JP Morgan's ongoing multibilion dollar loss from credit default swap (CDS) trades shares some disturbing similarities to the CDS trades that caused AIG to collapse in 2008. In both cases, the firms sold massive amounts of CDS protection. By 2007, AIG had sold in notional value $78 billion in ultimately ruinous CDSs. By some estimates, JP Morgan is currently long as much as $100 billion in losing CDS positions. In both cases, the regulators and executives that should have prevented or at least known more about the trades were caught blindsided. Reliance on flawed risk models also enabled both firms' losses.
Yet as Congress focuses on JP Morgan's CDS losses in its hearing today with bank regulators, and next week with JP Morgan CEO Jamie Dimon, it is worth noting that there are crucial differences between JP Morgan's and AIG's CDS losses. The differences are important because they indicate that the CDS market has become much safer than it was prior to the financial crisis, even if particular firms still misuse the instruments.
Different Underlyings: Corporate Bonds Versus Mortgage-Related Securities
The first and most significant difference is that JP Morgan sold protection referencing a far more rationally priced and liquid market than did AIG.
JP Morgan's losing trades reference an index of North American investment grade bonds (the Markit CDX NA IG Series 9). Although bonds are not as liquid as stocks, the market for corporate bonds is robust and pricing is readily available. AIG, by contrast, sold CDSs referencing residential mortgage-related securities. When AIG was selling these CDSs, residential mortgage-related securities were mispriced, and the instruments were rarely traded and difficult to value.
Indeed, the efficiency of the corporate bond market underlying JP Morgan's trade explains why JP Morgan's massive CDS position distorted the CDS market in a way that became readily apparent to its counterparties. In the case of AIG, the market distortions caused by its mortgage-related CDS trades led it to become the "golden goose" underlying the mispriced synthetic securitization market of the better part of the last decade.
Importantly, the CDS market today poses much less of a risk to the financial system because CDSs are rarely written on illiquid mortgage-related securities any longer, in large part because of the shut down of private-label mortgage securitization since the financial crisis. This shut down is reflected in the following figure by Paul Rowady (page 68), which shows the collapse of special purpose shell entities selling mortgage-related CDSs:
Different Types of Risks: Market Value Versus Cash Crunch
The second major difference is the types of risks that arose from JP Morgan's and AIG's CDS trades. While JP Morgan's failed CDS trades are causing it unrealized paper losses, AIG's CDS trades caused it to practically run out of cash overnight and created risk for its counterparties and the economy.
AIG posted nearly $20 billion in collateral by August 2008 as the market value of the securities referenced by its CDSs plummeted. AIG was later bailed out by the government when it was unable to meet a second $20 billion collateral call from its mortgaged-related CDSs. AIG's collateral posting obligations were so large and sudden in part because it never posted collateral when the trades were first executed.
By contrast, the losses to JP Morgan from its CDS trades require the firm to reduce the balance sheet value of its CDS positions. JP Morgan was required to mark down the value of its CDS trade because the price of the reference index increased, thereby decreasing the value of the CDS protection it sold. Although JP Morgan's paper loss will reduce its profits, may require it to set aside or raise more capital, and lead to a realized loss once the trade comes to completion, it is unlikely that JP Morgan will actually have to make a cash pay out under its CDS trades. This is because the likelihood of default of any of the investment grade companies making up the referenced index is low.
Due to these differences, one should think twice before drawing conclusions about the CDS market based upon analogizing between JP Morgan and AIG.