| NEW YORK, June 14
NEW YORK, June 14 JPMorgan Chase & Co's
disastrous bets on corporate debt may have caused unexpected
collateral damage: erratic behavior in a barometer that measures
the financial health of blue-chip U.S. companies.
Those bets used Wall Street derivatives called credit
default swaps. They are supposed to act like homeowners
insurance, allowing bondholders, banks and hedge funds to buy
protection against declines in the value of corporate debt, and
ultimately protection against a default.
In this case, though, they became more like the pawns in a
battle between JPMorgan and hedge funds on the other side of its
bet. This struggle so dominated a corner of the market that it
sent false negative signals about the credit quality of some
major companies whose underlying finances were largely
unchanged, market experts said.
A Reuters analysis shows that in recent weeks the trading
may have sharply increased the cost of default insurance for
companies such as railroad operator CSX Corp and
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
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.
New York University finance professor Marti G. Subrahmanyam,
who looked at the results of Reuters' analysis, disputed
JPMorgan's statement that there was no cause-and-effect
relationship between the big bets and the subsequent increase in
default insurance costs.
"How could it be otherwise?" Subrahmanyam said. "The whole
market knows that one agent has a substantial position, and the
market will react to that."
Peter Tchir of TF Market Advisors, a financial advisory firm
in New Canaan, Connecticut, analyzed the trading in May and said
the spikes in default insurance were a result of the struggle
between JPMorgan and the hedge funds. That type of trading "can
just influence the whole market," Tchir said.
On Friday, Barclays Capital analysts said default insurance
for some companies was more expensive than their credit quality
seemed to warrant.
Making a direct comparison is impossible because there are
no companies that are exactly similar to the 121 in the index at
the center of the trades, Subrahmanyam cautioned.
But if the broader economic concerns were the dominant
factor, companies in the unrelated index should have had an
equally strong jump in the cost of their credit insurance,
A surge in credit default swap prices can sometimes make a
big difference for companies. When the cost of insurance
increases, it can signal a company is in trouble because
investors, increasingly worried that debt won't be repaid, buy
more protection against default.
For example, the cost to protect against default at Bank of
America Corp climbed last autumn, sending jitters through the
A company's borrowing costs can be affected. At least 33 of
the 121 companies in the credit default swap index in the
JPMorgan trades have loan commitments from banks whose interest
rates are tied to various versions of the index or their
individual default insurance costs. Companies use these loan
commitments to provide cash for day-to-day operations.
Financially strong companies typically do not tap the loan
commitments except in times of stress.
A look at one credit agreement illustrates how borrowing
costs can be affected. Caterpillar Inc has a $3.9
billion loan commitment whose interest rate will go up if its
five-year default protection increases, according to Thomson
Reuters LPC data.
From May 1 to May 14, the construction equipment maker's
five-year default insurance has increased to $104,000 a
year from $82,900. That means that if Caterpillar had to tap the
loan commitment, its cost to do so would have increased. Under
the agreement, though, the company's interest rates on the loan
would be calculated based on a maximum default insurance cost of
A Caterpillar spokesman declined to comment.
(Editing by Dan Wilchins, Alwyn Scott, Martin Howell and Lisa