Such stratagems as crossing dealers aside, BlueMountain became a coveted customer for banks that trade derivatives, people familiar with the firm’s relationships say. By mid-2008, it was turning over billions in assets and paying millions in commissions. That year, BlueMountain was Goldman Sachs’s fourth- largest counterparty in credit derivatives, according to a 2011 report by the Financial Crisis Inquiry Commission.
Feldstein (Source: BlueMountain)
Then prices plunged, and the banks panicked. Goldman and Morgan Stanley asked BlueMountain to put up more collateral, according to five people familiar with the matter. On the other side, hedge funds such as BlueMountain worried about the stability of their prime brokers. By the end of 2008, BlueMountain had less than $1 billion left at Goldman, according to a person familiar with the matter.
One bank still welcomed BlueMountain: JPMorgan, Feldstein’s alma mater. It became, and remains, BlueMountain’s biggest prime broker.
BlueMountain’s investors also got nervous in 2008, and some asked for their money back. Feldstein invoked the terms of the investors’ contracts and refused, saying he’d have to hold a fire sale to raise the money.
“We are not comfortable with this state of affairs,” Feldstein told investors in a letter dated Nov. 3, 2008.
Some investors who wanted their money out of the flagship Credit Alternatives fund had to wait until 2009. Bailing out, however, was a bad move. Credit Alternatives lost 6 percent in 2008. It then roared back, putting up a 37.6 percent return in 2009 as the panic subsided and credit markets recovered.
BlueMountain’s 2012 returns had been lackluster -- up 5.4 percent -- until the London Whale came along.
That trade was tailor-made for BlueMountain. JPMorgan’s Iksil was trading in an esoteric security: the ninth series of the Markit CDX North American Investment Grade Index, known as IG9. The index tracks prices of CDSs on the debt of 121 companies, and it fell sharply from December to March. The reason: Iksil was selling swaps linked to the index.
Feldstein and others saw that IG9 was trading below what they would pay if they bought swaps on the companies separately. Buying the index got you $1 of protection for 80 cents. BlueMountain bet against Iksil by buying IG9 and selling the constituent swaps, wagering they would converge.
For months, they were wrong. Iksil kept selling IG9, driving it downward. BlueMountain held on. Then, on May 10, JPMorgan ended the game by announcing a $2 billion loss, attributing it to bad bets in Iksil’s unit. The index rocketed skyward, jumping from as low as 102 basis points in March to 175 basis points on June 5, or $175,000 a year to protect $10 million of debt, according to data provider CMA. (A basis point is 0.01 percentage point.)
JPMorgan had to get out of Iksil’s position, which was huge relative to the daily volume in IG9. In the 14 weeks ended on April 6, outstanding bets on the index using swaps rose an unprecedented 65 percent to $148.2 billion, according to Depository Trust & Clearing Corp., which runs a central registry for the market.
BlueMountain owned contracts JPMorgan needed to offset its losses. Feldstein could buy more without attracting attention, because the firm traded so many derivatives already.
BlueMountain picked up more IG9 positions and sold more than $20 billion worth of offsetting contracts to JPMorgan, according to people familiar with the trade.
Both BlueMountain and JPMorgan are careful to point out that the hedge fund was not acting as an agent of the bank. Hedge funds and their bank counterparties often form “strategic partnerships” that result in “win-win” situations for both, Markus, BlueMountain’s senior portfolio manager and managing principal, said in an October interview. “You achieve the goals of the banks, and you achieve the goals of guys like ourselves.”
In the six months after JPMorgan’s May 10 announcement, returns on BlueMountain’s flagship fund more than doubled. And the bank, even as it racked up $6.2 billion in losses, had Andrew Feldstein and his bailout crew to thank that the Whale did not sink its ship.
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