JP Morgan CDS exposure may top $10trn notional

JP Morgan's proposed acquisition of Bear Stearns could thrust the bank's already formidable footprint in the credit default swaps (CDS) market through the $10 trillion barrier, raising questions over the prudence of such large concentrations within a single firm.

JP Morgan already has $7.9 trillion of CDS contracts outstanding, more than twice that of Citi, the second largest player in the market, with $3 trillion outstanding. Bear Stearns holds a share somewhere below this, and although it was unable to confirm the exact size of its CDS business, analysts estimate it has as much as $2.5 trillion in swaps outstanding.

Should the sum be added to JP Morgan's own CDS book, the resulting $10.4 trillion volume would constitute just under a quarter of the credit derivatives market, estimated at $45.46 trillion in notional outstanding as of June 2007 by the International Swaps and Derivatives Association. The prospect of a single institution acting as counterparty for almost 25% of outstanding CDS trades has raised fears about extreme concentrations within the market.

Last month, analysts at Barclays Capital calculated that the failure of a dealer with $2 trillion in CDS contracts outstanding would lead to losses of between $36 billion and $47 billion for counterparties in those trades. JP Morgan analysts stress, however, that its CDS receivable mark-to-market exposure - a method they insist is a more reasonable measure of risk - is just $22 billion.

In fact, some participants suggest the idea of a $10 trillion notional CDS exposure is far-fetched, and that a significant proportion of Bear Stearns' outstanding CDSs would be netted against offsetting JP Morgan trades.

Netting

"JP Morgan will take Bear Stearns' CDS inventory on to its inventory and then net it down against other trades it has on its own book," says Lars Toomre, president of Connecticut-based financial engineering consultancy Toomre Capital Markets. "All outstanding swaps between JP Morgan and Bear Stearns will immediately be unwound, but there will also be CDS trades with other counterparties that both firms have in effect, and they too will have to be taken off. A lot of netting is likely to go on with such a big book of business, especially since those CDS contracts will probably be concentrated among the 20 US banks that serve as primary dealers."

In the last week of March, after news broke of JP Morgan's increased $1.2 billion offer, five-year CDS spreads on financials tightened, with Bear Stearns narrowing by 35 basis points to 330bp on March 24, according to data from New York-based interdealer broker Phoenix Partners Group.

Peter Madigan.