Collateral (Call) Damage – no pun intended
All those margin and collateral calls that JP Morgan Chase likely faced on its massive “London Whale” CDS trades likely had further reaching effects on several other related derivatives. Despite total CDS volumes having fallen to lower and lower levels over the past few years, another outcome of a “shrinking” market could be larger and larger effects of these one-off type trades on individual company derivatives.
As the chart from Reuters shows, After JP Morgan reported their loss, spreads on some otherwise low-spread stable names (Caterpillar, CSX and McDonald’s are demonstrated in the graph) appear to have widened more than usual.
As explained in Reuters,
In late April, CSX indicated it was in good financial shape. The company reported first-quarter earnings that beat analysts’ expectations, while ratings agency Standard & Poor’s said it expected CSX’s credit “to remain satisfactory.”
Yet the cost to insure against a default at CSX surged 28 percent to $64,300 for five-year protection on $10 million in debt on May 14 from $50,100 on May 1. At the same time, the company’s stock fell just 5 percent.
A CSX spokesman declined to comment.
There was a similar pattern at McDonald’s. The cost of protecting the fast-food company’s debt against default rose more than 19 percent to $24,300 on May 14 from $20,400 on May 10, while McDonald’s stock fell just 1.1 percent.
Again, there was no news during that time to explain a significant increase in the cost of default insurance. “It’s business as usual for us at McDonald’s,” spokeswoman Becca Hary said when asked about the jump.
The first two weeks of May were a critical period because JPMorgan announced May 10 that a flawed trading strategy led to at least $2 billion in paper losses for the bank. The losses could eventually total $5 billion or more, analysts said.
Trading in default insurance for major U.S. companies showed unusual spikes during that time.
To be sure, renewed concerns about the U.S. economy and the European debt crisis are at least partly responsible for increasing worries about companies’ financial health. There is no way to quantify whether JPMorgan-related trading contributed more or less than the broader economic concerns to the increases in costs for credit default insurance.
A JPMorgan spokeswoman said there was no causal link between the credit derivatives prices and the trading tied to the bank’s losses. The theory, she said in an emailed statement, “is wrong and ridiculous.”
But the Reuters analysis showed the 121 companies underlying the index of credit derivatives at the heart of the trading battle had a sharper increase in default insurance costs than 41 companies in a separate index that was not believed to be part of the big bets.
The trend held true even when distressed companies, whose default insurance costs are more sensitive to market movements, were removed from the analysis. Reuters used data from Markit, the index publisher, for the analysis.