Views on improving the integrity of global capital markets
14 May 2012

JPMorgan’s Derivatives Blow-up May Benefit Taxpayers

It was bound to happen, a bank getting caught red-handed trading derivatives like it was a reunion of 2007 risk traders. But that it was JPMorgan Chase that found itself under the bare light bulb of significant “risk-on” derivatives losses is a true surprise.

Luminary Chairman and CEO Jamie Dimon did his best to navigate the controversy as an honest mistake: “Admit it, fix it, and move on — it is part of the normal process of hedging firm risks.”

He was no doubt hoping that would be the end of it. Yet, more than a few will want to know how “hedging” losses can wipe out 1 percent of this firm’s capital in a few short weeks and erase $11 billion in market cap in minutes. Not very reassuring when one considers that JPM and many banking firms of lesser reputation are putting taxpayer dollars at risk every day.

The disclosure coincides with the recent filing of the firm’s 10-Q and amounts to what is called a “Type II subsequent event.” The Wall Street Journal reported that the trades came from the bank’s Chief Investment Office, which the Journal notes is responsible for managing the firm’s risk.

“The bank, betting on a continued economic recovery with a complex web of trades tied to the values of corporate bonds, was hit hard when prices moved against it starting last month, causing losses in many of its derivatives positions. The losses occurred while J.P. Morgan tried to scale back that trade.”

I’m no trader, but that sounds more like a proprietary trade than a hedge. A legitimate hedge is intended to offset potential losses in a cash position, not create a loss on its own. And if the hedging instrument creates a loss, it is typically offset by a gain in the cash instrument.

It is possible that the instrument they used to hedge was a poor match for the position being hedged. In that case, one wonders just how often the global leaders in over-the-counter (OTC) derivatives simply outsmart themselves in the structured market. We can think of more than a few who are no longer around to tell us.

More troubling is the potential that the Chief Investment Office took it upon itself to take a proprietary position on the direction of the market. Indeed, the Journal quoted Dimon as saying that the hedging strategy was “flawed, complex, poorly reviewed, poorly executed and poorly monitored,” suggesting something was askew in the trades. That is precisely what a properly calibrated Volcker Rule is designed to prevent.

Regardless, the $2 billion write-off is but 1 percent of the $190 billion the bank reported as equity in its just-released first quarter 10Q. Dimon also noted that the bank would still earn around $4 billion for the quarter, versus $5.4 billion last quarter.

But JPMorgan is damn good at this — they’ve been leaders in this market since the mid-1990s. Even they suffer from a continued lapse in oversight and strategy. That raises concerns about all the other firms, both in the United States and elsewhere, with less experience, weaker controls, and weaker financials. Once again, this is the point of the Volcker Rule — to prevent banks from putting bank capital, insured deposits, and taxpayer funds at risk to support bad trades.

The JPMorgan mess highlights another problem, as well: the difficulty in distinguishing prop trading from other legitimate and permitted activities. In this case it was hedging, but there also are concerns with market making. When CFA Institute wrote its letter to U.S. regulators otherwise supporting the idea of the Volcker Rule, we expressed concern about its implementation, due to difficulties distinguishing prop trading from legitimate market making, particularly in the fixed-income markets. Rather than ban market making, we suggested moving such activities to a separately structured and capitalized broker/dealer affiliate, and insulate (ring-fence in the parlance of the Vickers Report) the bank — and taxpayers — from such trading activities.

For the banking industry, this news couldn’t come at a worse time in its battle against implementation of the Volcker Rule. The odds were that something like this was going to happen eventually. That it happened now, and to JPMorgan, only makes their arguments for a lighter-touch Volcker Rule more hollow.

For taxpayers, on the other hand, the circumstances might be opportune.

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Image Credit: ©

About the Author(s)
Jim Allen, CFA

Jim Allen, CFA, is head of Americas capital markets policy at CFA Institute. The capital markets group develops and promotes capital markets positions, policies, and standards.

5 thoughts on “JPMorgan’s Derivatives Blow-up May Benefit Taxpayers”

  1. The bank last week disclosed a massive trading bet that resulted in the $2 billion-plus loss. As the chief investment officer of J.P. Morgan, Ms. Drew was the head of the risk-management group that sustained the trading losses.It affect tax payers as well.

