The hedge funds that are profiting off JPMorgan’s bad trade

Earlier this year, Neil Chriss, who runs hedge fund Hutchin Hill, said in a Bloomberg interview that he was looking to profit by buying up positions that the large banks might be forced to exit because of Dodd-Frank banking reforms. It appears he found one. Hutchin Hill is one of the many hedge funds rumored to be making money on JPMorgan’s $2 billion trading blunder.

Star hedge fund manager and chess master Boaz Weinstein, who ranked 17 on FORTUNE’s 40 under 40 last year, appears to be on the other side of the JPMorgan trade as well. Back in February, he told a crowd at a charity event that his No. 1 investment idea was to buy 10-year credit default swaps on the CDX IG 9, which are the exact type of CDS contracts being sold by JPMorgan’s London whale. He told the attendees at the conference that the CDS contract was “very attractive” and was trading at a discount.

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A spokesperson for Hutchin Hill and Weinstein’s Saba Management declined to comment.

Wall Streeters who specialize in the CDS market say it appears that dozens of hedge funds have piled into the anti-JPMorgan trade. A number of the funds, including BlueMountain Capital and Lucidus Capital, are run by traders who formerly worked at JPMorgan. Perhaps that’s not all that surprising. CDS contracts were basically created at JPMorgan more than a decade ago. So it makes sense that the traders with the most expertise in the market would come from the bank. But it’s just another sign that many traders who are fleeing the big banks are coming back to haunt their old employers.

To be sure, much of the blame for the $2 billion trading loss should be heaped on JPMorgan and its flawed idea that you could make money and hedge at the same time. Nonetheless, it appears Dodd-Frank may be amplifying JPMorgan’s losses. Dodd-Frank was supposed to move the risky business of Wall Street out of the really large banks that have federally insured deposits, and, oh yeah, an implied backing from the government, and into hedge funds. It was known that banks would lose money because they would have to close businesses they were no longer allowed to be in. But on top of that hedge funds appear to have figured out that there is money to be made by exploiting the transition and that money is coming out of the profits of the banks. JPMorgan is the first clear example of this, but expect to see more.

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Without the law, JPMorgan probably would have been able to devote more resources to the trade. In fact, Dodd-Frank was reportedly one of the reasons some hedge funds got into the trade in the first place. They figured JPMorgan’s position was so large that regulators under would eventually crack down on the bank and force it to sell its positions at a loss. It didn’t exactly happen that way. The Volcker rule, which is suppose to limit risky trading at the banks, doesn’t officially go into effect for another two years. Nonetheless, as more hedge funds rushed into the trade – buying the CDS contract that was being sold by JPMorgan, which was betting it would fall in value, that pressure instead caused the CDS contract to rise in value producing losses at JPMorgan.

If losses at JPMorgan and other banks are being created in part by Dodd-Frank, it certainly is an unintended consequence, but surprisingly it might not be a bad one. Regulators, for instance aren’t going to be able to police every trade at a big bank to make sure it is not proprietary trading. But as the banks have mission creep away from pure hedging, the fact that the law allows hedge funds to be more nimble and deliver a smackdown to banks that get out of line is a good thing. True market regulation. That is as long as the losses suffered by the banks, as is the case in this instance with JPMorgan’s $2 billion hit, are not big enough to cause a bank to fail.

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But unlike say John Paulson’s bet against housing, or Soros against the pound, this trade is unlikely to produce a huge haul. BlueCrest Capital, another hedge fund firm that is reportedly making money taking the opposite trade of JPMorgan, has a closed end mutual fund that anyone can buy into. The fund, BlueCrest AllBlue, which is traded on the London Stock Exchange, has about a third of its funds in the BlueCrest hedge fund that has the anti-JPMorgan trade on. But anyone that has bought into the fund hoping to make a big haul on JPMorgan’s misfortune has so far been mostly disappointed. The closed-end fund’s net asset value is up just 1.2% since JPMorgan disclosed the news of its trading losses last week. Not a whale of a trade.