JPMorgan’s soap opera makes clear that Wall Street is detached from reality

Jamie Dimon was right about one thing: The embarrassing $3-billion-and-counting trading loss at JPMorgan Chase has played right into the hands of pundits who think Wall Street needs to be put on a shorter leash.

Honestly, we pundits probably couldn’t have made up a better story than this one:

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Steven Pearlstein is a Pulitzer Prize-winning business and economics columnist at The Washington Post.

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JPMorgan shareholder meeting draws protesters: JPMorgan Chase, the nation’s largest bank, held its annual shareholder meeting in Tampa on May 15, just days after it disclosed its $2 billion trading blunder. Protesters came out to show their disapproval of the company.

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Since JP Morgan publicly admitted to losing $2 billion in a trading bet, many people are wondering if the fallout will be like our most recent financial crisis. Jill Schlesinger of CBS MoneyWatch explains who the JPMorgan fallout will affect.

A secretive trading operation whose ostensible purpose is to hedge risks that actually makes a quarter of the giant bank’s total profits doing just the opposite.

A cocky London derivatives trader with the nickname of Voldemort who overplays his hand and finds himself squeezed by a couple of hedge fund sharks who pocket tens of millions of dollars profiting from his miscalculation.

Risk management models that were flawed and risk managers who were ignored.

Press warnings that were dismissed as a “tempest in a teapot” by a celebrity chief executive who seems to have been unaware of the risk in a $100 billion trading position.

And all of it going on right there under the noses of resident bank examiners desperate to show they won’t let it happen again.

So much for the idea that the greatest threat to the financial system is overzealous government regulation.

Aside from the embarrassment and the short-term financial hit, the real damage to JPMorgan is that it exposed how the big Wall Street banks were planning to get around the new Volcker rule, by which Congress meant to prevent the too-big-to-fail banks from taking hedge-fund-like risks with their own capital or borrowed money. Rather than running these trades through their old “proprietary trading desks,” which used to generate a majority of their profits, the Volcker work-around plan would disguise such trading as part of the bank’s normal hedging operations.

The banks had taken great care to get the hedging exemption written explicitly into the legislation. And until last week at least they were in the process of muscling regulators into adopting the broadest possible interpretation, one that would not only allow them to hedge risks associated with individual loans and securities but also broad “structural risks” running through the bank’s balance sheet. According to the Federal Reserve’s official description, that was the focus of a meeting between its Volcker rule writers and six top JPMorgan executives who traveled to Washington on Feb. 22. Included in the delegation was Ina Drew, the now-departed executive who ran the now-famous chief investment office.

It is this exemption that would allow Drew and her team to hedge the credit risk on the bank’s unusually large portfolio of corporate bonds by purchasing a “synthetic” derivatives instrument whose value would go up when a widely-traded index of more than 120 blue-chip corporate bonds went down-or vice versa. But it was also broad enough that it would make it possible for them to later hedge their original hedge and move aggressively to take the other side of the bet.

In their rush to switch gears and sell rather than buy risk protection using these new derivatives contracts, however, the JPMorgan crew apparently wound up driving the price of insuring the entire index below the price of protecting the individual corporate bonds that make up the index. That rang a bell at a number of hedge funds that are constantly trolling the market for a chance to make a quick buck from such discrepancies by buying one and selling the other. Their profitable arbitrage had the effect of driving down the market value of JPMorgan’s positions, which under accounting rules required the bank to post a giant paper loss. The bank’s position was so large that it could not begin to unwind it without driving down the price even further.