At the root of JPMorgan’s difficulties was a unit whose goal is to reduce risk throughout the bank — by buying and selling investments that would offset other positions the bank had taken. Hedging, as it is known, is a common practice encouraged by regulators.
The question is whether what happened in JPMorgan’s London office — where traders went far beyond normal hedging and appear to have become trapped in a money-losing position — was just a mistake, or an example of how banks continue to gamble recklessly even after the financial crisis.
“It’s basically a perception problem: How can anyone trying to prevent themselves from losing money end up making such a big mistake?” said Jaret Seiberg, an analyst at Guggenheim Securities. “Two billion sounds like a really big number if you don’t understand the bank is enormous and 2 billion is not catastrophic.”
But other financial experts said that the JPMorgan fiasco was more than a matter of perception. “If they’re too big to hedge, you have to at least ask the question: Are they too big?” said a former Treasury official who spoke on the condition of anonymity to protect his current business relationships.
At a taping of the television show “The View” on Monday, President Obama made the case that JPMorgan’s experience shows why there needs to be tough financial regulations.
“JPMorgan is one of the best managed banks there is. Jamie Dimon, the head of it, is one of the smartest bankers we got and they still lost $2 billion dollars,” Obama said. “Even if you’re smart, you can make mistakes, and since these banks are insured, backed up by taxpayers, we don’t want you taking risks where eventually we might end up having to bail you out again, because we’ve done that, been there, didn’t like it.”
Since disclosing the losses Thursday, JPMorgan has been going through a series of mea culpas. Its chief executive, Jamie Dimon, one of the giants of Wall Street, has been apologetic and welcomed outside scrutiny.
On Monday, the bank announced that Chief Investment Officer Ina Drew, who oversaw the London unit, would leave the firm, which she has served for 30 years.
Dimon lamented the loss. “Despite our recent losses in the CIO, Ina’s vast contributions to our company should not be overshadowed by these events,” he said.
The bank also announced that Mike Cavanagh, a top executive, would lead a team of officials to investigate the losses.
“We maintain our fortress balance sheet and capital strength to withstand setbacks like this,” Dimon said Monday, “and we will learn from our mistakes and remain diligently focused on our clients, who count on us every day.”
Whether JPMorgan is simply too big is one of the key questions emerging from the fallout.
“Two billion dollars looks to most people like . . . a lot of money,” said Alan Blinder, a Princeton economics professor and former vice chairman of the Federal Reserve. “But if compared to the scale of JPMorgan, it’s not a lot of money. This doesn’t come close to posing a systemic risk.”
However, Jim Millstein, a former Treasury chief restructuring officer and chairman of Millstein & Co., a financial restructuring and advisory firm, said JPMorgan’s size is partly why it got into trouble. With a sprawling portfolio of loans and investments, the biggest risk to the bank was the direction of the economy itself, and that was a difficult risk to hedge.
“So, in order to manage that risk, they appear to have put on a huge macro hedge,” he said. “Although the disclosure is still incomplete, it appears that the sheer size of that hedge made it impossible to unwind without exacerbating their losses. In the event, they have proven that they aren’t merely too big to fail but too big to hedge.”
Douglas Elliot, a former
JPMorgan executive who is now a Brookings Institution scholar, said this raised difficult questions for regulators.
“It suggests that perhaps there are significant risks being taken that aren’t well understood,” he said. “If it can happen at a truly top-notch bank like JPMorgan, what might be happening at other banks?”
From what Dimon has said, it appears that the bank’s London office was unable to extricate itself from the exotic hedge, because it bought up such a large portion of that market. It essentially bought scores of billions of dollars worth of Wall Street-
created securities that would pay off if underlying bonds and loans declined in value, based largely on economic uncertainty in Europe. Other financial traders, sensing JPMorgan’s predicament, are believed to have taken advantage and fueled further losses.
While this loss does not threaten JPMorgan’s survival, the taking of an enormous and unwieldy position in a market resembles the type of problem that has brought down institutions such as Long Term Capital Management.
“If you’re trying to do gigantic transactions in markets that are not gigantic, you may have trouble executing a trade or you may push the market against you,” Blinder said.
The JPMorgan revelations also have reignited debate on Capitol Hill over the Volcker Rule, a piece of the financial regulatory legislation named for former Federal Reserve chairman Paul Volcker. He has urged the prohibition of speculative trading, known as proprietary trading, by commercial banks that qualify for federal deposit insurance.
“I support the intent of the Volcker Rule, which is to get rid of gambling with taxpayer-insured money,” Blinder said. “I’m afraid that telling what’s proprietary from what’s not proprietary is an almost impossible task.”
But Karen Shaw Petrou, a veteran banking analyst, said there are some key indicators. “The way you tell the difference between a hedge and a proprietary trade is very simple,” she said. “Is the transaction designed for an identified risk position, and are those executing it managed and compensated so that their objective is to reduce risk rather than make money?”
She said it appears that JPMorgan’s London office, which placed the ill-fated trade on insurance-like investment premiums known as credit default swaps, was paid based on its profits, not its effectiveness at offsetting risks elsewhere in the bank.
“The internal controls needed to assure that were missing,” she said.
But, like Dimon, she said that is a job for the bank. “Regulators can’t run the bank,” she said. “Regulators can’t be sitting on the desks, nor should they be.”