AppId is over the quota
AppId is over the quota
That may be the lesson of the debacle at JPMorgan Chase. And if regulators take the lesson to heart, they could close a gaping loophole in the Volcker Rule, which is supposed to ban speculative trading by banks that take insured deposits.
When he disclosed a $2 billion trading loss last week, Jamie Dimon, the chief executive of JPMorgan, said the trades were intended to hedge the firm’s credit exposure — that is, reduce the risk of investments it had made. This week, speaking to shareholders, he modified that, saying: “What this hedge morphed into violates our own principles.” We still don’t know exactly what the trades were, other than that they were complicated, very large and apparently difficult to unwind. It appears the loss is growing rapidly. A former top risk manager on Wall Street, who asked not to be named because his current employer had not authorized him to talk about JPMorgan, told me he thought some kind of problem like this was inevitable. Big banks are just too big to be able to safely hedge huge investment positions. The JPMorgan debacle is reminiscent in some ways of the first big disaster of the supposedly sophisticated era of derivatives, that of the Long Term Capital Management hedge fund in 1998. The trades that firm did were supposed to be all but risk-free, since they were simply bets that long-term relationships in prices of various securities would hold, even if there were temporary gyrations that created opportunities for traders who understood the relationships. It helps to understand what was in many ways the simplest — and seemingly among the surest — trades that got Long Term Capital into trouble. It was a bet that yields on the newly issued 30-year Treasury bond would converge with those of the 30-year bond issued three months earlier. When the bonds’ interest rates diverged, for what were surely temporary market reasons, the obvious trade was to buy the higher-yielding Treasury and short the lower-yielding one. When they came together, that strategy would produce a certain — but small — profit. But the profit would be large if the fund borrowed a lot of money to take a large position. What happened then was that so many people put on the trade that even the large and liquid market in Treasury securities was strained. The divergence grew larger. If you could be sure the yields would eventually converge, the obvious course was to increase your bet, which is what Long Term did. In the long run, that trade would have worked. But the margin calls mounted and it ran out of capital. It seems likely that something similar — if far more complicated — happened at JPMorgan. At first, when prices diverged in unexpected ways, JPMorgan raised its bet. Managers accepted assurances that the market had to turn around. But it did not. Perhaps market rumors spread about the risks the bank was taking, and others sought to take advantage of it, increasing the divergences. Eventually, JPMorgan blinked. Immediately after the losses were disclosed, officials of the Comptroller of the Currency, JPMorgan’s principal regulator, assured a Republican senator that all was fine. “They were adamant that hedges like these are there to make the bank safer,” Senator Bob Corker of Tennessee told my colleague, Ben Protess. The officials were said to have opined that the Volcker Rule, whose details are still being debated by regulators, would not have prohibited the trade. It appears that the unnamed officials were right about the rule, but very wrong about the wisdom of the trading. As proposed by a panel of regulators, the Volcker Rule contains two provisions that are quite reasonable on their own, but that together can create a toxic mix. The first provision, which is in the Dodd-Frank law, specifies that banks can maintain investment portfolios. The second says it is acceptable to trade securities for the purpose of hedging other holdings, even if it would not be O.K. to buy the same security as a speculative investment. For market makers, who may buy unwanted securities that customers want to sell, hedging may be wise and prudent. But it will also be short term, until the bank trades out of whatever position it took on in the course of making the market.
Floyd Norris comments on finance and the economy at nytimes.com/economix.
This article has been revised to reflect the following correction:
Correction: May 19, 2012
A picture caption on Friday with the High & Low Finance column, about the lessons to be learned by the trading debacle at JP Morgan Chase, misstated the federal agency headed by Thomas J. Curry. He is the comptroller of the currency, not the director of the Federal Deposit Insurance Corporation, which the column referred to incorrectly as the Federal Deposit Insurance Commission. The column also contained an outdated reference to R. Dan Brumbaugh Jr., an author of a working paper from the Office of the Comptroller of the Currency in 2000 on the merits of repealing the Glass-Steagall law. He is a former senior fellow at the Milken Institute, not a current one.
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