Ex-J.P. Morgan trader wins at BlueMountain by betting against bank

Andrew Feldstein
Andrew Feldstein

Andrew Feldstein, who bet against J.P. Morgan Chase & Co. before helping the bank unwind more than $20 billion of trades, has emerged as one of the biggest winners among hedge fund managers profiting from a flawed strategy.

The $4.3 billion flagship fund of Mr. Feldstein's BlueMountain Capital Management LLC returned 9.5% this year through June 22, according to a person familiar with the data. That's up from the 5.4% return before J.P. Morgan announced a $2 billion loss by one of its traders. BlueMountain, which was on the other side of those wagers, stands to make as much as $300 million, said market participants familiar with the trades.

Mr. Feldstein, a former J.P. Morgan executive who helped the company create the credit-derivatives market, profited by exploiting price distortions caused by the outsized bets and then aiding the bank in unwinding the trades as it sought to cap the loss, according to four people with knowledge of the strategy who asked not to be identified because the matter is private. BlueMountain enabled J.P. Morgan to unload more than $20 billion of bets on a credit-swaps index, two of the people said.

“Andrew Feldstein is one of the most creative and sophisticated investors in fixed income,” said Sarah Quinlan, founder of hedge fund advisory firm QAM in New York and a former BlueMountain investor. “It is not surprising that J.P. Morgan would reach out to him to assist in the unraveling of this complicated and very public situation.”

By assisting J.P. Morgan in unwinding its trades, Mr. Feldstein enabled the bank to take losses in the second quarter and move ahead with less uncertainty, said Adrian Miller, director of global markets strategy at GMP Securities LLC in New York. BlueMountain also helped J.P. Morgan CEO Jamie Dimon put behind him a trading debacle that brought scrutiny from Congress and regulators and tarnished his reputation as one of the industry's best risk managers.

Mr. Dimon “will be judged by how this problem is rectified,” Mr. Miller said.

Doug Hesney, a spokesman for BlueMountain, declined to comment, as did Kristin Lemkau of J.P. Morgan.

J.P. Morgan hired Mr. Feldstein, a graduate of Georgetown University and Harvard Law School, in 1992, as it was developing a new market that allowed banks to pay investors to take on the risk that companies default on their debt. Those financial instruments, known as credit-default swaps, evolved into a market with more than $62 trillion of outstanding contracts at its peak in 2007.

A former Harvard Law classmate of Barack Obama's who played pickup basketball with the future U.S. president, Mr. Feldstein has kept a low profile outside financial markets, rarely giving interviews.

“He's a very modest individual,” said William S. Demchak, president of Pittsburgh-based regional lender PNC Financial Services Group Inc., who hired Mr. Feldstein at J.P. Morgan. “The reason he doesn't talk publicly is he has no ego. He's not a master of the universe and wanting to make big bets and be a hero. He comes to work every day and tries to, with his team, earn a sensible return on the money they're investing.”

Messrs. Feldstein and Demchak later teamed up to raise money for the Darfur Project, which from 2007 to 2009 sponsored airlifts of food and medicine to those affected by conflict in Sudan's Darfur region.

Master arbitrager

Since starting New York-based BlueMountain in 2003 with Harvard Law friend Stephen Siderow in a spinoff from BlueCrest Capital Management LLP, Mr. Feldstein has earned a reputation as a master arbitrager. His hedge fund has generated almost 10% annual average returns largely by spotting abnormalities in the price relationships in credit swaps. Rather than bet on whether the price of a company's debt will rise or fall, the fund often takes both sides of the trade and profits when the price relationships revert to normal.

With complex trades that can sometimes have more than 100 separate pieces, that strategy also has helped make BlueMountain one of Wall Street's biggest clients.

By June 2008, BlueMountain was Goldman Sachs Group (GS) Inc.'s fourth-largest counterparty in the credit-derivatives market, with $590 billion of outstanding contracts, bigger than that of banking giants Barclays PLC and Credit Suisse Group AG, according to a 2010 report by the Financial Crisis Inquiry Commission, a U.S. panel that investigated the credit seizure.

Goldman Sachs at the time was acting as a prime broker for BlueMountain, lending money and securities and clearing credit- swaps transactions, according to two people familiar with the firm, who asked not to be identified because they aren't authorized to discuss the business.

The hedge fund's trading book reached the size it did in large part because, rather than tear up the bulk of its swaps when it was ready to close out a position, BlueMountain put on offsetting trades to cancel them out, the people said.

Exodus of investors

After Lehman Brothers Holdings Inc.'s 2008 bankruptcy, as fears of a cascade of bank and hedge fund failures gripped markets, BlueMountain faced an exodus of investors, even as its flagship Credit Alternatives Master Fund outperformed an industry average tenfold. Mr. Feldstein moved to bar withdrawals and freeze $3.1 billion of assets.

BlueMountain shifted almost all of its trades out of Goldman Sachs. Most of those went to J.P. Morgan, now the fund's biggest prime broker, perceived by the market at the time as a more creditworthy counterparty, according to a person familiar with the fund. Tiffany Galvin, a Goldman Sachs spokeswoman, declined to comment.

