Thoughts on the Big JP Loss

May 12th, 2012 at 12:06 pm

I’ve been waiting to learn more about the big JPMorgan Chase loss–$2 billion and probably growing when a derivative bet went bad—before writing about it.  So after perusing this AMs papers, here are some thoughts:

–What happened?

The bank invested in corporate bonds, then bought insurance as a hedge against losses on the bonds.  The form of these insurance policies are those good old credit default swaps (remember them from the meltdown days?) where JP makes bets with other banks that pay off if the underlying bonds go bad.

Now, here’s where the trouble starts.  They then added another level of hedging, essentially selling insurance policies on the first hedge.  So now, if the firms backing the bonds do badly and the bonds default, JP is covered by hedge #1.  But under hedge #2, as long as the companies covered by the insurance do well, JP collects insurance premiums from investors betting the other way.

The bet on the second hedge grew so large that other banks recognized that if the economy were to look a bit more shaky, the underlying CDS index could flip and JP could lose big.  Remember, these are derivatives—securities whose value is tied to a price.  So for JP to lose money on hedge #2, they don’t have to actually pay out like a real insurance company.  They just have to make a wrong bet of the direction of the index.

JP had such large bets of hedge #2 that counterparty banks recognized JP would be cornered if the CDS index spiked.  And that’s just what happened.

–Will JP need another bailout?  Are we headed back into another financial recklessness-induced recession?

Though the extent of the losses are not yet known, that’s not likely.  JP appears to be handily able to cover the losses.  Of course, we should not forget the reason they’re back in the black had a lot to do with $95 billion in bailout funds from the TARP, which they’ve since paid back.

–What does this say about financial oversight reform? Would a fully implemented Dodd-Frank bill have prevented this loss?

That’s the most interesting part of this.  The answer to the second question is not entirely clear, though I think if the rules were properly implemented and enforced, Dodd-Frank would have prevented this outcome.  Hedge #1 would probably be legit but hedge #2—the one that blew up—looks more like the type of proprietary trading the Volcker rule is intended to block.  (The usually careful and reliable Allen Sloan gets this wrong today—the facts of the case and the magnitude of the losses aren’t even known yet and he’s somehow determined that the case proves we don’t need the protection of a Volcker rule.)

It’s also possible that under Dodd-Frank transparency rules regarding derivative positions, market participants and more importantly, regulators at the Federal Reserve, would have seen that one bank—actually one trader at one bank—was getting cornered such that a reversal in the index had the potential to cause sudden and systemically dangerous losses.

But the fundamental truth here is the one known since Adam (Smith, that is) and amplified by the great financial economist Hy Minsky: humans underprice risk.  Their proclivity to do so increases as the business cycle progresses and confidence takes over (remember, JP’s bet was unwound by the fact that the economy wasn’t as strong as they thought).  The advent of a global derivatives market with notional trades in the trillions greatly amplifies the risks.

The fact that humans like Jamie Dimon—he who presided over JP’s self-proclaimed “fortress balance sheet”—he who inveighed against financial reform as imposing unnecessary oversight on such skilled risk managers as he and his staff—fall prey to this fundamental truth only underscores the lesson of this episode in financial hubris.

And that is this: financial markets are inherently unstable.  They will neither self-correct nor self-regulate.  Their instability poses a threat to markets and economies and people across the globe.  Therefore, they need to be regulated.  That’s not to say that anyone knows the best way to do this yet in order to balance the necessity of oversight with the dynamics of the markets.  We don’t know where to set the speed limits.  It must be an iterative process.

But we do know they need to be set, and JP’s loss should be taken as a warning that our tendency is to set them too low.  And it should be taken as an even bigger warning against positions like that of Gov. Romney that Dodd-Frank should be repealed.

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10 comments in reply to "Thoughts on the Big JP Loss"

  1. Keith Sader says:

    Would an active Glass-Stegall act have prevented this?

    • Jared Bernstein says:

      Sort of. GS wouldn’t have prevented an investment bank from betting its money on derivatives like this, but it would have hived off the investment bank from the depository bank, thus reducing bailout risk. The fact that bank deposits are insured by the FDIC means that if the depository (as opposed to investment) bank loses enough on its bets, the taxpayer ends up on the hook since the FDIC is backed by the US gov’t. JP/Chase is a bank-holding company with depository banks as subsidiaries so we need a Volcker rule to play a similar role to GS here.

  2. perplexed says:

    -”Now, here’s where the trouble starts. They then added another level of hedging, essentially selling insurance policies on the first hedge. So now, if the firms backing the bonds do badly and the bonds default, JP is covered by hedge #1″

    Hedging a hedge is an oxymoron. One or the other is a speculative bet. Bankers using symantics to make excuses is not something the public should be at risk of in order to do nothing other than support banker and bank stockholder profits. Its crony capitalism and corporate welfare at their finest. There is nothing inherently wrong with “investors” making speculative bets but this free public insurance has to end. With most corporations accessing debt financing by going directly to capital markets, there is no public benefit whatsoever to having these TBTF’s. “We have nothing to fear but fear itself,” its time to move boldly and break these institutions up to protect the public from their malfeasance. Controlling them without even having full disclosure of what they’re doing until it goes wrong is a dangerous myth that puts the public at risk for nothing in return.

    Where is there any public benefit in allowing this to continue?

  3. davesnyd says:

    Matt Taibi (usually fun to read; often profane; occasionally profound) has an interesting column up:

    What seems most informative are Michael Greenberger’s comments about how Dodd-Frank would have either eliminated or controlled these trades in a way that would have helped make them less damaging to the bank.

    I’m expecting push back that the JP debacle proves that DF isn’t valuable and so should be scrapped. I’m concerned that in the current talking head ecosystem, the obvious conclusion that it demonstrates that DF needs to be strengthened, not eliminated, will be ignored.

  4. save_the_rustbelt says:

    Dodd-Frank will ultimately fail because it is too complicated to implement — it appears to have been written by Rube Goldberg.

    Liberals never learn that ten good rules well enforced are better than one hundred rules poorly enforced.

    • Mimi Stratton says:

      Hubris. Don’t make this about liberals vs. conservatives. We don’t enforce the rules we’ve got.

  5. MaryinChicago says:

    Here’s a simple rule for you: NO synthetic or naked derivatives, EVER. How can a “hedge” against price movement in an underlying asset you DON’T OWN or an underlying asset that DOESN’T EXIST ever be anything more than gambling?

  6. clarence swinney says:

    Why do not Democrats stick to success? They have the record. Republicans always Country Club Party.
    Democrats created all Safety Nets. Why vote against your standard of living?
    The overwhelming majority are being confused to be lis-led by top 10% who own 73% net wealth 83% financial wealth and take 50% of individual income. Democrats allow depreciation of standard of living for majority.

    Stop getting into petty debates. Stick to Standard of Living SOL SOL SOL SOL SOL

  7. clarence swinney says:

    Jared, it hurts that those like you with knowledge and top down oversight do not get Talk Shows. We have so much nonsensical talk.Irrelevant. Distorted.
    A Talk Show wiht Reich, you, Kevin Phillips,
    Paul Krugman would be outstanding.
    Truth could prevail

    I appreciate all of you Truth Seekers As I but our power is small

    Thanks anyway. Keep at it.

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