MAY 13, 2012 5:37PM

Economics and Finance Lessons From JP Morgan $2 billion loss

Rate: 4 Flag

A lot of people viscerally dislike banks, probably in part because no one likes depending on other people that much, and banks people depend on rather a lot.

When you add to that a natural social class resentment towards those who move money around, as opposed to people who do manual labor who often say "I work for a living," and with real asperity, banks are rarely popular.

Andrew Jackson made a political fortune crushing the bank of the United States, and lots of people always will win plaudits from some for railing as he did against "the money power."

Banks one could say haven't been popular since at least the time of Christ in the Temple with the money changers, and yet, so long as we live in the world that we do, healthy banks are important for everyone.

Look at the complaints nowas to the recovery which boils down to this: banks are too cautious lending money.

Of course, we ended up in the soup because banks weren't cautious enough lending money.

Maybe bankers need a hug?

But more seriously, there are numerous economics lessons to be learned from the JP Morgan affair as to the recent loss of $2 billion.

First, that sounds like a huge amount of money, and it is, except that banks always deal in relatively large amounts of money compared to what all but the wealthiest individuals would.

For example, Warren Buffet is usually worth between $40 and $60 billion, depending on fluctuations in the value of financial markets, something that right there is a cautionary tale about banks always having one thing that is part of what they are: risk.

Banks exist to manage risks that individuals could not do themselves generally speaking, and on a scale that is more efficient than would be the case for most people, if that raises what is the first issue so obvious in the J.P. Morgan case: agency issues.

Banks manage other people's money, which in the dreaded "literature" makes the bank your "agent," while your the principal, the latter being the one the bank is supposed to take care of.

The biggest single lesson in the JP Morgan fiasco is that it's really important to have good agency issue controls in place so some overeager beaver doesn't gamble too much with other people's money.

That would imply that one thing they ought to do with the "Volker" rule that is sure to be debated a whole lot after this affair is really think about how much of the banks assets should be allowed to be at risk in terms of value and leverage.

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With respect to context, JPM earns about $18 billion/year after tax. They have $180 billion in shareholder equity. Therefore, $2 billion, by itself, isn't much more than a blip on quarterly earnings.

HOWEVER. JPM lost it on what was referred to as a hedge. That is a serious issue.

They also lost it using Credit Derivatives.

My lessons:

1. The entire credit derivative market needs disclosure, first. And then needs to be hived off to institutions that aren't SIFI's. (Systemically important financial institutions).

2. Even if JPM had MADE $2 billion, but the $2 billion came from another SIFI global bank, that would be a problem for the system.

3. For a hedge to fail, there needs to be a reason. Which is usually some sort of basis risk. Which means that nothing is ever 100% completely hedged. The best hedge is simply to sell the instrument that one is attempting to hedge.

4. Hedge accounting is rather strict, and this was either booked as a hedge under GAAP or not. Either way, there is a serious flaw in not only the transaction, but accounting for the transaction.

It's pretty well known that credit derivatives aren't in deep, liquid, efficient markets. My guess -- this is why it failed. But, the existence of such markets is the underlying rationale of such instruments.

The possible upside:

1. Failure of a strategy without significant financial damage either to the bank or the system.

2. Dimon disclosed this immediately. Its a start at transparency.

3. JPM can work on correcting this flaw.

4. JPM might get smart and simply split itself into a stand alone investment bank and a regulated entity. That might be the best solution for everyone.
Since the beginning of financial history, the banks have always been working hand in glove with the government. As such, they should be regarded as creatures of the government. And in times like now, they are existing in an unhealthy symbiotic relationship that can only be broken by strict government regulation and a redistribution of the wealth.
The devil is in the details.

Looks like JPM had massive positions in CDX.NA.IG.9

And, the thing blew up.

Still don't know how, but it isn't impossible that the credit derivatives came unhinged from the underlying credits.

Or, to be a bit more speculative, JPM had been fucking their counter parties and the various llhedge funds, etc turned the tables and ass raped JPM.

Possible that this has zero to do with any real world economic activity.

Here's a link to FT. http://ftalphaville.ft.com/blog/2012/05/11/996131/too-big-to-hedge/
Risk and uncertainty are a comparatively small part of the reason big banks aren't loaning to Main Street businesses. Yes, Main Street businesses have a problem because consumers have far less discretionary income these days, thanks to the economic wizards who've been foolishly destroying the middle class since 1980. And it's pretty damned hard to run a consumer economy without consumers.

But beyond that, "investment" banks don't want to loan money out to businesses at 7-1o% or so per annum, when they can speculate with it in foreign currencies, commodities, derivatives and other risky hedges and double their money in a matter of days or months.

