JPMorgan’s flacks and apologists have, unintentionally, exposed the fact that their cover story – hedging gone bad – is false. JPMorgan runs the world’s largest gambling operation in financial derivatives. The New York Times reported the key facts, but not the analytics, in an article entitled “Discord at Key JPMorgan Unit is Faulted in Loss.” The analytics suggest that the latest JPMorgan cover story – it was JPMorgan’s “Achilles the heel” (based in the UK) who caused the loss – is misleading.
The thrust of the story is that in the beginning JPMorgan’s Chief Investment Office (CIO) was run by a fair princess (Ina Drew) and all was fabulous. Sadly, Ms. Drew contracted Lyme’s Disease and was unable to ensure peace and prosperity in her land. The evil Achilles Macris, based in the UK, became disloyal and mean. He made massive, bad purchases of financial derivatives that caused major losses. CIO senior officers based in the U.S. (and women to boot) tried to warn Achilles but he screamed at them and refused to listen and learn. The just king, Jamie Dimon, did not act promptly to save his kingdom from loss because of his great confidence in Princess Drew.
The personal story of Achilles acting like a heel makes compelling journalism, but it obscures rather than clarifies the analysis as to why JPMorgan poses a clear and present danger to the global economy.
We need to begin with context. It was toxic financial derivatives (not) backed by fraudulent liar’s loan mortgages (“green slime”) that drove the U.S. crisis. Paul Volcker urged the administration and Congress to bar any entity that received federal deposit insurance from investing in financial derivatives. The Dodd-Frank Act did so in a provision called “the Volcker rule.” Treasury Secretary Geithner and Federal Reserve Chairman Bernanke, who exist to serve the interests of CEOs of the largest banks, oppose the Volcker rule. Jamie Dimon leads the banking industry’s opposition to the Volcker rule. Dimon has a three-part strategy: stall the Volcker rule, gut its effectiveness by creating a massive loophole, and get the rule repealed by a future Congress. The loophole takes advantage of the fact that the Volcker rule was not intended to prevent banks from using derivatives to create (true) hedges. The current draft of the rule, however, renders the rule useless because it allows banks to call non-hedges “hedges” – it adopts a standard I call “hedginess.” A systemically dangerous institution (SDI) like JPMorgan has vast amounts of financial derivatives and it can (and does) call any speculative bet it takes in financial derivatives a “hedge.”
The NYT article demonstrates that JPMorgan is speculating, not hedging, and that the current draft of the Volcker rule would render us defenseless against the next financial crisis. The article misses these analytics and presents a misleading portrayal of the purportedly good years of CIO under Princess Drew. It turns out that CIO’s profits and losses come from the same practice – gambling on massive amounts of financial derivatives – not hedging. The NYT misses this key analytical point. Here is how the article portrays the events:
“But when the losses were mounting in recent weeks, Ms. Drew’s command of the chief investment office was far different from what it had been during her stellar performance of 2008, according to interviews with more than a dozen current and former traders, bankers and executives at JPMorgan Chase.”
The CIO did not have a “stellar performance” in 2008. It simply had a run of good luck at the gambling table. Indeed, big wins in gambling indicate a terrible bank operated in an unsafe and unsound manner. Big wins from gambling in financial derivatives can only come from enormous, extremely risky gambles. A bank that makes enormous, extremely risky gambles is a bank that desperately needs to have its senior management team removed – immediately – and that is true regardless of how those bets turn out in any particular year. There is no conceivable social purpose to providing the explicit federal subsidy of deposit insurance and the (much larger) implicit federal subsidy of “too big to fail” that all SDIs enjoy to a bank so that it can take massive gambles on financial derivatives. The Jamie Dimons of the world know that if they win the gambles they will be made immensely wealthy and that when they lose the gambles massively the federal government will bail them out. Every gamble a federally insured bank (or an implicitly guaranteed SDI) takes is a gamble with government money. Bank leverage is always extreme in the modern era; it vastly exceeds the reported (and often inflated) capital. The government is the true creditor through its explicit and implicit guarantees of the bank’s creditors.
