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version of the old Glass-Steagall Act that used to separate commercial from investment banking before it was repealed in 1999, saying it would unnecessarily impinge on derivative trading (the lucrative practice of making bets on bets) and hedging (using some bets to offset the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.