One sure way to curb the worst impulses of speculators would be to throw a few of them in jail. But by all appearances, the DoJ isn't aggressively pursuing white-collar financial crimes. Yes, a blue-ribbon panel headed by the NYAG was appointed to go after banksters, but as usual, it's underfunded, and god knows prosecuting white-collar crime is a very expensive proposition.

I make no claim to being anything more than a casual observer about finance, but it seems quite clear even to an ignoramus that something is rotten on Wall Street. What seems equally clear is that Wall Street bankers will do everything in their power to keep regulators from saving the from themselves.
Those are interesting details there Nick.
The point that I think is most interesting is the agency issues that always arise with banks; who do the people running the banks serve: themselves, the shareholders only, or community too in the sense that how they operate is efficient.
So per Tom and Old Lefty's points, "right wing economists" have long argued that the financial interests of society oftern are "captured" by banks that because of the bailout potential, hence the argument for some regulation, maybe beyond just the disclosure Nick is pointing too. Really interesting details there.
The thing is, for a long time the argument was made, correctly, that America had a weird number of banks compared to other capitalist systems. We used to look horrible in comparisons internationally as to asset base, in which many argued that say the prohibition of interstate banking was limiting our economic competitiveness, hence the mergers, and note, that was a real issue, but when you fix one, you create another issue.
So, in any event, now you have these really, really large banks, which pose some system risk when they fail. They should be ok for the reason Nick points out as to size of capital shields under Basel II rules at 8 per cent, and that's a good point about how the size of that bank started to impact markets through pricing power; he was known as the whale, because when he made moves, prices moved, and, that attracts counter-strategies, if Nick has that more colorfully defined. In the end, most of the gain and loss is money handed from one relatively large set of wealthy people to another, in which the rationalization of such activity is to elicit market expectations as to ultimate valuation.
The leverage issue and the percentage of the total portfolio hedged I think are reasonable to consider in taxpayer insured institutions, because per the "capture" argument, if you don't think about that carefully, you get too many "heads I win, tales the taxpayer loses" gambles, like with the Savings and Loans, and which is a sort of right wing interpretation of it, if maybe they go too far with expectations of what average consumers will understand about banking if they were to just totally deregulate AND uninsure a la the "free banking school." People on the Left tend to react visercally to banks as far as the money issue goes, people on the right to regulation.
It seems to me that you want a mix of market discipline and focused regulation on what it is you really don't want the banks to be risking with taxpayer money, which is partly how things are reported as what Nick is talking about in disclosure.
As to disclosure, a pet peeve of economists for a long time has been that financial returns are not "normally" distributed, partly because they can't be because asset prices aren't really ever negative, but also because there are asymmetries that matter a lot. Basically, really bad news is a lot more common than really good news, not really a surprise as to how easy it is to smash things compared to creating real value. Value at Risk models got really, really popular at one point, but, that normality assumption which is convenient, also did very poorly as to the risks we just witnessed. Too much of that on the other hand would have you correcting for so many heavy tail events that are negative that we'd live in caves.
Those are interesting details there Nick.
The point that I think is most interesting is the agency issues that always arise with banks; who do the people running the banks serve: themselves, the shareholders only, or community too in the sense that how they operate is efficient.
So per Tom and Old Lefty's points, "right wing economists" have long argued that the financial interests of society oftern are "captured" by banks that because of the bailout potential, hence the argument for some regulation, maybe beyond just the disclosure Nick is pointing too. Really interesting details there.
The thing is, for a long time the argument was made, correctly, that America had a weird number of banks compared to other capitalist systems. We used to look horrible in comparisons internationally as to asset base, in which many argued that say the prohibition of interstate banking was limiting our economic competitiveness, hence the mergers, and note, that was a real issue, but when you fix one, you create another issue.
So, in any event, now you have these really, really large banks, which pose some system risk when they fail. They should be ok for the reason Nick points out as to size of capital shields under Basel II rules at 8 per cent, and that's a good point about how the size of that bank started to impact markets through pricing power; he was known as the whale, because when he made moves, prices moved, and, that attracts counter-strategies, if Nick has that more colorfully defined. In the end, most of the gain and loss is money handed from one relatively large set of wealthy people to another, in which the rationalization of such activity is to elicit market expectations as to ultimate valuation.
The leverage issue and the percentage of the total portfolio hedged I think are reasonable to consider in taxpayer insured institutions, because per the "capture" argument, if you don't think about that carefully, you get too many "heads I win, tales the taxpayer loses" gambles, like with the Savings and Loans, and which is a sort of right wing interpretation of it, if maybe they go too far with expectations of what average consumers will understand about banking if they were to just totally deregulate AND uninsure a la the "free banking school." People on the Left tend to react visercally to banks as far as the money issue goes, people on the right to regulation.
It seems to me that you want a mix of market discipline and focused regulation on what it is you really don't want the banks to be risking with taxpayer money, which is partly how things are reported as what Nick is talking about in disclosure.
As to disclosure, a pet peeve of economists for a long time has been that financial returns are not "normally" distributed, partly because they can't be because asset prices aren't really ever negative, but also because there are asymmetries that matter a lot. Basically, really bad news is a lot more common than really good news, not really a surprise as to how easy it is to smash things compared to creating real value. Value at Risk models got really, really popular at one point, but, that normality assumption which is convenient, also did very poorly as to the risks we just witnessed. Too much of that on the other hand would have you correcting for so many heavy tail events that are negative that we'd live in caves.
Well, one place to start reform would be with real transparency. Personally, I think transparency should apply not only to transactions, but to the instruments themselves.

