Banks in US sold more Europe-debt insurance as risks rose

May 18 (Bloomberg) -- 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.

JPMorgan Chase & Co. 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 JPMorgan’s $2 billion loss on similar derivatives, which shows that risks don’t vanish when offsetting bets are taken, said Craig Pirrong, a finance professor at the University of Houston.

“All these hedges trade one risk for another,” said Pirrong, whose research focuses on derivatives markets. “The banks say they’re flat on European risk, but that’s based on aggregated positions. We don’t know how those will hold off if the European crisis blows up.”

JPMorgan’s Chief

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 aren’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.

JPMorgan said in a regulatory filing that it purchased $144 billion of CDS related to the five European countries as of the end of the first quarter, while it sold $142 billion. Goldman Sachs bought $175 billion of protection and sold $164 billion, the firm said in its filing. Spokesmen for the two New York-based companies declined to comment. Bank of America Corp., Morgan Stanley and Citigroup Inc. report only net CDS exposures.

The five banks together account for 96 percent of the credit-derivatives market in the U.S., according to the Office of the Comptroller of the Currency. JPMorgan has written a quarter of the total. U.S. banks’ sales of CDS on five European countries’ debt surged 30 percent during 2011 from $496 billion at the end of the previous year, BIS data show.

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