J.P. Morgan’s trading losses expose finance’s most familiar and humiliating of unclothed emperors — naked hedges that once again reveal the need for regulatory reform. No amount of crisis management will change that — not CEO Jamie Dimon’s mea culpas, nor the bank’s PR people’s spinning derivatives trading as risk management, nor its lawyers’ claiming that the Volcker Rule would not have prohibited the losing trades.
What is marketed as risk management sometimes is merely risk inapt for financial institutions subsidized by public funds — that is, banks.
The drama of the J.P. Morgan losses is the Theater of the Absurd with a CEO admitting fault but resisting reform, and a colorful cast including a trader nicknamed The London Whale, a chief risk officer who reportedly had left his prior job losing money, and a former chief investment officer who made $15 million in comp before losing $2 billion for the house, raising speculation about potential compensation claw backs.
The press, once mostly deferential to J.P. Morgan, is now reporting on internal politics and risk management practices at executive and board levels — where one member of its risk policy committee was apparently previously one of the directors of AIG as that institution famously wrecked its ship on an iceberg of bad derivatives organized in London, collapsing into the arms of the U.S. government. There are stories about an army of regulators overseeing J.P. Morgan but no one serving as its treasurer, and about who’s-in-charge politics over its London trading operation.
Once the theatrics have ended, what will remain is a finance lesson that could swing the politics of financial reform or even the U.S. presidential election.
First, the disclosures to date have the valence of trading, not hedging. J.P. Morgan’s stated goal was to hedge its exposure to Europe but how can anyone hedge Europe? Europe is not a security like shares of IBM that can be shorted or an index like the S&P 500 which could be hedged by selling SPIDRs. Europe, the world’s second largest market area, is in tailspin with 22 distinct sovereign economies including Germany, which borrows at cheap rates; Italy at moderate rates; and Spain and Portugal at high rates. European equity markets are similarly volatile as its credit crisis catapulted economies into double digit unemployment and political instability.
Any attempt to hedge Europe surely is a fool’s errand, unless·you work·at a hedge fund where investors want to take these risks and where compensation for successful traders can be far greater than at a bank. Ask John Paulson, who made billions for his investors and himself betting on the direction of a whole market (subprime) — only to show poor results more recently as he tried unsuccessfully to hedge other markets. Risks and profit and loss swings like these are not the province of banks, which enjoy public subsidies for public systemic purposes.
Every trade has a winner and loser, so the word hedge does not mean safe. Derivatives are bets. For some investors they have hedge qualities depending on what else the investor owns — but maybe not. Even when valid in theory, hedges may not be in practice since derivatives markets move based on current technical supply and demand for particular securities which might not reflect longer term fundamentals.
So hedging Europe sounds like trading. As was said about the definition of a bank in the early years of U.S. deregulation a quarter century ago, if it walks like a duck maybe it is one. Perhaps the same is true of trading. Or, to quote U.S. Supreme Court Justice Potter Stewart, pornography and obscenity may be difficult to define, but “I know it when I see it.”
Second, if this was hedging then it was damned poor hedging. It remains unclear to what extent the bank was hedged at all: The bank was reportedly long some derivatives contracts and short others. Anyone still wondering if J.P. Morgan’s trades were a valid risk management tool need look no further than the bank’s own CEO who acknowledged the trades were “bad strategy, badly executed and poorly monitored.” Over the U.S. Memorial Day weekend the financial press reported that Bruno Iksil — the famous Whale — had made money shorting European credit markets last year only to give all that back, and a lot more, on long positions this year.
If J.P. Morgan felt it was over exposed in Europe, rather than selling derivatives, it could have simply reduced or sold loans to European companies. But this might not create windfall profits for bonuses. The concern is that banks may trade to enrich insiders and then spin this as risk management. This is what my former banking partner Paul Volcker wanted to curb with the iconic but still not implemented Volcker Rule.
Third, if we learned anything at all four years ago in the greatest financial crisis in modern history, it is that derivatives are risky for financial institutions and markets. They can be especially inappropriate for banks, which should be risk averse as they are subsidized by the public through cheap credit and deposit insurance to make public and private credit flow in the economy safely, soundly and predictably. A publicly-subsidized credit system exists to promote safety and soundness, not risk.
For sixty-six years the Glass Steagall Act, which separated safe banks from riskier investment entities, worked well. The repeal of Glass Steagall in 1999 in pertinent part led to the banking crisis of 2008. The Volcker Rule was a compromise between reinstating Glass Steagall (which would have necessitated a break up of banks) and continuing to live with broad systemic risk posed by vitally important publicly subsidized institutions called banks.
Anyone who doubts that public subsidies are a boon to financial institutions should recall the immediate aftermath of the Financial Crisis of 2008 when virtually every major U.S. investment bank that survived the crisis immediately converted to (indeed, was granted accelerated conversion to) bank holding company status so as to receive public subsidies in the form of deposit insurance and discount window. When the price of risk went up, the risk takers sought cover from the Fed.
All this brings us to the election of 2012. The two contenders are graduates of Harvard Law School representing divergent financial policies. Barack Obama, as the incumbent, inherited the financial crisis and sponsored Dodd-Frank. Romney is winning the wallets of Wall Streeters who would thwart the reforms necessitated by the Financial Crisis of 2008. But what seems good for J.P. Morgan — characterizing risk as risk management to drive private bonus pools through public subsidies — is not good for the country.
American voters, still reeling from the long recessionary shadow of the 2008 financial crisis, will not further allow financial regulation-lite unless they buy Wall Street’s spinning risk as risk management. They ought not, but to be safe, since I am a banker who values safety, I wrote this article.
Marshall Sonenshine is chairman of investment banking firm Sonenshine Partners and Adjunct Professor of Finance and Economics at Columbia University and was a Teaching Fellow in Government at Harvard University. He is writing a book about the future of finance.