Mr. Feldstein laid out a plan to restructure the fund, and investors owning 80% of the assets agreed to keep their money in place while markets improved, according to a November 2008 letter to investors, a copy of which was obtained at the time by Bloomberg News.

The credit-alternatives fund, which lost 6% in 2008, went on to return 24.4% in the first eight months of 2009 as markets recovered from the crisis, according to a letter to investors at the time.

One of the trades BlueMountain has mastered better than almost any other hedge fund, according to market participants, involves arbitraging the gap between credit-swaps indexes and contracts on the companies tied to those benchmarks. When the cost to buy protection on the index drops below the average cost of swaps on the companies, the fund will purchase protection on the benchmark and sell it on its constituents, profiting when the swaps converge.

That was the opportunity funds noticed last year as a trader in J.P. Morgan's chief investment office in London, Bruno Iksil, began making outsized bets on the Markit CDX North America Investment Grade Index Series 9. The index, known as IG9, is tied to 121 companies that were investment-grade when it was created in September 2007, including now junk-rated bond guarantor MBIA Insurance Corp., a unit of MBIA Inc., and retailer J.C. Penney Co.

Mr. Iksil managed a portfolio of credit swaps that, Mr. Dimon told the Senate Banking Committee June 13, was intended to profit in a financial crisis and make “a little money” in a benign market.

Mr. Iksil's group was instructed to cut positions in December in anticipation of new capital rules, Mr. Dimon told the Senate panel. Instead Mr. Iksil sought to offset the hedges by selling protection on the IG9 index through December 2017 to dealers such as Bank of America Corp. and Citigroup Inc., which in turn sold that protection to money managers including BlueMountain, market participants said.

In the 14 weeks ended April 6, outstanding bets on the index using credit swaps surged an unprecedented 65% to $148.2 billion, according to the Depository Trust & Clearing Corp., which runs a central registry for the market.

The net amount of credit-derivatives protection the bank sold on investment-grade companies using contracts expiring in more than five years doubled to $101.3 billion in the three months ended March 31, Federal Reserve data shows.

Mr. Iksil's bets were so large that he drove the price of the index far below the average of the underlying companies. That made the price of the index equivalent to buying $1 of protection for about 80 cents, market participants said. Hedge funds could arbitrage the gap and build positions against J.P. Morgan by buying swaps on the index and selling CDS on the constituent companies.

The potential gains lured BlueMountain and other hedge funds to buy more protection as Mr. Iksil continued offering to sell to brokers — even as it initially led to losses because the J.P. Morgan trader's bets moved the index lower.

After J.P. Morgan announced the $2 billion loss, the cost of the IG9 index surged in anticipation the bank would unwind its bets. The swaps, which had fallen to as low as 102 basis points in March, jumped to 175 on June 5, or $175,000 a year to protect $10 million of debt, according to data provider CMA.

Exiting the index bets quickly was difficult because they were large relative to the amount that trades on any given day, DTCC data show. Unlike the current version of the index known as Series 18, on which an average $27.6 billion trades each day, $5.5 billion of IG9 exchanged hands each day in the 12 weeks ended June 22.

Hard not to notice

“When you put on a large trade, it's hard for people not to notice what you're doing,” Scott MacDonald, head of research at MC Asset Management Holdings LLC in Stamford, Conn., said in a telephone interview last month. “It's a treacherous landscape to be unwinding the trade in.”

That's where BlueMountain came in. Because the hedge fund executes so many trades in credit swaps to support its arbitrage strategies, and it falls outside the typical web of market-makers, it was in a better position than J.P. Morgan to take the bank out of a large chunk of its losing bets without tipping off other investors, said two market participants familiar with credit-swaps trading.

“(Mr.) Feldstein is a former J.P. Morgan exec and likely has a good relationship with senior management,” said Mr. Miller of GMP Securities. “Since transacting these trades with as little market knowledge as possible is the key to not creating big price fluctuations, who better to go to than a trusted prior colleague?”

Within the past few weeks, BlueMountain, which oversees $9.2 billion across all of its funds, has been buying default protection on IG9, a position that would offset the bets J.P. Morgan already has, and then selling it to the bank.

The transactions, first reported by Bloomberg News on June 20, are among trades that may have helped reduce the bank's exposure to the index by more than half, according to estimates from market participants familiar with trading activity.

During the three weeks ended June 22, as the cost of the IG9 index contracts fell to 159 basis points from as high as 175, swaps dealers cut the net amount of protection they had sold on the index by 65%, DTCC data show. J.P. Morgan is the only one of the six biggest U.S. banks to have sold more protection on investment-grade companies than it had bought, Fed data through the end of March show.

Mr. Dimon said on May 10 that the bank's loss could reach $3 billion or more. Charles Peabody, an analyst at Portales Partners LLC in New York, estimated the amount could be between $4 billion and $5 billion. J.P. Morgan hasn't disclosed how much of the money-losing trades it's still holding. The bank has said it will provide an update on the loss and where its position stands when it reports earnings July 13. 