I'll concede that some instruments will of necessity be too complex for the "layman" to understand. But when those who deal in them -- and I'm alluding here to trust and pension fund managers in particular -- don't comprehend the instruments in which they invest their clients money, the instruments themselves should be outlawed.

You may recall the loss a few years back by a so-called "rogue" trader at Barclays. The plain fact is that guy wasn't rogue, he was the norm, he just guessed wrong. Blame for that loss was also laid on the fact the trader was twenty-nine.

Well, that flimsy excuse doesn't hold water, in light of the fact that the two-billion dollar loss at JP Morgan has led to the resignation of the Chief Investment Officer, a so-called sophisticated money manager.

The simple truth, the undeniable fact and the inherent danger in all this is that it's much easier to take crazy risks when it's other people's money your risking. Thus, the very first reform that should be instituted is an immediate return to the provisions of Glass-Steagall that separated commercial and investment banks.
Ah Tom, but there was a reason Glass-Stegall was repealed, which was the competitive disadvantage it put American financial institutions into, or so it was argued, and many places fuse those businesses. It's also an imperfect world. Every problem you solve creates another problem.
I don't buy that argument for a minute, tho I'll admit economic "genius" Phill Gramm did a monstrously good job of peddling that argument to unsuspecting so-called sophisticates. It seems to me BoA, Citibank, JP Morgan, Bears-Stearns, Merill Lynch, Lehman Bros, et al, were doing pretty damn well prior to dumping Glass Steagall.
Small correction -- it wasn't Barclays but Barings that took that bath. THAT and the S&L crisis were clear warning shots over the bow -- as was the still unexplained precipitous drop in Dow. But the so-called economic sophisticates blithely sailed on, crashing the economic Titanic into the not-so-metaphorical iceberg called Reality.
I think the fundamental problem that has been building for a while, if there's time to deal with it Tom is that we have an empire, with entitlements and other public goods we like, and like relatively low taxes, which leads to financial arrangements that are risky as to the unbounded creation of money, and in 87, that was on the table as far as worries over the dollar and the trade situation.
I repeat, the S&L crisis, the Vatican Bank scandal, junk bonds and all the rest were still fresh in everyone's mind in '87, and it should have been clear to all in a position of authority -- in govt and in the financial industry -- that continuing to expand credit thru over-leveraging was NOT the answer to the problem. Yet despite the obvious, many of the same people responsible for those crises continued to repeat their mistakes. That would include Joseph Cassano, who made his bones back in the Eighties alongside Michael Milken at high-flying Drexel Burnham before becoming head knocker at AIG Financial Products Division.

Who thought putting a casino croupier like him in that position was a good idea? I strongly suspicion a Mafia connection in all this financial malfeasance, but I even more strongly suspicion there is no chance of that coming to light.

We can blame this on unsophisticated borrowers, but that will solve nothing unless we put the blame where it belongs -- on banksters and other crooks -- and their enablers in Congress -- who professed a belief that greed is good -- and in most cases continue to do so.

In short, Ayn Rand was flat wrong.
Don:

Spot on with your emphasis on Agency problems.

It is much bigger than banks. It is a root issue in Capitalism. It seems like it is generally possible to manage it, but it can't be eliminated.

One minor point. It was first discussed in those terms (as I recall) by A A Berle and G Means in the late 20's/early 30's -- and those guys were lefties.

Other than the ubiquitous Agency problem -- I think the details in this case simply will not support the weight of the larger critique.

Not that there isn't other evidence.

The real problem is not that they are crooks but that they are idiots.

People expect the Titans of capitalism to be greedy. When they come off as dumb -- it scares the hell out of people. And it should.