The consequences of the next SDI failure could easily be a global financial crisis. We have a compelling need to minimize the risk of SDI failures. Stopping SDIs from investing in financial derivatives should be one of our top, urgent financial priorities.
The NYT business reporters don’t see any of this. If a bank reports extreme profits in 2008 in must be because its senior officers are brilliant. The following passage shows how blind the reporters are to the concept that when a bank officer wins a gamble (with our money) she does not demonstrate skill or “steely resolve.” When she gambles she demonstrates that she poses an improper and wholly unacceptable willingness to put the public at risk. She demonstrates that she acts in an unsafe and unsound manner and that she needs to be removed.
“Ms. Drew also enjoyed the confidence of her subordinates, according to former employees. Part of her skill, they said, was her steely resolve. One former trader recalled that Ms. Drew counseled a credit trader who had a large bet in bank-preferred securities, which began to lose money during 2009. Instead of folding, Ms. Drew supported the trader who wanted to hold on, ultimately generating $1 billion in profits.”
Notice the word that never appears in this account – “hedge.” The word that the reporters use is the correct word (“bet”), but they have no understanding that it is grotesquely improper and unsafe for a bank to take “a large bet in bank-preferred securities.” Notice that when the bank’s bet moved against it and it “began to lose money” in what the reporters aptly call a “losing bet” Princess Drew did not hedge the bank’s exposure to losses. (A hedge would have capped the bank’s losses, but also locked them in.) Instead, she continued the bank’s risk exposure on a “large bet” and (purportedly) generated $1 billion in profits. Assuming those statements are facts, the bet must have been massive, exposing the bank to many billions of dollars of losses. The reporters and their sources at JPMorgan plainly think that this anecdote reflects well on Drew and Dimon. It does the opposite.
If the good king Dimon and Princess Drew want to make “a large bet in bank-preferred securities” let them start a small hedge fund that poses no systemic risk and has no explicit or implicit federal guarantee. They can bet private investors’ money to their hearts’ content – if they can convince wealthy folks to invest in their hedge fund. The reality is that Dimon is running the largest hedge fund in the world and that, in economic substance, he is gambling with our (federally-guaranteed) money on huge positions in financial derivatives. If he continues these bets, it is only a question of time before JPMorgan suffers catastrophic losses and we have to bail out the bank’s creditors. True conservatives support the Volcker rule because they agree that we should not be subsidizing a government sponsored entity (GSE) like Fannie, Freddie, or JPMorgan, to bet on financial derivatives. The NYT reporters do not even seem to understand the issue, even though it is central to the Volcker rule.
The reporters repeatedly come back to a central theme and meme – the CIO was a gambling operation, not a hedging operation.
“‘No one could really challenge Achilles’s traders,’ a former risk officer said.
Beyond that, the chief investment office was performing well, earning sizable profits for JPMorgan even as other businesses at the bank, like home loans, began to hemorrhage money. Those gains came as the size of the unit’s trades was increasing, but the office’s success blunted questions that were raised about the added risk.
During this time, Mr. Macris gained more latitude to build and expand trades from his desk in London — including the wagers that ultimately went so wrong for the bank.”
If “no one could really challenge Achilles’s traders” then Achilles was not hedging – otherwise the positions would not have posed significant risks and would not need to be challenged. If The CIO was “earning sizable profits” it was not a hedging operation. A hedge does not generate “sizable profits.” Why would the CIO’s purported short-term “success” have “blunted questions that were raised about the added risk”? That clause is both nonsensical and revealing. It again reveals that the CIO was not hedging, which would have reduced risk – it was taking positions that “added risk.” Sophisticated, prudent senior bank managers would never allow short-term reported income to “blunt” “questions … about added risk.” Any competent banker knows that taking greater risks often leads to increases in short-term reported profits – and catastrophic longer-term losses. The larger the reported short-term “profits,” the more reason to ask tough questions about risk. The real problem is compensation – the CIO executives where made wealthy when Macris gambled and won, so they had powerful incentives to blunt any warnings about the risk. The passage does admit that the positions Macris took that caused the growing losses were “wagers” (bets) rather than hedges. But again, the authors show no comprehension that this admission is exceptionally important because it exposes the “hedginess” lie and shows why Dimon and the entire senior management team at CIO need to be removed from office.
