J.P. Morgan Adds to Derivatives Muscle
Bear's Collapse Risked
Weakening Big Market
For Spreading Out Risk
By SERENA NG and DAVID REILLY
March 19, 2008; Page C2
With J.P. Morgan Chase
& Co.'s rescue of Bear Stearns Cos., a behemoth in the complex
world of derivatives trading has become even bigger, and the business is
now more concentrated.
J.P. Morgan has a
derivatives portfolio that is the largest by far among U.S. commercial
banks. At the end of last year, its portfolio hit $77 trillion in
"notional value," which is the value of the assets underlying these
contracts, according to its regulatory filings.
•
The Issue: J.P. Morgan, already one of the biggest players in
derivatives, is even bigger after taking on Bear Stearns's trading
obligations.
•
Background: In rescuing Bear, J.P. Morgan had an interest in
helping to prevent a broader market meltdown that could have hurt
other firms it trades derivatives with.
•
What It Means: As financial institutions merge, the risks that
derivatives are meant to disperse could become more concentrated
among fewer players.
The company's positions
were more than twice as large as those of Citigroup Inc. and
Bank of America Corp., according to data from the Office of the
Comptroller of the Currency. They run the range from straightforward
stock futures contracts to interest-rate swaps and more complex
agreements with individual trading partners.
Analysts say J.P. Morgan's
large position in the derivatives markets meant it had an interest in
seeing Bear Stearns's problems sorted in an orderly way, because Bear is
another big derivatives player. Bear's failure might have weakened the
entire market.
Now, the planned
acquisition of Bear means the risks that derivatives are meant to
disperse may be getting more concentrated among fewer players. J.P.
Morgan's influence in the market has risen because it is now standing
behind Bear's derivatives book.
"'Many pathways through
this maze of derivatives lead back to J.P. Morgan," said Martin Weiss,
president of Weiss Research, an investment-research firm in Jupiter,
Fla. "The domino effect of a major firm like Bear defaulting on its
derivative transactions may have hurt other counterparties in the
marketplace, many of which trade with J.P. Morgan."
According to its
regulatory filings, Bear had derivatives covering notional amounts of
$13.4 trillion at the end of November. Around $1.85 trillion of these
were in futures and options contracts that trade on exchanges. Nearly
$11 trillion were more complex agreements with individual parties.
In the fast-growing credit
derivatives market, the 10 biggest players were parties to nearly 90% of
the volume of contracts traded in 2006, according to a survey last year
by Fitch Ratings. J.P. Morgan was ranked third. Bear was ranked No. 9.
While most investors are
more familiar with stock and bond markets, the world of derivatives
linked to debt, interest rates and currencies is far larger and more
opaque.
Some derivatives, such as
popular futures and options contracts, trade on organized markets such
as the Chicago Mercantile Exchange. The vast majority trade directly
between big banks and financial institutions in the over-the-counter
market.
Customers in that market,
which can range from companies looking to protect against swings in
currencies to banks betting on the direction of interest rates, deal
either directly with each other, or through intermediaries called
interdealer brokers.
The market is vital to the
functioning of companies and the financial system. The total amount of
interest-rate, currency and credit derivatives outstanding at the end of
2007 was about a notional $400 trillion, the International Swaps and
Derivatives Association says.
Eye-popping notional
amounts can be somewhat deceptive. They represent the total value of the
underlying securities affected by a contract, although actual contract
values could be a fraction of that. J.P. Morgan, for example, said in
its regulatory filings that while its total derivative notional amounts
were $77 trillion, what it is owed on these contracts is 0.1% of that,
or $77 billion.
Kristin Lemkau, a J.P.
Morgan spokeswoman, said the bank didn't feel overly exposed to Bear
before the deal. "We are comfortable with the risks we are taking in
acquiring Bear at the price we paid," she said.
Policy makers are deeply
worried about the threat of a big player in these markets failing, which
could cause problems for many of its trading partners.
Sunday night, in unveiling
its acquisition of Bear, J.P. Morgan said it would immediately guarantee
the Wall Street firm's trading obligations and its counterparty risk. "J.P
Morgan Chase stands behind Bear Stearns," the bank's chief executive,
James Dimon, said in a statement.
J.P. Morgan's guarantees
effectively provided a backstop for Bear, whose credit ratings were cut
Friday by the major rating services to the low-investment-grade rung of
triple-B from single-A because of the firm's funding problems.
Those downgrades could
have forced Bear to fork over significant amounts of cash or collateral
to some of its swap counterparties, demands that could have bankrupted
the firm. The backing of J.P. Morgan, with its stronger credit rating,
prevented that from happening.
"The immediate
counterparty problem we tried to avert is tabled for now," said Carlos
Mendez, a senior managing director at Institutional Credit Partners, a
boutique investment firm in New York. "However, widespread credit
problems persist, and no solutions are on the table."
--Tom McGinty contributed to this article
Write to Serena Ng
at serena.ng@wsj.com1
and David Reilly at
david.reilly@wsj.com2
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