Posted by Charleston Voice, 05.23.12
A tough read for people like me, but I'm coming along more each day...
Submitted by Tyler Durden on 05/22/2012 23:53 -0400
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. For the Cliff Notes' version - see the summary at the bottom...
First things first, the position does not appear to have any HY9 tranche involvement at all, but a modest short HY credit index position was unwound in mid-Feb (we suspect related to the IG9 tranche unwind - since the delta ratio makes some sense at 1x ($25bn HY) to 5x ($120bn IG tranche). But nothing has been done 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 drop in gross tranched notional was around $65bn in mid-Feb and a further $55bn this last week - which provides us with approximate sizing of around $120bn for the whales' exposure (tranched - in senior risk so modestly unlevered) - which is in line with the insider estimates of $100bn notionals. Furthermore the gross untranched (index) notionals dropped by around $100bn also which at a DV01 of ~$45mm implies the $2.5bn loss from the 50bp index shift alone.
Add to this the massive loss they would have incurred to get the remaining $55bn of tranche off the books in the last week (as a guesstimate - based on moves in the equity, mezz, and index positions that are the 'opposite' of the tail-risk hedge) around 10% of notional or a further $5.5bn loss) and the total loss is around $8bn.
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, 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 the basis risk (the difference in dynamics between the two side of the trade) could be very painful.
Think of the notional amounts as measuring the market's aggregate exposure to various indices - the details of net vs gross are important but do not change the narrative below...
1. HY9 net notionals are minimally changed the entire year - both tranched and untranched - the drop (and green arrow) is a tiny $0.6bn drop in net notionals (check right had scale).
2. HY9 Gross notionals show a drop of around $25bn in mid-Feb - which would fit with a beta-neutral HY hedge for an IG position - this was a short-cover in our opinion - which is a shame since it would have saved JPM a lot if they kept it on...
3. The main story is here!
In Mid-Feb, as with HY9 above, it looks like a decent chunk of the original tranche (tail-risk hedge) was removed (red line below). Whether this was in anticipation of LTRO2 - perhaps on the back of the market's massively strong momentum post LTRO1 (and his likely losses) - the whale appeared to decide to leave the index (blue line) long credit position in place (even though he had reduced his tail-risk hedge position dramatically.
This is the momentum-jockey arrogance of knowing better and having an unlimited capital account to draw on... in a nutshell - he had a hedged position into this point (that admittedly the delta was probably outperforming his original hedge quite well) and thinking he knew better, he just decided to get naked long credit (orange oval)...
Of course this basically marked the top in the market and instead of LTRO2 providing more ammo for the rally, it signaled the end of easing and market dumped. This put his hugely naked long credit underwater as he had less of a hedge against it now...
And as the chart below shows - the unwind (black vertical line) relieved some of the pressure on the IG9 skew (the spread between the index and the intrinsic value of the portfolio) - which had been stuck massively wide for months (orange horizontal arrow) until this unwind which allowed the arbs to get their payoff (dark red arrow)... Finish reading @Zero Hedge