanisms for the global central banks' liquidity flows is leveraged credit - which implicitly enables stocks to be supported by lower funding costs and exhibit the kind of portfolio rebalancing effect that was desired. Perhaps even more critical is the fact that IG9 (the credit index in question) contains some of the most worrisome of the major corporate credits and thus the highest short-interest in stock-land - which implicitly exaggerates any non-MtM-based entity's ability to create a short-squeeze? Is the entire market now a function of one prop trader (hence forbidden by the Volcker Rule) being forced to (un)wind his trade now that he is finally in the public spotlight as we wonder - are recent market jitters merely the byproduct of Iksil selling some of his excess exposure, and being the marginal price setter across virtually every asset class?

It was only last week that we highlighted the facts and fiction behind JPMorgan's prop-trading CIO office activities and Bruno' London Whale' Iksil's magnificent market cornering 'hedging' activity. Well, Bloomberg's chart-of-the-day provides the clearest and most destructive indication of just how ridiculous this supposed 'hedge' position had become. Thanks to Mary Childs and Shannon Harrington's data scrubbing, its turns out that, according to the DTCC, the net notional of contracts on Series 9 on the Investment Grade credit index (this is the credit derivative index that is most closely tied to the massive haul of outstanding tranche deals that remain in the market) surged an incredible 65% (to $148.2bn) in the last 14 weeks. As is clear from the chart, relative to every other credit derivative index this level of activity cornering, which managed to drive the index 18% below its 'fair-value', stands out rather dramatically and perhaps should jog a few regulator's from their porn-surfing lunch-breaks. The footprints of this particular whale seem a little too large to ignore but that then again, Spain did manage to sell some short-term debt so who cares?

• More on JPM's uber-prop trader Bruno Iskil - 'London Whale' Rattles Debt Market (WSJ):
• Traders Eye 45-Minute Window After Good Friday Report (Bloomberg)
• Sky News admits hacking of emails (FT)
• Britain’s Economy Barely Grew in First Quarter, Niesr Estimates (Bloomberg)
• Olbermann sues Current TV for $50M, cites glitches (USAToday), full lawsuit here
• Morgan Stanley broadens clawback rules (FT)
• Swiss Franc Showdown Looms as Jordan Defends SNB Ceiling (Bloomberg)
• Key Democratic donors cool to pro-Obama Super PAC (Reuters)
• Investors' Prying Eyes Blinded by New Law (WSJ)
• U.S. not backing off as Iran sanctions bite (Reuters)

With volatility so low and risk seemingly removed from any- and every-one's vernacular, perhaps it is time to refresh our perspective on downside and tail-risk concerns. While most think only in terms of equity derivatives as serving to create a tail-wagging-the-dog type of reflexive move, there is a growing and increasingly liquid (just like the old days with CDOs, so be warned) market for options on CDS. Concentrated in the major and most liquid indices, swaption volumes have risen notably as have gross and net notional outstandings. Puts and Calls on credit risk - known as Payers and Receivers (Payers being the equivalent of a put option on a bond, or call option on its spread) have been actively quoted since 2006 but the last 2-3 years has seen their popularity increase as a 'cheap' way to protect (or take on) credit risk - most specifically tail risk scenarios. Morgan Stanley recently published another useful primer on these instruments - as the sell-side's new favorite wide-margin offering to wistful buy-siders and wannabe quants - noting the three main uses for swaptions as Hedging, Upside, and Yield Enhancement. These all have their own nuances but as spreads compress and managers look for ever more inventive ways to add yield so the specter of negative gamma appears - chasing markets up into rallies and down into sell-offs - and the inevitable rips and gaps this causes can wreak havoc in markets that have momentum anyway. Given the leverage and average notionals involved, understanding this seemingly niche space may become very important if we see another tail risk flare and as the Fed knows only too well (as it suggested here) like selling Treasury Puts, derivatives on credit are for more effective at establishing directional moves in the the underlying than simple open market operations.

CDS is once again (still) in the spotlight. We have moved on from debating whether or not a Credit Event has occurred in the Hellenic Republic, to concerns about whether the CDS market will settle without a problem. There is a lot of talk about “net” and “gross” notionals and counterparty risk.  What I will attempt to do here, is build a CDS world for you. We will look at various counterparties, the trades they do, and the residual risks in the system. It will be loosely based on Greek CDS but some liberties will be taken. None of the institutions are real world institutions (in spite of how much they sound like some people we know). It is a simplification, but to make it useful, it has to be robust enough to give a realistic picture of the CDS market/system.

As European bank deleveraging continues, Middle East tensions rise, and oil prices (Brent and Crude alike) oscillate from headline to headline, we thought it intriguing that the entities with net notional outstandings in CDS markets at or near their largest in history are China (and Chinese banks), LatAm Oil companies, Abu Dhabi, and Israel. Quite a crop of potential risk bombs that at least credit traders appear to demand protection on more than others.

As we wait for more IIF announcements about the Greek Private Sector Involvement (PSI), Greek CDS remains bid above 60 points up front.  For a contract that is about to be "worthless", this seems to have a lot of value. Why would Greek CDS still be so well bid? Whether it is stubbornness, stupidity, or more simply a reality check on the IIF's negotiating power (just how many bonds do they speak for?) and the future unsustainability of Greek debt anyway, it seems that an impressive immediate exchange of all Greek debt with at least a 50% notional reduction, 30 year maturity, and low coupon is pretty well priced in (away from actual Greek bonds that is). Anything less is likely to disappoint the market as the realization that nothing is fixed sinks in, and that this may not even take near term "hard default" off the table (this PSI is a default no matter how it is spun even if it isn't a Credit Event).