JPMorgan Bets Sent False Signals to Wider Debt Market

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 McDonald's Corp.

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.

CRITICAL PERIOD

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.

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."

WIDER INFLUENCE

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, Subrahmanyam said.

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 stock market.

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 $100,000.

A Caterpillar spokesman declined to comment. (Editing by Dan Wilchins, Alwyn Scott, Martin Howell and Lisa Von Ahn)