The deleveraging of financial markets in 2008 sent one particular trade into the stratosphere last year, and it seems that JP Morgan Chase captured the opportunity to generate as much as $5 billion in profits.
The trade involved interest rate swaps, which pay off when the gap between coprorate bond rates and Treasuries widens. Last year, of course, saw a terrifyingly wide gap open as investors fled corporate bonds, into the safety of Treasuries. By some accounts, the normally boring interest rate swaps became the performing instruments last year.
JP Morgan was a big player in this market, and got even bigger when competitors such as Lehman Brothers and Bear Stearns collapsed.
The largest U.S. bank by market value, which reported $5.6 billion of total profit in 2008, hasn’t disclosed earnings for its interest-rate swap, municipal bond and foreign exchange derivatives group. The unit was among the most profitable at the New York-based company, said the people, who declined to be identified because they weren’t authorised to divulge the figures. JPMorgan spokeswoman Kristin Lemkau declined to comment.
The JPMorgan trading desk, led by the 38-year-old Matt Zames, who previously worked at hedge fund Long-Term Capital Management LP, may have benefited as the collapse of Lehman Brothers Holdings Inc. and JPMorgan’s takeover of Bear Stearns Cos. left companies and hedge funds with fewer trading partners in the private derivatives markets. JPMorgan emerged “unscathed by the disasters” on Wall Street and positioned to capture more revenue as trading volumes grew, said Craig Pirrong, a finance professor at the University of Houston.
“It’s a flight to quality,” Pirrong said. “They expanded the scale of business, the number of trades people wanted to do with them, and it gave them pricing power.”
The interest rate swap market dwarfs the size of the relatively more discussed credit default swap market. It is often used by defined benefit pension funds to guard against inflation. Borrowers of bank credit, especially riskier companies borrowing under high-yield agreements, also buy interest rate swaps to protect them against sudden changes in the corporate borrowing market. Last year’s turmoil produced historically rare changes in interest rates that put these into demand.
Most corporate debt is priced against LIBOR, with borrowers paying a certain percentage above the rate banks pay to borrow from each other over night. Last year, a huge gap developed between LIBOR and Treasuries, which meant that corporate debt was paying interest at rates much higher than the rate paid by Treasuries. This made the interest rate swaps particularly valuable to borrowers.
Here’s how Bloomberg describes the profits at JP Morgan:
The majority of JPMorgan’s OTC trading profit may have stemmed from interest-rate swaps in 2008, according to revenue figures reported by the OCC. During the first three quarters of last year, JPMorgan took in a total of $6.36 billion in OTC derivatives-trading revenue. Of that, $4.87 billion resulted from interest-rate positions, according to data from the OCC. The remaining $1.49 billion came from foreign-exchange trading.