(FORTUNE Magazine) – In this jittery market, it takes only a rumor to send investors dashing to the lifeboats. A few weeks ago fears that deteriorating credit would push Ford Motor into bankruptcy sent its stock down 8% and helped the Dow plunge more than 200 points in one day. Now new rumors are starting to swirl around an exotic area of financing called credit derivatives. And the industry's biggest player, J.P. Morgan, is at the center of the storm.

Few areas of finance are so convoluted. But in its simplest form, a credit derivative is a hedge against bond or loan losses. A financial institution sells a holder of, say, $100 million of IBM's debt a promise that if the computer giant defaults, the holder will get back his money in full. If nothing happens, the institution pockets the fee. But if Big Blue comes up short, the institution has to cover the loss. The credit derivatives market has boomed--it's grown 60% worldwide over the past year to cover $2 trillion of debt, according to the British Bankers Association. And insurers and banks have come up with mind-boggling structures to spread credit risk around, trading it back and forth until it's nearly impossible to tell where the liability is. No less an authority than Alan Greenspan has said this is a good thing; better to have lots of little hidden losses than one big loss that rocks the whole system.

Except that now the system is being tested. Corporate borrowers around the globe have defaulted on $136 billion of debt through the third quarter of this year (far outpacing the $117 billion for all of 2001, already the third year of record defaults). The impact on users of derivatives--insurance companies in particular--is starting to show. Chubb, for instance, reported a $10 million loss in credit derivatives in the second quarter. Analysts think more pain may soon surface. "We've had huge value destruction this year, much more than in 1998, but it's much less visible," says Chris Francis, head of credit research at Merrill Lynch in London.

Which brings us to J.P. Morgan. It practically invented credit derivatives half-a-dozen years ago and is the biggest player by a huge margin: The bank currently accounts for 60% of the U.S. bank market and between 20% and 30% of the total global business. But J.P. Morgan has credit troubles of its own, and they threaten to roil the entire derivatives market. On Sept. 17, the day J.P. Morgan unexpectedly warned it would have $1.4 billion in losses on plain-vanilla loans, S&P lowered the bank's credit rating to AA-. That sliced 5% off the stock, which is down 44% so far this year. Worse, analysts say this puts J.P. Morgan just one notch away from real trouble, as most derivatives players don't want to deal with counterparties with less than a AA rating (there are fears that another downgrade could be on the horizon).

The bank can--and in the case of some deals, must--rejigger derivatives contracts to appease leery counterparties, and that will take a financial toll. But stopping the erosion of confidence is going to be even tougher. "Financial institutions are either highly rated or they go into a spiral and start to lose business," says Tanya Azarchs, S&P's banking analyst in New York. Should that happen, it will affect every part of J.P. Morgan's derivatives business, not just the 10% or so that credit derivatives makes up. "A further downgrade of J.P. Morgan would lead to a big disruption in the credit derivatives and other derivatives markets," says one research analyst in London.

So far any damage at J.P. Morgan is hard to gauge because the bank doesn't break out gains and losses on credit derivatives. The company's overall trading revenue dropped by 68%, to $365 million, between the second and third quarters of this year. (The bank blamed bad interest rate bets and losses in equity derivatives and convertibles, but some analysts believe bad credit derivatives bets are also to blame.) For its part, J.P. Morgan says the market's fears are overblown. Blythe Masters, who runs the bank's overall credit portfolio, says it would take the default of fully 30% of America's investment-grade corporate bonds for the bank to post big credit derivatives losses. Were a further credit downgrade to occur, the bank says it could still "maintain our position as the world's leading derivatives provider," though it would be "difficult to speculate on the effect to our earnings."

That speculation is what has investors spooked. "The bottom line is that there is a great deal of information risk," says Mike Mayo, banking analyst at Prudential Securities in New York. He compares assessing the bank's exposure to "looking at a black box." But in this market, that's a risk most investors are no longer willing to take.

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