Bloomberg News

Structured Notes Mirror JPMorgan’s London Whale Credit Trades

April 09, 2013

Banks are boosting sales of structured notes based on derivative bets similar to those that cost JPMorgan Chase & Co. (JPM:US) more than $6 billion in the so-called London Whale loss.

Nordea Bank AB (NDA), SEB AB and BNP Paribas SA (BNP) sold more than $60 million of notes this year tied to portions of credit- default swap indexes protecting against losses on company debt. The tranches offer investors varying degrees of risk among a pool of companies.

JPMorgan trader Bruno Iksil became known as the London Whale because of the size of his trades in tranches of the Markit iTraxx CDX North American Investment Grade index of swaps. Nordea and SEB’s structured notes are mainly linked to portions of the Markit iTraxx Europe Index of investment-grade companies and the Markit iTraxx Crossover Index, which tracks mainly junk-rated companies in Europe.

“Sophisticated investors should run far and fast from this,” said Janet Tavakoli, founder of Chicago-based consulting firm Tavakoli Structured Finance Inc. Wealthy individuals, who are the main buyers of the securities, are unlikely to understand all the risks they are taking or be appropriately compensated for them, she said.

Issuers of the notes generate income by selling default insurance on portions of the credit indexes that have various levels of risk and reward.

iTraxx Europe

Nordea sold $35.5 million of notes tied to the 4 percent to 12 percent tranche of the latest series of the Markit iTraxx Europe index. That means investors start losing money when losses on the index reach 4 percent, and that they’re wiped out when they exceed 12 percent.

The notes pay as much as 5 percent, according to data compiled by Bloomberg. The largest Nordic lender also issued 46.1 million Norwegian kroner ($8 million) of securities yesterday linked to the 10 percent to 100 percent tranche of the Crossover index.

“Investors are looking for additional yield through leverage and these notes are one way of achieving that,” said Antti Parviainen, head of investment products for Finland at Nordea in Helsinki.

Investors in the note linked to the Crossover tranche would start losing money when eight companies on the index default, according to Abel Elizalde, European credit derivatives strategist at Citigroup Inc. in London. His calculations are based on a 40 percent recovery rate, the amount bondholders would get back in a default.

Significant Risk

Structured notes tied to index tranches can have “significantly higher” risks than notes tied to whole indexes or single companies, said Elizalde. Potential returns on the securities can also be higher, he said.

Norwegian papermaker Norske Skogindustrier ASA (NSG) is the company in the Crossover index with the highest perceived risk of failure, with credit-default swap prices signaling an 82 percent chance the company won’t be able to meet its liabilities within the next five years, Bloomberg data show. Spanish gaming company Codere SA has an 78 percent probability of default, swaps show.

The global speculative-grade default rate is forecast to end this year at 2.8 percent, compared with an average of 4.7 percent since 1983, Moody’s Investors Service said yesterday.

SEB also sold notes tied to tranches of the Markit’s iTraxx Europe and Crossover indexes, said Holger Cassens, head of structured derivatives at SEB’s German unit in Frankfurt.

Capital Protection

The Stockholm-based lender issued 5 million euros ($6.5 million) of notes in November that are linked to the 12 percent to 50 percent tranche of the Crossover index and pay 8.75 percent, Bloomberg data show. Investors’ capital is protected for up to five credit events, after which their principal will be reduced by 5 percent for every additional credit event, said Cassens.

The bank also sold $6.2 million of five-year notes on Feb. 12 linked to the 16 percent to 35 percent tranche of the Markit CDX North American High Yield Index, Bloomberg data show. The securities were sold via two offerings in dollars and euros with coupons of 6 percent and 7 percent.

“Demand is rising for these notes because investors get more attractive yields and they are protected for a few credit events,” said Cassens. “You can’t predict what will happen in the future, but so far clients feel comfortable with the buffer.”

Lehman Brothers Holdings Inc. sold the first structured notes tied to a credit default-swap index tranche in November 2005, when it issued 15 million euros of 10-year securities tied to the 3 percent to 6 percent portion of the fourth series of the Markit iTraxx Europe Index, according to data compiled by Bloomberg.

The notes were unsecured and investors lost their money when the U.S. bank collapsed in September 2008. Note holders would be creditors in bankruptcy proceedings.

To contact the reporter on this story: Alastair Marsh in London at amarsh25@bloomberg.net

To contact the editor responsible for this story: Paul Armstrong at parmstrong10@bloomberg.net


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