The Size of J.P. Morgan's potential liability (NYSE: JPM)

NEW YORK - It is possible to figure out the possible loss of JP Morgan's trading operating. The company sold credit default swaps something that is probably the most dangerous kind of derivative. This is because the credit market is very related and a collapse in one sector can cause a domino effect and collapse the market. This differs from selling insurance on a house. If one house crumbles its unlikely a house in another city will fall. If a bank crumbles its likely to have shock waves throughout the market.

The other giant risk of credit default swaps unlike insurance is that the payout can be extremely large. This is because someone may pay 1% to buy insurance on a bond but the payout would be 100% of the bond and unlike a bond as soon as the company defaults the maximum payout happens.

JP Morgan said it expected $800 million of profit in its CIO unit. From this we can deduce the size of the derivative. Because the company has about $1 billion of overhead expense tied to this unit as well as a tax expense on its profits. The CDS was likely very stable which the bank would want. Probably it had a CDS yeiled of 0.5% to 1%.

If J.P. Morgan sold $200 billion of CDS with a yield of 1% they could expect about $2 billion a year in interest income and that matches up nicely to the expense of around $1 billion. Which the company would need to make a $200 million profit. This 1% payment also makes sense because the yield on mortgage backed securities at this time is small and its unlikely the yield would be too high. Since no one would pay more for protection than the yield itself.

Here is a graph of possible loss scenarios. Given that J.P. Morgan sold $200 billion CDS at a yield of 1%.




As can be seen the losses would be linear. It is fairly simple example. And perhaps is not exactly how JPM's cds function but it should be similar. The notional amount of the derivative is $200 billion. Had they sold it at a yield of 1% then they would expect $2 billion in premiums a year. At the end of each quarter if the yield stays at 1% they would recognize 1/4 of the profit since there was no default that month. However if the yield goes up to say 2% then they would start recognizing losses. This is because the value of the option is now $4 billion but JP morgan is getting only $2 billion. So the $1 billion in premium would not be compensating.

It is likely the total loss if the U.S. system collapsed would be $200 billion but if JP Morgan had to pay that out then there would be bigger problems to worry about. Meaning the eventual loss will likely be zero. That is if they hold the position. Something the company is probably not doing because the potential maximum loss is so huge it would wipe out the company. The bank will probably buy back its position for the loss.   The possible paper loss this currently could not be more than $6 billion. Since its unlikely the yields can really rise more than a few percentage points given the quality of the collateral.