Chart of the day: The CDX NA IG 9 basis

By Felix Salmon
May 11, 2012


Here’s the chart you’ve all been waiting for, courtesy of Reuters’s very own Scotty Barber: the spread on the CDX NA IG 9 index — the synthetic index on which JP Morgan’s Bruno Iskil was selling enormous amounts of protection — minus the spread on the index’s constituent bonds.

Three things jump out here. Firstly, the basis is negative, not positive. That means that the obvious trade was to buy the underlying bonds and hedge by buying protection on the index. That obvious trade, if held to maturity, should always make money. Iksil was funding that trade, by selling protection on the index.

Secondly, the chart is going up and to the right. Since Iksil was selling protection, that means the market was moving against him. Or, to put it another way, the obvious trade makes money when it expires at zero, and as the chart moves towards zero, Iksil loses money on a mark-to-market basis.

Finally, the move doesn’t seem to be all that huge — only about 30bp in this quarter. Which doesn’t seem remotely enough to cause a $2 billion loss. Still, Iksil managed it somehow.

Update: Many thanks to Sally Kohn for making the chart infinitely better by putting whales on it.


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Meaningless chart: there are 3 CDX.NA.IG 9 indices

Posted by alea | Report as abusive

i think you might have the trade wrong, Felix. check out Lisa Pollack’s FT post: 11/996131/too-big-to-hedge/

Posted by KidDynamite | Report as abusive

30 bp of spread on $100 bn notional CDX is about $1.2 bn in return. That’s in the right ballpark.

Posted by FosterBoondog | Report as abusive

I have a very basic question that I would be grateful if someone could answer about how CDSs work. If I sell an option and it expires out of the money, I lose nothing even if the underlying rises.

But from what I read about CDS trading, if I sell protection I can lose money if the index goes up even though no one defaults. This seems to be the case with the JPM trade.

Thanks in advance.

Posted by Will.01 | Report as abusive

Will.01 – they are mark to market losses: the current value of the trade has moved against you, but you haven’t had to pay out on any of the protection that you sold yet. that’s the boat that JPM is in.

Posted by KidDynamite | Report as abusive

Mr. Dynamite: thank you.

If one were to open a trade like jpm did and hold it long enough (assuming they could) would it expire worthless like an option would if it weren’t in the money?

I understand that if someon sold protection on a bond and there was no credit event the seller wouldn’t lose any money once the bond matured or was called. I don’t quite get how cash index CDSs work, obviously.

Also, is a CDS a derivative?

Thanks again from the cheap seats.

Posted by Will.01 | Report as abusive

If you look at the bonds in the index JPM’s “bet” is exactly right. The lifetime credit losses (net of recoveries) on that balanced portfolio of investment grade debt will be less than 1%.

Things I don’t understand:

#1. Why would JPM close out of this trade… it’s not like they got stopped out or faced a margin call forcing their hand. 2 bil is a lot of scratch but in the context of a 2 tril balance sheet it’s not the end of the world.

#2 Who is on the other side of this trade. I’ve seen a refrence that two hedge funds run by ex-JPMers have pocketed a cool 30MM each… that’s nice money but this is a zero sum trade… where is the other 1,940,000,000?

#3 If the financial community is understanding this correctly/fully (which I doubt) then the original opportunity JPM was looking to exploit should be crazy ripe for the picking. Would not supprise me at all to see Berkshire take the risk off JPM’s hands. Pre-crisis a berkshire subsidary (Kansas Surety) use to insure bank deposits in excess of the FDIC limits for a mer 15 basis points… this trade is way jucier!

Posted by y2kurtus | Report as abusive

Hedge funds were saying he was selling the 10Yr S9 and buying 5yr S9. To get a net buyer position he would have to buy up an impossible amount of the 5yr S9 to get anywhere near enough of a position for this 30bps to produce a large loss.

None of this computes, given the relatively benign moves in the indices recently. Haven’t looked at possible correlation trades, but I think that’s the only thing that might help explain it.

Posted by ClarenceD | Report as abusive

Replying to my own post :)

Sorry, screwed up the side in my previous post. So, for this to work he would have almost 150bn notional sold (to get to roughly 2Bn in losses) of 10y?

Posted by ClarenceD | Report as abusive

I think the trade is the Index Tranche. (IG9 has 125 original constituents, of which 4 have defaulted.) The tranche is 3%-7%. I.e. you lose money once 3% of the capital is wiped out. (i.e. say 6 names default, and recovery is 50% on each)

The biggest problem with CDOs, is the correlation between defaults is difficult to estimate or model. (i.e. if one of the underlying name defaults, how likely are the balance)
This can range from +100%, i.e. all credits in the index default together, 0%, i.e. no default is correlated with another, or -100%.
i.e. When one company defaults, all the others are surely not going to default during the balance tenor. (negative correlation happens when one company goes bust, but economy is doing very fine, and spreads on other credits tighten)

Now the basis is between the tranche, and the underlying index (not cash and CDS)

more details in this ZERO Hedge column il-trade-ig9-tranches-explained

Posted by kanodra1 | Report as abusive

Has anybody besides me noticed that Danny Black has been eerily quiet since about the time The Whale started taking harpoons?

You don’t suppose ….?

Posted by MrRFox | Report as abusive

Agree- this is all about tranches….he would struggle to lost that much in single names, but the deltas on tranches make it a lot easier

Posted by DMW1111 | Report as abusive