How to Lose a Couple of Billion (or More)

When Jamie Dimon, Chairman and CEO of JP Morgan Chase, made his curious announcement earlier in the month that it had lost $2 billion in one of its trading units, all of the Henny-Penny regulators and politicians, including the full-time campaigner and part-time President, went on full alert as if the financial sky was falling. Congress called for hearings, the FBI and DOJ jumped into the act, and the SEC began an investigation.

The reason I call Dimon’s announcement curious is because JPMC is a public company and thus required to make regular SEC filings. Instead of calling attention to it, why not disclose the losses in a filing and let the analysts – the only people who read those things – ask questions? That way Dimon could have shrugged his shoulders and said, “Hey, we’re in a business that requires us to manage risk; sometimes we don’t do a good job at it.” Then he could have pointed out that JPMC had net income of $5.4 billion in the first quarter so it’s not like a $2 billion trading loss is going to sink it, and after the loss, the bank still has $127 billion in equity. Moreover, the trading unit in which the loss occurred had made over $5 billion during the last three years while the bank’s profit during that period was more than $48 billion, according to SEC filings.

Keeping in mind that most of the career politicians in Congress and the one in the White House have never held a real job, (those jobs exist only in the value-creating, risk-taking private sector) they are clueless that it isn’t a crime to lose money. More regulations will fix everything, they quickly announced. They obviously don’t understand that big banks don’t make money by taking deposits from little old ladies with blue hair and lending them out to the community in small loans. To meet the expectations of Wall Street – the provider of capital – there isn’t enough economic activity for big banks to deploy all of their assets. Therefore, in order to generate the earnings per share growth that makes their shares more valuable, at least half of the bank’s activity is related to credit speculation, interest rate arbitrage, and other such activities. Big banks have to make money in many different ways, and more regulation is just going to slow the economy down as government regulations do. Think Sarbanes-Oxley, which has been estimated to have an average compliance cost of over $5 million per public company and has caused firms to deregister from American stock exchanges.

Dimon’s curious announcement immediately vaporized $12 billion in market value – six times the amount of the loss – so shareholders and a few execs who won’t have as big a bonus as they’d hoped ought to be the ones stamping their feet in anger, not regulators, politicians, and a former community organizer whose banking experience is limited to giving ACORN legal advice on how to shake down banks for not making loans to bad credit risks.

The other thing that makes Dimon’s announcement curious is that it came just as regulators are on the cusp of interpreting the Volcker Rule, an arcane limitation on activities banks can do, and Dimon’s announcement will no doubt cause the regulators to take a second look and make the rule even more rigid. Dimon has been an outspoken critic of the Dodd-Frank bill and the Volker Rule along side a number of Republican legislators. By calling attention to the loss in a press conference, instead of an SEC filing, he played right into the hands of the anti-capitalist lawmakers. Dimon is the guy that Obama called “the smartest banker we’ve got” when the Prez last appeared on The View where he makes all of his really important policy pronouncements. By the way, while he was gushing all over Dimon, a Democrat, Obama didn’t mention that he and Michelle have a “JPMorgan Chase Private Client Asset Management” checking account with a million bucks in it, according to his latest financial disclosure. Obama’s new-found pontifical banking expertise apparently pays well.

The JPMC losses occurred in the treasury department of its commercial bank. The function of this department is to invest most of its demand deposits in overnight money markets. But since interest rates are nearly zero, some of the deposits – those that are not demand deposits (which can be withdrawn without notice or penalty) – are invested in longer term investments with higher yields. This is where the losses occurred.

The risk in managing long term investments, bonds for example, is in interest rate fluctuations which will affect the bond value. If you hold a $100 bond paying a 5% yield, you can sell that bond for its face value as long as comparable risk bonds or other investment instruments pay 5%. If the interest rates in the market fall to, say 3%, your 5% bond gets more valuable because it pays above-market rates. Its owner will continue to receive $5 annually. But since competitive yields are 3%, theoretically the bond price will appreciate from $100 to $167 where its $5 yield now represents 3%, making its yield comparable to similar risk instruments. The price of fixed income securities moves oppositely to its interest rate.

Therefore it works the same way when rates rise, causing bond prices to fall. If competitive rates rose to 7%, your $100 bond paying $5 annually will depreciate to about $71 in order for its yield to be 7%. If you borrowed the $100 originally to buy the bond, when the redemption time comes you owe the lender $100. Currently, you can only sell the bond for $71, meaning $29 of the redemption comes out of your pocket, or in the case of a bank, out of its equity capital.

The lender of the $100 also expects to get a return for letting you use her $100 for a while, so depending on the deal you originally made, some of the interest earned before redemption must be paid to her. In some cases the interest paid to her will vary as interest rates fluctuate in the market, affecting the bank’s profits further.

Banks, therefore, try to mitigate the impact of interest rate fluctuations and other risks by hedging in a transaction called a credit default swap. A CDS is essentially an insurance contract. You buy life insurance to hedge against untimely death and home and car insurance to hedge their loss and replacement cost. CDS contracts work similarly by protecting a lender in case a borrower of the bank’s capital can’t repay. CDS contracts can be detached from their derivative risk and traded separately. Here’s how.

Suppose I needed some money and all I had of value was a life insurance policy. Obviously, I’m not going to be around to collect its benefits so if I have no heirs, I can sell that policy to a third party. Let’s say that upon my death, my insurance will pay $300,000. The third party buyer won’t pay me the full death benefit because there would be no way to make a profit, but perhaps the buyer is willing to pay $150,000. He might pay more if I’m old and in poor health, or he may pay less if I’m young and in good health because he has to wait longer to make the profit. Yes, it may sound a bit ghoulish that the buyer is waiting for me to die, but there is a small market for buying and selling life insurance policies. It works because the owner of the policy can designate anyone to be the beneficiary, and if the person to whom I want to give the death benefit isn’t a relative, I could sell it.

