“Sloppy, stupid, bad judgment, too much risk, barely vetted and barely monitored. A terrible, egregious mistake.” These were the epithets used by JPMorgan Chase’s Chairman and CEO Jamie Dimon on Meet the Press, following the disclosure that his bank had lost more than $2 billion in an imploded hedging strategy. Press reports for over a month had rumored that a JPMorgan trader in London nicknamed “the London Whale,” was making vastly outsized, speculative trades designed as hedges, which were so large that they were distorting the market and risking the outsized losses that eventually occurred.
Hedging, when properly executed, allows financial institutions to make trades to offset the normal risks that they face by virtue of their corporate and mortgage debt holdings. In this case, JPMorgan’s speculative the strategy to hedge against risk became a major liability. According to news reports, the $2 billion in losses came about through a complex series of trades in credit derivatives and credit default swaps — the same instruments that are tied to the banking crisis of 2008. The use of those instruments, which are not cleared through an exchange, and cannot be quickly sold without losing value, raises the all-too obvious question of whether the trades truly were hedges, or merely bets. Although JPMorgan is large enough to absorb the losses in this case, other banks engaging in similarly-risky trades may not be, leaving taxpayers on the hook to bail out insured depositories that find themselves on the losing side of their bets.
JPMorgan’s losses were not caused by a rogue trader. These bets were sanctioned by the highest levels of the institution, fixed on obtaining the maximum profits possible. The irony is that JPMorgan has been an outspoken critic of new regulations aiming to curtail risky bank behavior. JPMorgan’s lobbyists spent more than $8 million in the last two years into lobbying against rules designed to place tighter restrictions on hedging, especially “proprietary” bets using bank funds. The Dodd-Frank law itself only allows hedging tied to specific investments, which would curb large bets aimed at hedging entire investment portfolios. However, the proposed rules implementing Dodd-Frank released in October 2011 create a loophole that would allow insured depositories to continue to engage in proprietary trading to offset the risks of entire investment portfolios and not just specific classes of investments.
“Portfolio hedging is a license to do pretty much anything,” said U.S. Sen. Carl Levin, who has introduced legislation that has come to be known as “the Volker Rule.” The rule, which has yet to be finalized, attempts to distinguish between true hedging and prohibited trading, by forbidding insured depositories from making bets with their own money. Or, in common parlance, separating the casino from the bank. If depositories are to be allowed to trade for their own accounts, then safeguards must be built into the system, including increased capital requirements, limits on leverage, and stepped up transparency in trading regulations.
Dimon, the JPMorgan CEO, has attacked the Volker Rule and financial reform generally, as creating a costly burden for banks – estimated at hundreds of millions of dollars for JPMorgan alone. Instead, by engaging in “too much risk, barely vetted, barely monitored,” JPMorgan lost many times the amount that regulatory compliance might cost it. By shooting itself in the foot, JPMorgan has provided large-bore ammunition to the regulators. Or, as U.S. Rep. Barney Frank has put it: “The argument that financial institutions do not need the new rules to help them avoid the irresponsible actions that led to the crisis of 2008 is at least $2 billion harder to make today.”•