JPMorgan Hedge Update

This weekend the Wall St. Journal had more details about the large gamble/hedge that JPMorgan (JPM) has taken in a derivative index called IG9 that tracks the overall health of corporate bonds. The full value of JPM’s position is about $100 billion or about 78% of the firm’s entire market cap.  Other hedge funds are waiting for JPM to start unwinding their position, aiming to profit at JPM’s expense.  Some estimates are that JPM’s losses could run as high as $6 – $7 billion.

In my blog yesterday, I stated that JPM had about 150 regulators working on site, supposedly supervising JPM’s operations to ensure the public safety.  The Office of the Comptroller of the Currency (OCC) revealed that they had 60 regulators who did nothing but monitor JPM’s trades and were aware of these highly aggressive trades.  As of late April, those regulators evidently saw nothing unsafe in JPM’s trading positions.  Do those regulators still have their jobs?  Probably.

The Federal Reserve and the FDIC also have onsite regulators who monitor JPM’s activities.  So many regulators and no cause for alarm before this blew up?  The Senate Banking Committee has started an investigation into this debacle.  In the political merry-go-round, we can expect more hearings, more regulations, more regulators, more cost to the taxpayer and less safety, less effectiveness from our government.

JPMorgan Hedge

The recent scandal involving JP Morgan’s hedging loss of $2.3 billion (and is growing by $100 to $150 million per day),  has refocused attention on the Volcker rule, a key provision of the 2010 Dodd-Frank bill that initiated a new set of regulatory restrictions on the banking industry.  At more than 800 pages, the law spawns millions of new regulations, many of which won’t be finalized until July of this year, when the Federal Reserve is to start supervising the banking industry to bring them into full compliance with all the regulations by 2014.  The Volcker rule was ostensibly designed to curb the gambling type of hedging that brought the banking industry and the economy to its knees in 2008.  The JPMorgan fiasco has ignited a debate among politicians and pundits, bankers and regulators as to whether this trading strategy would have fallen under the purview of the Volcker rule.

As always, the devil is in the details.  Section 619 of a draft version of the bill stated that banks might initiate hedging trades “in connection with and related to individual positions.”  The banking lobby wanted to insert two small words “or aggregated” so that the final version of the bill would read “in connection with and related to individual or aggregated positions.”  They may have argued that banking and/or investment firms do aggregate a position over time through a series of trades, a common practice to avoid “moving the market” with a single large trade.  This, in fact, is the final language of the Dodd-Frank law (pg. 249)
Some argue that these two simple words effectively negates the effect of the Volcker rule because it allows an investment bank to engage in any hedging strategy as a tool to ameliorate the risk of any portion of the banks portfolio of investments.  The entire bank’s portfolio is, after all, an aggregated position in the market.  In effect, the language of the law allows investment banks to engage in the same kind of risky bets that the Dodd-Frank law is supposed to curtail. Jamie Dimon, the Chairman and CEO of JP Morgan, insists that the failed hedge would not have fallen under the Volcker rule.  There are about 150 bank regulators who work in the home offices of JP Morgan, constantly monitoring the operations of the largest bank in the U.S.  Either those regulators did not know of the hedge or did not understand the risks involved.  The trades were initiated in London so it might be feasible that the regulators did not know of the trades – except that both Bloomberg and the Wall St. Journal had called attention to the risky trades in April and Jamie Dimon had dismissed any concerns about the risks.  This example should refute the arguments of those who champion ever more regulation and more regulators of all business activity as the solution to keep the public safe.  The housing, securities, banking and insurance industries are all heavily regulated yet the confluence of poor risk management in these industries led to the debacle of 2008.  Regulations too often morph into a job programs for regulators and lawyers without achieving the desired goal of protecting the public from grievous harm.

The voters elect representatives to go to Washington to write competent laws.  Instead, the voters get poorly written laws written by a mish-mosh of inexperienced lawyers, industry lobbyists and passionate but impractical partisans.

JPMorgan gives the impression that Bruno Iksil, the London trader responsible for these aggressive trades, was a rogue trader  –  that the bank’s risk management team should have supervised him more closely.  What JPMorgan doesn’t readily disclose is that Mr. Iksil made the bank almost a half billion in profit just six months ago using equally aggressive trades.  Why supervise someone who apparently has the golden touch?

Where does JPMorgan get the money to engage in this risky gambling?  Your money.  JPMorgan had about $1.3 trillion in deposits from small depositors and large customers on its books but only about $700 billion in loans, leaving it with a lot of extra money, insured by the taxpayer, to gamble with.  They lost.  For now, the stockholders are the ones who have paid the price.  The stock has lost 24% of its value since the trading loss was confirmed by Jaime Dimon.  The amount of money lost so far is less than 1% of JPMorgan’s assets.  But it raises the question raised so alarmingly just a few years ago:  WTF????!!!  When I put my money in a bank, I expect them to keep it safe.  I don’t want the bank to take my money and gamble it.

Banking Reform

Stayed up way too late watching the Senate banking committee debate resolutions to correlate the language of the House and Senate banking bills.  Finally went to bed at 1:30 AM MDT, and they were still going at it in Washington, where it was 3:30 AM.  Although pundits like to describe political conflict as a disagreement along party lines, there are other subtler alliances that cross party lines.  Democratic members of the 12 person Senate conference who were on the Banking Committee would align with banking members of the Republican Party on an amendment vote, while Democratic members on the Agricultural (Ag) Committee would align with a ranking member of the Ag who was a Republican, thus creating a difference in approach between Banking members and Ag members, regardless of party.

CNN money has a good summary of the reform bill that will probably go before the full House and Senate before July 4th.   Although proprietary derivatives trading restrictions on Wall Street firms was included in the bill, a 3% provision was included in the language, allowing these firms to trade derivatives as long as it does not exceed 3% of their capital, which most firms except for Goldman Sachs will not exceed.

What surprised me is the lucidity of members of the Senate at that time in the early morning, having spent 18 hours debating various language and amendments.  To pull an “all-nighter” at 20 years old is one thing – many of these Senators are in their fifties, sixties and seventies.  Very impressive.  What befuddles an ordinary person like myself is why, after 18 months of wrangling over the development of the bills’ language, does it have to come down to an endurance test?  The lawmaking process in a democratic republic is messy, almost as ugly as open abdominal surgery – and many of these lawmakers probably felt like MASH surgeons this morning as the sun came up.