JPMorgans several-billion-dollar trading loss has
certainly shredded the credibility of chief executive Jamie
Dimons criticisms of bank regulators. It is also more
likely to discredit the Volcker rules efficacy than
support it, say market participants.
The rule allows investment banks to hedge against risk, but
does not allow principal trading for profit. Its an
trading activity at JPMorgans chief investment office
(CIO) unit which faces losses that the bank has not
yet finally quantified and that could be as high as $4.25
billion, according to some analyst estimates is claimed
by the bank to have been part of a
portfolio hedge against macroeconomic risks. Fellow traders
and bankers are not convinced,
particularly given that the CIO reportedly contributed $4
billion towards net income during the past three years.
That portfolio was being managed aggressively,
says Chris Whalen, founder and director of Institutional Risk
Analytics. It was not a pure hedge. In this environment,
if you dont like a credit you sell it. You dont
hedge it. Net interest margin is too tight. Right now, the only
stuff on your book is the stuff you like.
Its a tough line to draw, especially when a
treasury division reports profits that become a regular
in-put into stock analysts earnings forecasts
and management has to offer guidance on them just the same
as on underlying operating businesses. HSBC, for example, found
reporting large earnings from its treasurys positions on
declining interest rates in the aftermath of the financial
crisis. These appeared as profits in one division but were
designed, the bank explained, to mitigate lower returns in its
core banking businesses where excess deposits and liquidity
could not be re-deployed at much profit in a low-rate
From the outside, it looks as if what happened at JPMorgan
was different. The people inside the CIO were traders to the
core of their being. They will have been intimately familiar
with the periodically wide basis risk between cash bonds and
CDS that often makes synthetic index positions a poor hedge for
underlying credit exposures.
This was the painful lesson that Deutsche Bank, which, like
JPMorgan, had seemed to have a good financial crisis, learned
at the very end of 2008 when it took a
$4.8 billion loss, including $1.2 billion from credit
trading that the bank tried to blame on exceptional
conditions of high volatility and correlation. As Euromoney
pointed out at the time, those conditions had stopped being
exceptional 18 months earlier but the firms gambling
instinct had not been tamed. It doesnt appear to have
been at JPMorgan either, until now.
|JP Morgan chief executive Jamie
Given the Volcker rule is not in place yet, whether
JPMorgans loss was a result of a hedge or a prop trade
matters little from a regulatory standpoint. But it does show
that the rule is too vague, says Rob Shapiro, former top
economic adviser to Bill Clinton and chairman of private
finance consultancy Sonecon.
There is nothing wrong with speculative trading, so
long as those doing it are not getting taxpayer
guarantees, he says. But with vague regulations,
whether a trade is a hedge or speculation may end up coming
down to what the bank says it was. JPMorgan says it was a
hedge, but it certainly looks like it was purely
After all that has happened, can we take banks at
their word? Under the Volcker rule, would this have been picked
up by the regulator?
Peter Wallison, senior fellow of the American Enterprise
Institute, says JPMorgans trading loss shows that a rule
is not enough.
It is too difficult to write a regulation that
differentiates between a hedge and a prop trade, he says.
The only way to prevent prop trading is to say: you
cannot trade for profit and enforce it through supervision,
where a bank regulator reviews the banks trading
activity. So its not a rule that can prevent it it
is supervisory oversight by the regulators.
Shapiro says that incentives within the finance industry
need to change. Ina Drew, the former head of JPMorgans
CIO, has resigned, but Shapiro points out: She took many
millions of dollars in bonuses over the last two to three years
without paying any price for the current huge losses. Employees
profit even when their behaviour is reckless, and shareholders
and taxpayers pay the costs.
Wes Christian, partner of law firm Christian, Smith and
Jewell, says the JPMorgan trade is evidence that greater
transparency is needed in the industry.