Taking Note of the Avoidance of a Disaster

May 16th, 2012 at 12:29 pm

I was debating someone earlier who took the following position:

“All this uproar around JP Morgan’s big loss is unwarranted.  Sure, investors lost a bunch of money on a bad, sloppily-managed bet.  But that’s the point: investors, not taxpayers, lost money.  If anything, this shows that Dodd-Frank type reforms are not necessary.”

To which I say: nonsense. 

First, a deal involving derivatives of this magnitude, where the inherent risk was so poorly understood, could easily have generated losses multiples higher than the ones we’re learning about now–losses that are growing, btw.

But the more important reason why it’s nuts to go to the “reform-is-irrelevant” place is that at the heart of Dodd-Frank is something I’ve written about a lot here: deeper capital reserves.  To their credit, JPM had enough of a capital cushion on hand to absorb a large loss like this.  But that’s no accident.  It’s a direct outcome of Dodd-Frank’s capital reserve requirements and the subsequent actions by large banks to build up their reserves in anticipation of the new rules. 

The fact of inadequate reserves–overleveraged banks whose bets couldn’t be covered by their capital on hand–was a major factor in the crash, and if anything, this episode reminds us just how important it is to get this right going forward.

To suggest the opposite–that this somehow shows reform is not necessary–is like saying sure, we crashed the car into a wall but the airbags deployed and only the passengers, not any bystanders, were hurt.  Therefore, we don’t need airbags.

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5 comments in reply to "Taking Note of the Avoidance of a Disaster"

  1. Robert G Williams says:

    The meme “no one was hurt, leave the banks alone” is alive and well on the internet.

    I keep seeing comments from various commentators on various websites to the effect that JPMC should be able to do what it likes with its“own” money. But this is shareholders’money. What should really happen when JPMC has excess funds (i.e., those assets which aren’t going be used to facilitate the growth of the nation’s economy through lending activities) is the following: distribute those funds to the shareholders who can then choose to invest in whatever asset classes they choose under their own decision regimens. If hedge fund investments are what they want, then let them make conscious decisions to invest in hedge funds, without any Federal (US taxpayer) guarantee of the investment.

    But what we have right now is a repeat of the 2007-2008 financial crisis scenario — the US taxpayer remains on the hook for the too-big-to-fail banks’ risky decisions.


    • Robert G Williams says:

      Correction to the second paragraph in above comment —

      I keep seeing comments from various commentators on various websites to the effect that JPMC should be able to do what it likes with its “own” money. But this is either depositors’ funds or shareholders’ money (retained earnings). What should really happen when JPMC has excess funds (i.e., those assets which aren’t going be used to facilitate the growth of the nation’s economy through lending activities) is the following: invest those excess funds in safe assets (US T-bills come to mind) or distribute the portion of those funds which are retained earnings to the shareholders who can then choose to invest in whatever asset classes they choose under their own decision regimens. If hedge fund investments are what they want, then let them make conscious decisions to invest in hedge funds, without any Federal (US taxpayer) guarantee of the investment.


  2. Larry in Hawaii says:

    I put down a big chunk of the crash to overleverage, and basically support the part of D/F that limits leverage. In fact, I’d like to see that principle apply to a lot more asset classes, particularly residential mortgages. Canada has no Fan, no Fred, no FHA and their homeownership rates match ours.

    It’s (much of) the rest of D/F that is crazy. Way too much was left to (soon to be captive) regulators and the architecture is way too complex…


  3. perplexed says:

    -”The fact of inadequate reserves–overleveraged banks whose bets couldn’t be covered by their capital on hand–was a major factor in the crash, and if anything, this episode reminds us just how important it is to get this right going forward.”

    And this myth of the need for debt financing of banks is sold to us by the banks just so they can be in the position of using high leverage and taking advantage of the free insurance the public provides while they place the bets that only they can win on. We really should know who in congress supports this scheme and how they benefit from it. Too bad we don’t have a competent investigative Press anymore, it could really help up us from being put in this position of uncompensated risk with all gains going to a select few TBTF banks and their stockholders, managers, and traders. Are we just trying to see how many and how serious the symptoms have to be before we come out of denial?

    http://www.gsb.stanford.edu/news/research/Admati.etal.html


  4. Misaki says:

    I like this summary of how to best instill accountability into the financial system:

    the overall vision . . . of the FDIC using “resolution authority” to oversee the failure and unwinding of a Too Big To Fail financial firm. . . .

    . . . a mechanism to allow firms to fail in a way that fairly allocates losses to the right parties. . . .

    Shareholders are wiped out, the bank is recapitalized through previous debt holders, and the old board is fired. Stability and accountability are both emphasized.


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