JP Morgan Chase was hard to ignore in 2001. With total notional derivatives positions of $24 trillion, and a one-day 99% trading book value-at-risk of more than $90 million in late December, the bank continues to dominate the derivatives market. According to co-head of credit and rates Bill Winters: “We’ve taken more risk this year than we have in other years, and we’ve done well on it.”

Considering the firm for the three awards, we not only had to think about the risk management implications of JP Morgan Chase’s exposure to Enron. In the derivatives businesses themselves – both interest rates and credit – there was the question: had the merger worked? A marriage of high-volume vanilla business and client-orientated structuring business appeared to be a natural fit, until you teased out the implications in specific areas. The bank’s clients praised it for its innovation but, surprisingly, they also praised JP Morgan Chase for its invisibility in transacting large or difficult deals. That clinched the interest rate and credit awards, but only then did it become obvious that JP Morgan Chase deserved the house of the year award, simply for its ability to be all things to all people.

Winters says: “It’s a virtuous circle that we’ve always striven for, and we’ve got. We take on large chunks of risk from our clients on an underwriting basis, whether it’s in the rate markets or credit markets, then we distribute it out. We distribute it out faster, to more places, with more discretion, and that’s why we’ve got the reputation we have.”

The visibility in innovation, and the invisibility in liquidity provision, form two legs of a tripod at JP Morgan Chase, the third being capacity for risk. Here, the firm has undergone severe tests in 2001, both due to credit events such as Enron, and from market risk events such as the US bond market sell-off in November – the worst of its kind since 1994. As Winters’ fellow co-head, Don Wilson, puts it: “The fact that we passed that test is an indication that the liquidity franchise, the client franchise and the risk franchise are complementary.”

Wilson praises the efforts of JP Morgan Chase’s market risk management team, headed by Lesley Daniels Webster, in controlling the risk exposure of the rates business: “Part of the reason that we as a firm are able to do as many complicated, structured, risky things is that we’ve got a good relationship with risk management.”

There is something about the kinds of deals that JP Morgan Chase does in interest rates and currencies that makes its clients want to talk – a degree of cleverness and audacity that, one suspects, they don’t find forthcoming at other dealers. Take Baxter for instance. This US manufacturer of healthcare products has a market capitalisation of $31 billion and $3 billion of debt. JP Morgan Chase is one of the company’s top derivatives counterparties, transacting a E650 million swap into floating off the back of a Eurobond issue in April 2001.

But it was the way JP Morgan Chase exploited a clever loophole in US derivatives accounting rules that really impressed Baxter’s assistant treasurer, Bob Hombach. With $5 billion of its annual sales of $8 billion earned in Japan, Baxter ideally would want to hedge its anticipated net income in yen using currency forwards.

However, since US accounting rules do not recognise hedges for anticipated income, Baxter would have had to mark such contracts to market before the income was realised, resulting in enormous earnings volatility.

JP Morgan Chase’s FASB-busting solution, called a hedge of investment translation (HIT), was to replicate a currency forward using an investment vehicle. Baxter made a commitment to invest using yen. At the beginning of the earnings quarter in which it planned to redeem its yen earnings into dollars, Baxter would purchase a risk-free security from JP Morgan Chase at an agreed price and, just before releasing its earnings statement, sell the investment back to JP Morgan Chase for a fixed dollar face value, realising a dollar inflow that served as a hedge for the spot transaction. The beauty of this arrangement was that it was covered not by hedge accounting rules, but by investment accounting, which did not require a mark-to-market during the interim.

According to Hombach: “JP Morgan Chase provided an innovative solution to hedge what was formerly an unhedgeable exposure in our foreign operations.” When the yen lost 13% of its value against the dollar in late 2001, JP Morgan Chase’s hedge saved Baxter $12 million–15 million, adds Hombach. Since then, JP Morgan Chase has done an even larger HIT transaction for the treasury department of a rival US investment bank.

Another corporate treasurer who praises JP Morgan Chase is Joe Brandt of AES Corporation, a medium-sized power generating company based in Arlington, Virginia, with a $9.5 billion market capitalisation. When AES made an $800 million hostile bid for Chilean company Gener, it guaranteed local shareholders a fixed price for their stock in Chilean pesos. Normally, this would involve borrowing in the illiquid local currency, which would have left AES at the mercy of Chile’s domestic foreign exchange dealers.

