PLANK JUNE 11, 2012
-
Read Later
READ LATERAvailable only to subscribers. SUBSCRIBE TODAY
-
Listen
ARTICLE AUDIO
- Font Size
When Jamie Dimon testifies in the Senate on Wednesday about JP Morgan’s $3 billion trading loss, the focus will almost certainly be on the speculative aspect of the trade. After all, the financial reform bill Congress passed in 2010—specifically, the provision known as the Volcker Rule—was supposed to stop banks from making risky bets with their own money, at least if they benefit from government support. And JP Morgan gets lots of government support.
But as Roger Lowenstein pointed out in a recent Bloomberg column, the congressional scrutiny would be more properly trained on the conventional part of the JP Morgan trade—the part that was garden-variety hedging, which the Volcker Rule allows, and whose praises mega-bankers never tire of singing.
The JP Morgan trade worked roughly as follows: The company made billions of dollars in loans to companies in Europe. Then, to hedge against the risk that those loans went bad—you may have heard that Europe is a dicey place to do business these days—JP Morgan bought insurance through a kind of derivative known as a credit default swap (CDS). The CDS would pay JP Morgan a pile of cash if the loans (actually, an index that tracked the performance of those loans) started taking on water.
That was the first part of the trade. The second part came once JP Morgan decided Europe wasn’t such a scary place after all. At that point it started selling insurance to all the bed-wetters still nervous about Europe (suckers!). This of course left the bank with lots of exposure to the continent, and, well, that turned out to be a lousy idea in the end.
Like a lot of other people, my view since the beginning of this fiasco has been that the second trade clearly violated the spirit if not the letter of the Volcker Rule. (And if it didn’t violate the letter, it’s only because JP Morgan gave the Volcker Rule a stiff copy-edit.) It was gambling, pure and simple. But Lowenstein’s point is that even the seemingly wholesome initial trade—the hedge—wasn’t all that wholesome.
As he explains it, the ability to hedge so quickly and seamlessly allowed JP Morgan to make a bunch of risky loans that it almost certainly wouldn’t have made if not for their hedge-ability. The problem, as Lowenstein points out, is that the hedge didn’t make the risk go away. It simply transferred it to some other fool. And that fool was probably less able to bear it than JP Morgan. In the runup to the financial crisis, for instance, that fool tended to be AIG, whose eventual implosion required a $180 billion government bailout. “[T]hanks to these instruments,” Lowenstein writes, “banks take more risks than they otherwise would and thus more risky bets are collectively owned by society.” Sounds like a bargain!
Which, in the end, is where Congress could do us all some good on Wednesday. As emotionally satisfying as it would be to put Dimon through the what-did-you-know-and-when-did-you-know-it ringer, it’s not clear what that would accomplish. (If nothing else, he’ll be expertly prepped to evade such questions.) A debate on the social utility of credit default swaps, on the other hand, could be a real teachable moment. Somehow I’m not holding my breath.
Follow me on twitter: @noamscheiber
9 comments
Noam, is it possible for you to get a job as a high-level Senate Finance Committee staffer, say, in the next 24 hrs? Your assistance to the country would be invaluable.
- tmmats
June 11, 2012 at 2:03pm
By all means put Jamie Dimon on the griddle. But I'm not sure that the Volcker Rule or the Dodd-Frank Law can make the big banks behave. There are too many temptations and banks reward the traders who make big money for the moment. Even at an institution like JP Morgan with a strong risk management culture, aggressive traders can steamroller the risk management officers. The best option is to restore the Glass-Steagall Act, a 1930's law that separated commercial banking from investment banking. (The slimey Texas senator Phil Gram lead the fight to have Bill Clinton sign off on repeal of G-S.) Then, Federal Reserve and FDIC back-stopped banks won't be able to gamble with the implicit guarantee of taxpayer bailouts.
- amidut
June 11, 2012 at 2:38pm
I would be refreshing if Dimon admitted in a public forum that he was asleep at the wheel and then told us that he had tracked down those responsible for his company losing 3 or 4 billion dollars and actually punished them, like blackballing them from the trading industry. But, like Noam, I'm not holding my breath. Dimon may be one of the more responsible CEO's on Wall Street, but I'm betting he's still more weasel than anything else.
- magboy47.