The reporters repeatedly return to the betting description.
“For example, Althea Duersten, who was Mr. Macris’s counterpart in New York and oversaw North American trading, raised objections to Mr. Macris’s outsize bet but was routinely shouted down by Mr. Macris during conference calls between London and New York, former traders said.”
It was not only a bet; it was known to be “an outsize bet.” Everything written in the article and every statement by the reporters’ CIO sources screams “speculative bet” – not “hedge.”
“The chief investment office continued to post healthy profits in 2011, as it had in 2010 and 2009. But the size of its bets continued to grow, and many of the trades assembled by Mr. Macris’s traders were growing more complex, making them harder to exit when market conditions turned against the bank in 2012.”
I love their use of the word “healthy” as a modifier of “profits.” The word, and the concept, of “hedging” do not appear. A bank addicted to gambling on financial derivatives cannot be earning “healthy” profits. At best, it is enjoying temporary good luck. The addiction of JPMorgan’s senior officers to gambling led the CIO to take three contemporaneous increases in risk: “the size of its bets continued to grow”, the trades grew “more complex”, and the derivatives they were betting on were increasingly illiquid and “harder to exit.” So we have a bank whose senior officers claim not to take any speculative bets, but who in reality not only have been making enormous bets for at least four years and have greatly and contemporaneously increased the risk of those bets along multiple dimensions. Neither JPMorgan’s senior managers nor the regulators took any meaningful action to prevent this massive, increasing addiction to ever riskier gambling even though investments in fraudulent mortgage-backed derivatives (the “green slime”) drove the ongoing financial crisis. What would it take for senior bankers and regulators to learn the most important lessons of the ongoing crisis? The derivatives scandal at JPMorgan did not begin a few months ago – it began at least as long ago as 2008 when the CIO made increasingly large bets in financial derivatives. A competent investigations would likely show that the bets began far earlier than 2008.
The NYT article ends by explicitly stating that Dimon’s claimed “hedge” that is causing the bank huge losses was actually a speculative bet.
“Undergirding these trades was a bullish bet linked to an index of investment-grade bonds. Unfortunately for JPMorgan Chase, the market has grown much more anxious about corporate credit in recent months. Now, with losses rising as hedge funds and other investors profit from JPMorgan’s distress, the company is trying to unwind the disastrous trade.”
A “bullish bet” means that JPMorgan bet that the bonds would increase in value. That bet would most likely lose money if investors became increasingly concerned about default risks. Dimon’s flacks’ original story (promptly supported by the usual apologists (Peter Wallison and Jonathan Macey) was that this investment in a derivative of derivatives whose value derived from investment-grade bonds was a “hedge” for the bank’s exposure to losses in some aspect of its European investments. (The Wallison and Macey apologias conflict on the purported nature of the hedge.) Note that the hedging story makes no financial sense because both bets are in the same direction. If credit worries in Europe increase one would expect that credit worries on corporate bonds would likely increase.
JPMorgan is in trouble because Dimon and his senior managers are addicted to gambling on financial derivatives with our money. The lesson they learned from the ongoing crisis is that they could get away with this. If they continue to gamble on financial derivatives it is only a matter of time before they suffer catastrophic losses. It is imperative that the SDIs be shrunk to the size that they no longer pose a systemic risk and can be closed without bailing out their creditors. The regulators need to replace Dimon with a manager who is not addicted to exploiting federal subsidies to gamble on financial derivatives.