U.S. banks increased sales of protection against credit losses to holders of Greek, Portuguese, Irish, Spanish and Italian debt in the last quarter of 2011 as the European debt crisis escalated.
Guarantees provided by U.S. lenders on government, bank and corporate debt in those countries rose 10 percent from the previous quarter to $567 billion, according to the most recent data from the Bank for International Settlements. Those guarantees refer to credit-default swaps written on bonds.
JP Morgan and Goldman Sachs Group Inc., two of the top CDS underwriters in the U.S., say they have bought more protection than they sold, indicating they may benefit from defaults in the region. That outcome is called into question by JPMorganâ€™s $2 billion loss on similar derivatives, which shows that risks donâ€™t vanish when offsetting bets are taken, said Craig Pirrong, a finance professor at the University of Houston.
â€œAll these hedges trade one risk for another,â€ said Pirrong, whose research focuses on derivatives markets. â€œThe banks say theyâ€™re flat on European risk, but thatâ€™s based on aggregated positions. We donâ€™t know how those will hold off if the European crisis blows up.â€
JPMorgan Chairman and Chief Executive Officer Jamie Dimon said last week that the bank was trying to reposition a portfolio of corporate credit derivatives and used a flawed trading strategy. The lender, the largest in the U.S. by assets, is believed to have sold protection on an index of corporate debt and bought protection on the same index to hedge its initial bet, according to market participants who asked not to be identified because their trading strategies arenâ€™t public.
The two bets moved in opposite directions this year, causing losses and proving that even hedges that look perfect can break down, Pirrong said.