According to Brandt: “JP Morgan Chase did a massive one-year $495 million dollar-peso cross-currency swap. They did a very good job borrowing pesos on our behalf. After the takeover succeeded [in January 2001], the swap was unwound in the money.” Since then, JP Morgan Chase helped AES obtain cheap subordinated dollar financing in its purchase of a UK power station using a cross-currency swap with a notional contingent on currency and interest rate correlation.

Invisibility seems to be a hallmark of JP Morgan Chase’s activity in the swaps market during 2001. The financial director at a large UK insurance company, who understandably asks not to be named, tells the following story: “We issued a long-dated sterling bond, and pre-hedged in anticipation of the issue using a swap. The swap was unwound after one month. It was a very discreet deal, because JP Morgan Chase was not the bookrunner on the bond deal. Despite the swap notional being hundreds of millions, JP Morgan Chase left no footprint in the market – impressively since we chose to unwind at 5pm on a Friday.”

To continental European insurers, JP Morgan Chase shows yet another face – that of the structurer of highly exotic long-dated deals. Consider the case of Unipol, an Italian life insurer with E16 billion of assets, based in Bologna. Unipol faced a dilemma common to many Italian insurers: to compete in the market for pension policies, they offer minimum guarantees, and increase these guarantees when long-term interest rates rise. However, when rates fall, the implicit option goes against them. To hedge against this risk, Italian insurers have been large buyers of interest rate volatility, in the form of so-called volbonds and constant maturity swap (CMS) floors.

JP Morgan Chase’s marketers noticed there was a mismatch between the protection offered by plain vanilla CMS floors and the liabilities taken on in offering competitive minimum guarantees. When guarantees were increased to match rising rates, the vanilla floors drifted out-of-the-money, and bonds in which they were embedded became worth less than par. JP Morgan Chase’s solution was to offer Unipol and other Italian insurers a swap out of their old sub-par vanilla CMS investments and into a ‘sticky floor’ or cliquet floor linked to the 30-year euro CMS rate, which tracked the liabilities much more closely.

JP Morgan Chase’s second innovation was a variant on the traditional volbond structure, which pays a coupon based on the absolute difference between successive spot swap rates. JP Morgan Chase found it could boost yield by linking coupons to forward swap rates instead. In late 2001, the firm sold one of these forward volbonds to Unipol. With a face value of E100 million, the product was linked to the 20-year forward swap rate and was leveraged 15 times. As a final twist, JP Morgan Chase added a ‘shout’ feature giving Unipol an option to convert the payout formula to a CMS floor after 10 years.

Unipol’s head of fixed-income trading, Claudio Mandrioli, is clearly satisfied: “Most of our interest rate derivatives transactions are done with JP Morgan Chase,” he says. “We very much appreciate their ideas, prices and the fact that services are not limited to the transaction itself. In fact, more than once they assisted us even after the transaction was concluded.”

Sophisticated exotic deals such as these were typical of the old JP Morgan, but how do they square with the high-volume, flow-business mindset inherited from Chase Manhattan? At the more exotic end of the interbank market, it seems the Chase model loses out. In Risk’s September Global Derivatives rankings, JP Morgan Chase failed to reach first place in volatility/variance swaps (used in volbonds), and only achieved fourth place in CMS products, notwithstanding the existence of large deals for clients such as Unipol. And the interbank volbond and CMS market – dominated by the likes of Deutsche Bank, Morgan Stanley and BNP Paribas – has been the subject of intense debates over pricing and hedging techniques (Risk December 2001).

There are clear signals that JP Morgan Chase quants, taking a conservative approach to modelling interest rate skew, have vetoed attempts by some of the more gung-ho JP Morgan Chase traders to enter this interbank market. But management seems happy with this profile, as Winters comments: “We never held ourselves out as being liquidity providers to our competition when we’re going after the same end-customer business. If we have access to the customers, we don’t want to put that risk into our portfolio by providing that liquidity to the interbank market.”

There is no question about JP Morgan Chase’s interbank dominance in other exotic interest rate products such as barriers and Bermudans, let alone the clean sweep it makes in vanilla categories. And here again, the firm’s clients provide ringing endorsements.

Consider Bank Julius Baer in Switzerland. This private bank and asset manager, with its Sfr15 billion balance sheet, is an extensive user of interest rate derivatives, ranging from overnight index swaps used for cash management to medium-term swaptions used for proprietary trading, all the way to long-dated swaps for hedging long-dated debt. Out of an average of 120 derivatives transactions a year, about half are transacted with JP Morgan Chase. Treasurer Thomas Maurer comments: “JP Morgan Chase never says no to a trade. For example, late one evening, we wanted to receive two-year dollars, and it was a slow market. JPM did a $400 million trade for us very fast. When we did a five-year E250 million swaption, they saved us E100,000 in premium. They warn us about market volatility, and give very good advice. For me it’s contingency planning – they’re always there.”