June 11, 2012 at 11:36pm
From the article: "As he explains it, the ability to hedge so quickly and seamlessly allowed JP Morgan to make a bunch of risky loans that it almost certainly wouldn’t have made if not for their hedge-ability. The problem, as Lowenstein points out, is that the hedge didn’t make the risk go away. It simply transferred it to some other fool. ". A hedge is a zero sum game between two private parties. JP may have lost a few billion on this one, but some other bank gained a few billion. The money wasn't lost. It was merely transferred to some other bank. The "fool" in this case was JP Morgan. The ability to transfer risk is a fundamental part of our lending system. Note, too, that banks make their money by shouldering risk. If loaning someone money carries no risk, then the interest rate falls to zero. And nobody can make money loaning money at zero %. So, a bank has a vested interest in making sure their loans are at least partially risky--they must in order to make money. If a bank believes in a loan, then they will want to keep the loan and collect the full profits that comes from selling and servicing that loan. But lets say a bank has decided the money they loaned on a sky scraper construction project is facing too much risk. It is very hard to sell the loan outright. But they can purchase a hedge that will pay them in the event the construction falls behind schedule. They might have loaned $50M. A hedge on that might cost almost as much if not more. In that case, while it might seem the bank is betting against themselves (or their customer), they are instead simply offsetting their current bet for success, which is the same as selling at a loss.
- seattleeng
June 12, 2012 at 7:58am
I fear that Dimon's testimony will be highjacked by the Republicans on the committee, who will focus on "Obama's bailout", rather than what can be done to prevent another financial collapse. Of course, that's not how informed observers will see it, but that's how American voters will see it (to the extend they see it at all). Democrats on the committee, God bless em, will be lost in the details, with endless statements about "hedging", "speculation", "credit default swaps", "moral hazard", "counterparties", and "Dodd-Frank". They will, no doubt, impress themselves with their knowledge, but they will be no match for the Republicans. [Noam, you can't believe that American voters will get the distinction between legitimate hedging by a lender who buys a CDS and risky speculating by that same lender who sells them. Heck, I don't get the distinction between what's legitimate hedging and what's risky speculating; after all, it's the outcome that determines it.]
- rayward
June 12, 2012 at 8:12am
"Noam, you can't believe that American voters will get the distinction between legitimate hedging by a lender who buys a CDS and risky speculating by that same lender who sells them." rayward, I can't believe that American voters will get the distinction between Up and Down, and I include myself in "American voters." Voters are a bit like hedgers. They bet by instinct, not intellect. Republican voters just have worse instincts than Democrats. Since the Twenties the GOP has crashed our economy 3 times. Under Romney we'll have a fourth catastrophe. Mittens has made it clear on the campaign trail that he'll deregulate Wall Street again, probably even more than Baby Bush did. Republicans don't care about the economic health of America. They're obsessed with proving false theories. And tens of millions of people vote for them. Can you say "suicide," boys and girls?
- magboy47.
June 12, 2012 at 11:34am
http://publicbankinginstitute.org/
- IggyPop
June 12, 2012 at 12:50pm
Seattle - can you clarify what you are trying to say there? The scale of your example ($50M) against the loss ($3B) seems to make it a bit pointless. The real issue here is that we need a functioning financial system, but currently we allow the institutions we need (banks) to act like hedge funds (which need to be able to bad bet themselves out of existence), meaning the taxpayer will continue to be on the hook, the institutions claims to the contrary notwithstanding.
- Nari224
June 12, 2012 at 1:29pm
Nari, sorry I wasn't clear. The $50M was an example in isolation and had nothing to do with the $3B. The point I was trying to make is that when a bank loans $50M on a construction project, for example, they are putting their capital at risk in hopes for a return. Most people grasp this. But there is a belief that banks will then bet against the original loan via hedge/cds/shorting and that somehow that is a conflict of interest by the bank. My point was: it is not. When a bank bets against itself, they are also ensuring they have wiped out all chance for profits. It is very similar to taking much the loan off the books without actually finding a buyer and selling it. I can buy insurance to cover me in the event my house DOES burn down. It might cost 1/5000 the value of my house. Most homeowners have this. This could be called shorting your house. But I could also buy insurance to cover me in the event my house DOES NOT burn down. But that would cost 4999/5000 the value of my house. This could be called the long bet. If I long and short my house, I will get the value of my house paid to me no matter what, whether it burns down or not, but it also COST me the value of my house to buy this coverage. So, it is a wash. Actually, it's not quite a wash, because the long and short insurer both need to make money, so I'd be out of pocket some no matter what. So, if JPM was betting for and against Europe, so what? It happens all the time. There's nothing sinister about it. I bet FOR a stock the day I buy it, and I bet AGAINST a stock the day I sell it. That might happen in the same decade, the same hour, or in the same second. Time scales really have nothing to do with it. The rises, the sun sets. What a lot of people believe is that you can long and short a loan/stock/asset and make money. On the whole, you cannot. Like the insurance above, it is priced to ensure that cannot happen. Once they understand this, then cds et al don't seem so sinister. You realize they are just tools for managing money. And if JP Morgan lost, then someone else gained that money they lost. Zero sum.
- seattleeng
June 12, 2012 at 5:09pm