Too quick to PIK?

Too quick to PIK?

The deals set to haunt European high yield

Project Neptune rising…

Project Neptune rising…

… amid renewed liquidity concerns

Thursday, May 24, 2012

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Regulation: JPMorgan’s trading loss proves Volcker rule won’t work

Fine line between hedge and prop trade; JPMorgan loses credibility


JPMorgan’s several-billion-dollar trading loss has certainly shredded the credibility of chief executive Jamie Dimon’s criticisms of bank regulators. It is also more likely to discredit the Volcker rule’s efficacy than support it, say market participants.

The rule allows investment banks to hedge against risk, but does not allow principal trading for profit. It’s an unworkable distinction.

The trading activity at JPMorgan’s 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 don’t like a credit you sell it. You don’t hedge it. Net interest margin is too tight. Right now, the only stuff on your book is the stuff you like.” 

Tough line

It’s a tough line to draw, especially when a bank’s 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 itself reporting large earnings from its treasury’s 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 world.

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.

JP Morgan chief executive Jamie Dimon’s
JP Morgan chief executive Jamie Dimon
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 firm’s gambling instinct had not been tamed. It doesn’t appear to have been at JPMorgan either, until now.

Given the Volcker rule is not in place yet, whether JPMorgan’s 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 speculative.

“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?”

Not enough

Peter Wallison, senior fellow of the American Enterprise Institute, says JPMorgan’s 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 bank’s trading activity. So it’s 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 JPMorgan’s 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.

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