The Big Hedge Snafu

Okay, I can’t resist getting wonky again.  I have to say that Robert Reich made me do it.  Well, that’s not completely true.  It’s just that the banking industry has become so concentrated that it’s frightening. Plus,  J.P. Morgan managed to lose $17.5 Billion this week.  I’m still trying to wrap my mind around this.  An organization this big has its tentacles in everything. Could JP Morgan become  another Lehman?

JPMorgan Chase (JPM) lost $17.5 billion this week. It all springs from a bad trade that’s still going bad — to the tune of $2 billion and potentially $3 billion. But then there’s the 9.3% plunge in JPMorgan’s market capitalization — adding another $14.5 billion in shareholder losses. And of course, there’s the additional capital it may need to raise in light of  S&P’s and Fitch’s concerns about its creditworthiness.

In my conversations Friday with reporters from Smart Money and the Boston Globe, I could not answer a basic question: What happened? According to the May 12th New York Times, JPMorgan decided to make a bet on a very obscure corner of the derivatives market. And due to the scale of JPMorgan’s trading, hedge funds figured out its identity and placed bets against the bank that are continuing to make profits for them at JPMorgan’s expense.

So, let me get back to why Robert Reich has me thinking. He’s offered up what we’ve been thinking here for sometime.  Basically, he’s arguing that this kind of thing is exactly why we need to break up the big banks and head back to an updated and effective version of Glass-Stegall.  The most ironic thing is that the catalyst for this is the same Jamie Dimon who insists that Wall Street doesn’t need any more stinking regulations.  We’ve got a tight oligopoly now in the financial sector and the rules are different for this market structure than in a market where a bunch of little banks compete.  We can survive the bad decision making of a few regional banks or community banks that collapse.  Bad decision making at JP Morgan can take down the global financial markets.  We’ve learned that already, haven’t we?

Ever since the start of the banking crisis in 2008, Dimon has been arguing that more government regulation of Wall Street is unnecessary. Last year he vehemently and loudly opposed the so-called Volcker rule, itself a watered-down version of the old Glass-Steagall Act that used to separate commercial from investment banking before it was repealed in 1999, saying it would unnecessarily impinge on derivative trading (the lucrative practice of making bets on bets) and hedging (using some bets to offset the risks of other bets).

Dimon argued that the financial system could be trusted; that the near-meltdown of 2008 was a perfect storm that would never happen again.

Since then, J.P. Morgan’s lobbyists and lawyers have done everything in their power to eviscerate the Volcker rule — creating exceptions, exemptions, and loopholes that effectively allow any big bank to go on doing most of the derivative trading it was doing before the near-meltdown.

And now — only a few years after the banking crisis that forced American taxpayers to bail out the Street, caused home values to plunge by more than 30 percent and pushed millions of homeowners underwater, threatened or diminished the savings of millions more, and sent the entire American economy hurtling into the worst downturn since the Great Depression — J.P. Morgan Chase recapitulates the whole debacle with the same kind of errors, sloppiness, bad judgment, excessively risky trades poorly-executed and poorly-monitored, that caused the crisis in the first place.

In light of all this, Jamie Dimon’s promise that J.P. Morgan will “fix it and move on” is not reassuring.

The most revealing thing is that this entire gaffe was supposed to be part of a hedging action which is a risk management tool.  Not every one is convinced that this was simply the fault of a dated-model with bad assumptions. Here’s some wonky FT analysis.

So what was JPMorgan’s hedge and how did it go wrong?

The precise nature of JPMorgan’s hedging is not known. One possibility was that the bank engaged in a trade known as a “flattener”. Such a trade would profit if the credits began to sour in the near-term and within certain limits. But such a trade must be rebalanced – meaning additional positions would need to be taken simply to maintain the original investment thesis behind the trade. This can be tricky once the trade becomes supersized and if liquidity in the derivatives market dries up. Some market participants believe recent publicity surrounding JPMorgan’s position may have made rebalancing the trade impossible, or simply unpalatable.

Isn’t that a bet more than a hedge? Aren’t those banned now?

JPMorgan has described its trading as a hedge – not a “proprietary” trade, or bet, made to boost the bank’s own profit. However, the size of the position and subsequent losses look likely to set off renewed speculation about the nature of banks’ hedging activities. Some analysts have warned that banks are becoming extremely creative with their hedging strategies, often in an effort to boost their bottom line at a time when new regulations are crimping traditional profitmaking capabilities. JPMorgan says it plans to manage the trade over the course of 2012 but noted that losses “could easily get worse” and possibly total another $1bn in the second quarter of this year. Indeed, one of the instruments that may be involved matures in December, lending an urgency to managing the position down.

There better be some serious regulator and oversight action on this before it gets out of control. It also would seem to be a good time for a few good senators to start looking into bringing back the wall between corporations that have fiduciary responsibilities because of their depositors and investment banks and brokerage firms.  Robert Reich’s got the right idea.   We need to break up these behemoths.  Then, we need to take a serious look at which parts of deregulation keep coming back to haunt us.

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8 Comments on “The Big Hedge Snafu”

  1. bostonboomer says:

    Obama just doesn’t get it. Or else he just leaves everything up to Geithner. I don’t know for sure, but he’d better start DOING something about the banksters and about jobs or the asshole bully is going to be in charge.

    • northwestrain says:

      There are a whole lot of voters sitting on the fence. 0bama’s typical non action and lack of understanding about anything difficult will continue to confuse voters.

      It seems so simple to me — jobs jobs jobs jobs — like the WPA — put people to work — they will put money back into the economy and pay taxes. These people will do stuff that will last for generations.

      I saw so much WPA projects from the 1930s this past winter — sidewalks in Silver City, NM — dated and signed with the WPA stamp. I saw dams — still in place and still ready to hold back the monsoon rains in the Southwest. Roads and bridges all built by the WPA in National Parks.

      Yet what happens — another Wall Street (too big to fail) gambling unit is going to be bailed out by the taxpayers — and we taxpayers will get nothing in return. No sidewalks, roads, bridges — just a quarter of a million workers who will run out of unemployment benefits. To which the GOP responds — “go get a job” you lazy bums.

      • northwestrain says:

        WA has been on an austerity kick for a few years — thanks to a few laws which restrict spending. First hit has been public health — and now WA state has a heck of a Whooping cough epidemic. As usual here’s a well reasoned opinion on the subject:

        http://www.esquire.com/blogs/politics/Welcome_Back_Whooping_Cough

      • Fannie says:

        I’ve been doing genealogy for years………….and you ought to see the number of men hired on road construction with WPA………..they were black topping and paving the roads in 1940 – and the census shows it.

  2. Kat, This coupled with the post you did on commodities is frightening stuff. It makes me think the banksters are terrorist in their own way, and what is worse they are getting away with it.

    • dakinikat says:

      The sheer size of these guys and the trades they make influence markets. That’s not supposed to happen in a competitive market. The reaction of the hedge funds is basically a class oligopoly game theory move. It’s dangerous.

    • dakinikat says:

      I did some GNMA hedging when I was a tender,young 20 something back in the 1980s for my going down the drain S&L employer. My boss wanted to stop the going out of business situation and tried to do an end run around FHLB on our hedging. I was sure he’d get us all thrown in Leavenworth. Funny, how regulators can look the other way too.