  2. Jim Allen, CFA says:

    Dear FMS:

    It was indeed a bizarre event – risk management engaged in massive trading to hedge a hedge (a plausible explanation of the trades is provided here, though I disagree completely with their suppositions about the purpose for the Volcker Rule and rules on derivatives). One might have thought that risk management was there to prevent those kinds of trades.

    On the positive side, the head of the chief investment office is gone, and several others are likely to face the job market very soon. Those who are still around, including Mr. Dimon, saw the value of their stock options and shares fall by 10 percent. In a sense, this is the accountability one wants from private institutions.

    The question is what would have happened if, instead of $2 billion, the losses had amounted to, say, $100 billion (hopefully this is taking things to the level of the absurd, but Fannie and Freddie substantially raised the absurdity threshold a few years ago). The traders and even Mr. Dimon certainly would have lost their jobs, and shareowners would have been wiped out. All well and good. But they are small pickings when it comes to modern, highly leveraged financial institutions. Creditors, including depositors, provide 90 percent or more of an institution’s funding (it was closer to 96 percent in Bear, Stearns & Co.’s case). And under the current state of things — nearly 30 years of saving too-big-to-fail institutions, and the FDIC’s explicit green light to acquire or guarantee the balance sheet of a failing institution — those creditors can be confident that the representatives of the taxpayer will protect them. That’s where the sense of rigged markets begins.

    As noted in my post, our letter on the Volcker Rule called for strict separation of trading activities (exclusive of proprietary trading, which we argued have no place in a banking company) into legally distinct and separately capitalized broker-dealer subsidiaries of bank holding companies. The goal is to ring-fence the taxpayer-supported depository. One can certainly argue that deposit insurance creates distortions, but its abolition is not on the table. So we need to do what we can to limit the possibility that the Treasury has to bail out another massive institution, and that includes making sure that trading activities are not part of the insured depository’s portfolio.

  3. Kevin says:

    I wasn’t aware of such things in the 90’s, but why was it a good thing to repeal Glass-Steagall in ’99?

    It seems like the bad mortgages (some would say fraudulent) leading up to the ’08 crunch were almost motivated by the banks’ ability to trade in credit default swaps that later fell through. Also, most companies who use forwards/derivatives to hedge asset/interest rate/commodity risk seem to have at least a “small” proprietary trading desk.

    Whether it’s a counterparty default, or simply a bad spec trade, there is always the potential for a blowup. I just don’t know why big banks are allowed to make such trades with federally insured deposits. If JPM’s loss HAD been $100 B, people would go hungry without government intervention. Which point on the integrity list does this hit?

  4. Jim Allen says:

    Dear Kevin,

    The Federal Reserve had started whittling away at Glass-Steagall long before its official repeal in 1998. Even smallish Dauphin Deposit in Harrisburg, Penn. (now part of M&T Bank Corp.) received Fed approval in 1991 to acquire Hopper Soliday and Co., a Pennsylvania-based broker-dealer. It was the fourth bank permitted to breach the G-S wall and underwrite corporate debt. That was seven years before repeal and a few years before momentum for consolidation between investment and commercial banking began in earnest.

    We concur that banks should not be allowed to benefit from insured deposits to engage in trading. It is bad enough having a call on the taxpayer to provide liquidity for banks’ bad lending decisions. That call allows all banks to raise deposits at the same cost, regardless of how poorly they perform. But at least in theory, changes in value of loans occur over a longer period of time, thus giving regulators sufficient time to respond accordingly. As regulators’ surprise in 2007 and 2008 shows (not to mention their poor responses to problems with S&Ls in the late 1970s, in the energy patch and emerging markets in the early 1980s, in commercial real estate in the oil patch in the middle 1980s, in the California and New England real estate in the late 1980s, just to pick at a few old sores) that theory doesn’t really work in practice.

    What makes matter worse with trading operations is that unpredictable market turns can develop almost overnight. Adding fuel to the flames, reactions of regulators and investors can quickly create even more problems. It is the speed at which problems can develop, multiply and spread that makes such activities so potentially damaging. It also is why we say (and we’re not alone) it is prudent to sequester trading activities into legally separate, independently financed broker/dealer entities that have no call on a depository bank’s capital or liquidity.

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