Another thumbs-up comes from Anglo/Australian mining conglomerate BHP Billiton, which uses a sophisticated in-house portfolio risk model to hedge its $8 billion debt. According to treasury front office manager Riaan Bartlett: “JP Morgan Chase provides us with online pricing tools and informs us of market developments. If I do a big hedge, I can do it with them at short notice, and with confidence.”

Germany’s PostBank is a provider of post office retail savings bonds with a E150 billion balance sheet which trades about 100 E500 million swaps a year to hedge the duration of its banking book. Treasury manager Guido Behrendt believes JP Morgan Chase is “quick and fair”, and is “normally better than rival dealers, especially in big size”.

JP Morgan Chase won the Credit Derivatives House of the Year award last year in recognition of its pioneering work in creating the Bistro synthetic CDO franchise, as well as deploying single-name default swaps as part of a merger transaction. Why should this firm deserve the award again this year? What stands out is the way it moved on so quickly from its earlier position of strength, yet again defining the nature of credit derivatives for another year running.

At the beginning of 2001, the greatest threat to JP Morgan Chase came from Deutsche Bank, which dominated the business in funded credit derivatives, selling to hedge funds and asset managers. JP Morgan Chase’s response was to hire Deutsche marketing whiz Stephen Stonberg as head of credit derivatives marketing in August 2001. But as with interest rate derivatives above, the real test is in JP Morgan Chase’s clients, who are overwhelmingly positive.

In the hedge fund community, the face of JP Morgan Chase is that of an eager facilitator, particularly for convertible arbitrage, where the effect of credit default swaps as hedging tools has been nothing short of revolutionary. According to Mohsin Ansari, a trader at Stark International, a $2 billion US convertible arbitrage fund: “Using default swaps, hedge funds have taken over the convert market – they can be as big as outright investors.” Ansari gives examples of successful trades conducted with JP Morgan Chase’s help, such as a default swap used to hedge Stark’s exposure to UK rail infrastructure company Railtrack. When the UK government pushed Railtrack into receivership, Ansari was able to promptly exercise the swap and deliver Railtrack convertibles to JP Morgan Chase at par.

Another example he mentions is that of Dutch telecom giant KPN, on whose default risk Stark bought protection from JP Morgan Chase at a spread of 89 basis points. When KPN subsequently issued a convertible bond, the spread widened to 400bp, and Ansari unwound the trade at a profit.

JP Morgan Chase’s expertise in single-name credits makes it popular with banking clients too. Germany’s Bayerische Landesbank (BLB) uses default swaps principally for proprietary trading. According to head of credit derivatives Josef Gruber: “In all market situations, JP Morgan Chase offers tradable prices in big size. $50 million–100 million deals are no problem.” He gives an example of a successful basis trade in June 2001 on Swedish telecom company Ericsson, where BLB bought five-year bonds and used default swaps to extract relative value. Spreads subsequently widened and BLB was able to unwind, gaining a pick-up of 75bp a year on a $40 million trade. Gruber also says JP Morgan Chase was the only dealer quoting two-way prices on Argentina protection during July, allowing BLB to unwind a $10 million trade.

Like the clients quoted earlier in the interest rate swap market, Gruber marvels at JP Morgan Chase’s ability to soundlessly absorb large trades, and offers his own analysis: “They have a huge loan book, and because of this they don’t act as a mere broker. For big trades, before providing a quote, other dealers will phone around looking to hedge the deal, which moves the market. JP Morgan Chase doesn’t do this.”

While BLB has loan assets of more than E150 billion, it has no pretensions to being a global investment banking powerhouse. One firm that definitely does is Swiss giant UBS, yet when portfolio manager Winnie Szu seeks to hedge UBS’s $70 billion loan book she turns not to the UBS credit derivatives desk but to JP Morgan Chase, citing the firm’s ability to trade a huge range of liquid and illiquid names. The rationale for these trades goes back to the debate that polarised bankers last summer – the pricing of unfunded loan commitments. Like other commercial banks, UBS syndicates such commitments if possible, but chooses to use default swaps to hedge exposures it can’t sell to the primary market.