In a similar manner there is a market for selling and buying CDS insurance contracts. They can be sold to third parties, they are traded Over-the-Counter, where there is less scrutiny and regulation than the New York Stock Exchange, and the market is small and illiquid compared to the stock and bond Exchange markets.

The JPMC treasury department held a large amount of corporate bonds and hedged interest rate increases using CDS contracts to buy insurance with a one maturity date while selling insurance contracts with a different maturity date. The bond portfolio was so large that the treasury trader, who happened to live in London, moved the market (i.e. affected prices) with his large buy and sell trades. Because of this, he earned the nickname “The London Whale.” Other traders in this small market – hedge funds and other investment banks – saw this happening and began to arbitrage against JPMC.

Quick side note: In a financial market some people sell when they don’t believe the market will go higher. But in order to sell, there have to be other people who become buyers because they think the market will go higher. They can’t both be right, so someone is going to win and someone is going to lose. Moreover, when there are a lot of sellers or a really big seller, like the Whale, prices go down. When there are a lot of buyers or a really big buyer, like the Whale, prices go up. The smaller the market, the more it magnifies larger transactions to sell or buy. To avoid getting into the specifics of arbitraging, suffice it to say that the moves the Whale was making were working against the arbitrageurs. When they bet the market would go down, he bought and drove prices up.

What the Whale was doing was the equivalent of “cornering the market,” which in a regulated market would have been illegal and preventable. A “cornered” market is controlled by one or a few people. The Hunt brothers tried it a number of years back in an attempt to drive up the price of silver and make a windfall profit doing so.

The Over-the-Counter market is allegedly “self-regulated” as I’ll explain in a moment. Having no regulator to turn to, the arbitrageurs turned to the media to complain about the Whale whom they had renamed Voldemort after the fictional villain in the Harry Potter series. The media reports reached the ears of analysts and investors who began asking what was going on in London. In the meantime, the treasury team had begun to run out of maneuvering room to hedge their risks.

Rather than rethink their risk management strategy, the team apparently began using more complicated, riskier, and volatile hedging transactions. Somebody, perhaps Dimon, decided that it was time to start unwinding what had been done in London. In order to do that the JPMC treasury team had to switch places – i.e. they had to sell contracts they had bought and buy some they had sold. That finally gave the arbitrageurs the relief they were looking for and they made JPMC pay – dearly.

No one knows what the final bill for the damage will be. If JPMC “dumps” its portfolio, the cost will be high because it will drive down market prices; if they are able to liquidate slowly, the market may rebalance and may even move favorably so the bank doesn’t take as large a loss. Shareholders have already suffered a loss of market value as New York Stock Exchange sellers drove down the JPMC share price after Dimon’s announcement.

Despite what critics say, CDS transactions and derivative instruments are not intrinsically bad any more than guns are intrinsically bad because some people use them badly or incautiously. The strategy and execution was at fault. It’s not a crime to make bad decisions or lose money. If it were, most politicians would be in prison, some for life.

But as with any insurance product, a decision has to be made concerning how much risk someone wants to keep and how much he wants to lay off on a third party. If he hedges all of the risk he eliminates any opportunity to make a hedging profit. A hedge ratio of 100% means laying off all risk; a ratio of less than 100% means he keeps some of the risk. Obviously, a number of considerations affect the choice of a hedge ratio and what was an acceptable ratio once may not be later.

When market trades move the market, the trades are too large or the market is too small or both. That should have given pause to the person supervising the London investment group. It didn’t. Moreover, there are many differences in Exchange trading, such as is done on the New York Stock Exchange where the Exchange itself is the counterparty of a trade, and Over-the-Counter trading, which is a bilateral transaction between the buyer and seller. For that reason the OTC is presumed to be “self-regulating” since the buyer and seller are responsible for evaluating their risks. Exchanges are centralized and participants must be members, so there are more enforcement mechanisms, and Exchange trading is more expensive than the OTC. But if it’s illegal to run a red light in Ohio, the risk and consequence should make illegal in Iowa or Georgia or Texas. Similarly, an activity that is illegal on an Exchange should be illegal in OTC trades where non-standard derivatives are now traded. It isn’t.

Dimon has called the bank's losses an "egregious failure," “stupid”, “sloppy,” and “bad thinking.” He is right. Senator Carl Levin (D-MI), the co-author of the Volker Rule, calls the losses a “textbook” example that Wall Street needs further regulation. He is wrong. Anti-capitalist politicians like Levin use every pretext to gather more power under the control of the federal government.

The fact that Levin fails to grasp is that risk management in the real world with real markets is more difficult than business managers and politicians understand. The difference, however, is that business managers will learn from experience. Politicians and regulators won’t. Managers have to learn because their future profits and incentives depend on it. Politicians never learn because they never make decisions based on profits, value, and costs. Most politicians are dead or out of office when the real consequences of their fiascos come home to roost. Social Security, Medicare, Medicaid, $900 billion in stimulus spending, $500 million lost on the Solyndra debacle, the auto bailout, ObamaCare, and the government-enforced, taxpayer-subsidized green car, the Chevy Volt (or is it the Chevy Vote?) all come to mind.

The vain conceit of politicians and regulators is thinking they have a clue in managing economic behavior they themselves have never engaged in. But the JPMC losses showed that private markets, so despised by politicians, function better than government regulations. The market immediately punished JPMC shareholders with a decline in market value which was 600% of those losses.

That’s regulation which really works. And it wasn’t invented in Washington.