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Thursday, May 31, 2012

Trading Losses at JP Morgan: What it Teaches

“The big lesson I learned: Don’t get complacent despite a successful track record”, is what James Dimon, the Chairman and Chief Executive of JP Morgan Chase & Co. said in an interview recently. Dimon, who is known as one of Wall Street’s savviest risk and financial managers and also the vocal critic of Volker rule has also said, “No one or no unit can get a free pass.”   

How true Dimon’s learning is! But then, at what cost? The bank is said to be holding derivative wagers with a face value of roughly $100 billion in a derivative index that tracks the health of corporate debt, which according to the bank itself is “…a sloppy, stupid and shouldn’t have happened” strategy it has designed to hedge itself, which incidentally had already inflicted a trading loss of $2 billion—according to market watchers, it might touch $ 5 billion in course of time—that made its share price fall by around 18%,  cutting off about $27 billion from its market value. 

As the index tracking the health of corporate credit in which JP Morgan bet is continuously deteriorating, analysts believe—as also Dimon says, “The portfolio still has a lot of risk and volatility going forward…. We’re willing to hold as long as necessary inventory and we’re willing to bear volatility”—that the losses, in all likelihood, are set to mount further.   Simply put, the cost of learning, be it to the bank, to the CEO of the JP Morgan, to its stakeholders, to the regulators and in turn to the government is certainly going to be pretty high. 

It’s however worth recalling here what Romney, the Republican Presidential candidate, said about JP’s losses: “This was a loss to shareholders and owners of JP Morgan and that’s the way America works. Some people experienced a loss in this case because of a bad decision. By the way, there was someone who made a gain.”  True, if it were the money of JP’s owners, nothing much to worry of the losses—even if they be $10 billion or even more. But that’s not the case here. The true position is: money used for betting belongs to the depositors—the common American citizens who have left their life savings to the trust of the JP Morgan for safe keep.  Which is why, the gain of somebody—in the present case, probably a few Hedge Fund players—is made good by the loss of JPMorgan’s depositors whose number runs into millions; and hence it is not OK for banks to take such risks. 

Indeed this point was proved beyond doubt by the global financial crisis of 2008 when institutions like AIG, Citibank and others were to be bailed out by pumping in huge amounts of taxpayers’ money simply to avoid a mad run on banks, which if allowed is sure to jeopardize the very nation’s economy as a whole. So, the wise insist that banks, being special, must be well regulated. And this episode, some believe, is only hastening up the need for a more rigorous Volker rule, that too, quickly. 

That said, there is an argument that the present trading at Morgan that has caused losses might very well fall within the allowances granted by the proposed Dodd-Frank’s laws, for it is intended to hedge the “aggregate positions” of the bank. 

Now the moot question is: What is a hedge? It’s simply a mechanism whereby one can reduce the financial exposure faced in an underlying asset due to volatility in prices by taking an opposite position in the derivatives market in order to offset the losses in the cash market by a corresponding gain in the derivatives market. It is of course a different matter that construction of an exact opposite position to the existing risk exposure in the face of uncertainty and the risk of opportunity loss is always a big question mark. Secondly, hedge has a cost and this makes it further complex. 

Against this backdrop, JPMorgan’s argument that its current loss is out of trading on derivatives for hedging its credit portfolio is not tenable because: theoretically, loss in underlying asset must  be set off by the gain in the position taken in the derivatives market and vice versa. But that didn’t happen here, which means, the current hedging is so designed that it is not only intended to protect the bank’s credit portfolio from any losses but also result in profits. It is perhaps this speculative element embedded in the whole trading on derivatives that had resulted in a whopping loss of $2 billion, which again is speculated by market pundits to go up to $5 billion as the positions unwind in course of time.

However the whole transaction is still shrouded in secrecy, for Morgan fears that such revelation is likely to worsen the chances of unwinding the positions without much of bleeding. Nevertheless, one thing is clear: rules or no rules, banks continue to cause systemic risk and the bigger the bank, the bigger will be the contagion. 

Therefore, some pundits argue that making banks bear their losses themselves by directing them to induct more capital is better than any regulation that merely attempts to curb speculative trading. Secondly, it is often found that regulation is far behind the practice in the market. In a dynamic market like banking, everyday a new risk-transferring product is evolving, understanding of which in itself takes time for the regulators to monitor effectively. Thirdly, players in dynamic markets are adept at circumventing regulations. Fourthly, regulations are ambiguous but there is no ambiguity in the capital requirement.   Hence, increased capital is suggested as an effective antidote for arresting contagion than regulations. 

The summum bonum of the argument emanating from this episode is that risk is all pervading and it can at best be transferred but not mitigated and hence, banks, particularly those supposed to be too big to fail, like JP Morgan, are monitored by regulators against set parameters that are unambiguous to ensure that ab intio banks take less risk, and once taken monitored by all the concerned to minimize the contagion. And if prescription of high level of capital is the best means to make banks sensitive to risk, fine that should be the priority. 

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