Backstopping Bear, Morgan saved the shadowy derivatives world

Morgan Adds to Derivatives Muscle

By Serena Ng and David Reilly
The Wall Street Journal
Wednesday, March 19, 2008

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 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."

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