JP Morgan Chase has adamantly opposed marking loan commitments to market, which, according to rivals such as Goldman Sachs, would demonstrate that this business was a loss-making form of ‘capital dumping’. By hedging such commitments to lend using credit derivatives, UBS is effectively marking to market, but is upfront about accepting this as a cost of winning ancillary business. According to Szu: “The reason UBS lends money is to support investment banking business – by providing liquidity, we then get equity mandates from clients.”

She highlights a regulatory capital advantage to hedging in this way: by exchanging corporate risk for the counterparty risk of JP Morgan Chase (acceptable under current rules), UBS can reduce a 100% corporate risk weighting to a 20% OECD bank risk weighting, which offsets some of the losses locked in by the use of default swaps.

Aside from the expansion of its client base, JP Morgan Chase’s most outstanding achievement in credit derivatives has been to add a new dimension to the market through its development of credit portfolio tranching technology. This development can be viewed in three stages: first, the pre-merger JP Morgan invented the Bistro structure to reduce its own capital commitment to credit risk. Then it marketed the technology to clients, initially to reduce regulatory capital for banks and subsequently for straight investment or arbitrage purposes. Today, the post-merger JP Morgan Chase stands astride an entire two-way market in tranched portfolio credit derivatives, which is used both for proprietary repositioning and to service clients. So sophisticated has the technology become that JP Morgan Chase quants have coined the phrase ‘correlation skew’ to describe the market’s view of the tranching spectrum on offer.

From this perspective, the original Bistro product as applied to JP Morgan Chase’s own portfolio has been superseded by a far more flexible range of structures with more tactical objectives. Says Winters: “The original Bistro transactions made a lot of sense, but reducing our capital commitment to credit is not the top priority for our portfolio management right now. Our top priority is to mitigate concentrations that come up in the portfolio, and to create capacity for new business. And we use the full range of tools, from cash securitisation, to synthetic securitisation, to single-name default swaps, to basket default swaps to tranches of all of the above, to accomplish that secondary market undertaking.”

JP Morgan Chase clients only see zoom-lens snapshots of this big picture, but by pasting such snapshots together, a fascinating scene emerges. The super-senior triple-A end of the spectrum, the original investor beachhead established with the old Bistro issues, still thrives as a source of assets for monoline insurers such as MBIA and the insurance division of XL Capital, while some reinsurers, such as France’s SCOR, play the investment-grade layer, underwriting the average loss on a basket of investment-grade names. JP Morgan has further expanded this segment using managed collateralised debt obligations (CDOs) for clients such as Dutch asset manager Robeco.

Meanwhile, the declining relative importance of regulatory capital-driven deals – both for JP Morgan Chase’s own balance sheet and for bank clients – means the bank’s traders and marketers have been freed to focus on selected portions of the tranching spectrum, which during 2001 was the first-loss or equity portion. Here, the firm has clearly outstripped its competition in placing this leveraged type of credit portfolio risk.

In October, Risk revealed one snapshot: JP Morgan Chase’s credit-linked investment-protected (Clip) product, sold to the German Schuldscheine market (Risk October 2001, page 6). BLB’s Gruber says his firm has acted as a distribution channel, placing E100 million face value in Clip notes sourced from JP Morgan Chase to German insurance companies.

Another snapshot comes from the reinsurers. SCOR is one of these, writing first-to-default baskets on investment-grade names with a total exposure of around E10 billion. Another especially satisfied customer is the capital markets division of Bermuda-based XL Capital, a multiline with $26 billion in assets. In a $1 billion five-year synthetic CDO transacted on a basket of 100 US investment-grade names, XL took first-loss risk, and received the swap premium as an upfront cash payment. According to managing director of capital market solutions Dan Seymour, XL requested this arrangement after it noticed that most of the 155bp spread was referenced to the senior tranches of the CDO, and would not be affected even if the first-loss portion was triggered. JP Morgan Chase agreed to guarantee this part of the spread, and pay the present value to XL, which as a result received $43 million in return for accepting the risk of losing $52 million – ‘an incredibly good deal’ according to Seymour. “Other banks told us they would never do a transaction on those terms. JP Morgan Chase really worked with us and listened to our concerns.”

With such a deep penetration across markets, where can JP Morgan Chase go from here? According to Winters, the firm wants to ‘bridge the gap between the banking market and insurance markets to a greater degree’. This is a timely comment given that a dispute over surety bonds recently doubled JP Morgan Chase’s Enron exposure. He and Wilson are also prepared to take on more cross-asset-class correlation risk, and are mulling over a move into energy and power markets, although regulatory issues constrain this.
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