The ongoing U.S. crisis was driven largely by financial derivatives. Nine of America’s systemically dangerous institutions (SDIs) failed or had to be bailed out – Bear Stearns, Lehman, Merrill Lynch, Fannie, Freddie, AIG, Countrywide, Wachovia, and Washington Mutual (WaMu). The SDI failures were primarily due to losses caused or aided by the sale and purchase of enormous amounts of fraudulent derivatives, and deregulation, desupervision, and de facto decriminalization proved exceptionally criminogenic. The Commodities Futures Modernization Act of 2000 and the Gramm, Leach, Bliley Act of 1999, respectively, made credit default swaps (CDS) into a regulatory black hole and repealed the Glass-Steagall Act’s prohibition against banks mixing commercial and investment banking.
The Dodd-Frank bill should have repealed the two deregulatory acts passed near the end of Clinton’s term with broad bipartisan support, but the Obama administration never tried to go back to the legal governance system for finance that worked brilliantly for nearly a half-century and Jamie Dimon and JPMorgan led the lobbying blitz that ensured that the Dodd-Frank Act would have the taste, depth, and substance of light beer made by an enormous commercial American brewery. The Volcker rule was intended to partially restore the Glass-Steagall Act by restricting banks’ proprietary derivatives investments to hedging. The rationale was that there is no public policy basis for providing federal subsidies to banks to speculate in financial derivatives. That public policy argument against subsidizing dangerous bets by banks in derivatives is compelling and cuts across all political spectrums. Among banks, only the SDIs are massive users and issuers of financial derivatives. The largest SDIs love financial derivatives. Merrill Lynch failed because it was the largest purchaser of its own “green slime” derivatives, particularly collateralized debt obligations (CDOs) “backed” largely by endemically fraudulent liar’s loans. Such purchases were guaranteed to swiftly make Merrill’s investment officers wealthy and destroy the firm. My most recent columns have quoted Dimon’s dictum about accounting control fraud:
“Low-quality revenue is easy to produce, particularly in financial services. Poorly underwritten loans represent income today and losses tomorrow.”
Dimon’s dictum is equally true about the purchase of derivatives and the sale of CDS “protection.” AIG’s managers in charge of selling CDS protection took advantage of a “sure thing.” They booked income immediately and posted no reserves against the credit risk they were taking. They grew massively and employed extreme leverage. Those tactics maximize reported (fictional) income and modern executive compensation. The catastrophic losses come years later and are borne by others (the government, creditors, and shareholders). The officers become wealthy through the accounting scam.
The Senators who questioned Dimon last week knew that JPMorgan held more derivatives than any other entity and had just suffered serious, growing losses through proprietary investments in derivatives that JPMorgan claimed to be a “hedge” even though the investments acted to magnify rather than reduce risk. (JPMorgan’s insistence upon calling an anti-hedge a hedge led me to dub their practice “hedginess.”) The Senators also knew that Dimon directed the lobbying effort designed to prevent the adoption of the Volcker rule in the Dodd-Frank Act and, when that effort failed, he directed the lobbying effort designed to eviscerate the rule.
Given all this, the thing Dimon feared in his Senate and House testimony was being pinned down under oath about the supposed hedge. Fortunately (from his perspective), he was the CEO of America’s largest bank and he was in front of the modern U.S. Congress. His greatest danger was dying of an overdose of fawning.
The questioning was so embarrassingly weak that no one seems to have noticed the “watch my left hand closely” sleight of hand routine that Dimon pulled on derivatives. In response to a comment by Senator Shelby, the ranking Republican on the Banking Committee, Dimon said: “The biggest risk we take is credit – loans.” He used a similar line with Senator Bob Corker (R. Tenn): “The biggest risk a bank takes is making loans” “Loans are our largest risk.” By contrast, he claimed that derivatives were essential to protect JPMorgan from systemic risk.
In a few sentences, Dimon sought to reverse the concept underlying the Volcker rule. Dimon’s axiom becomes: loans are the problem and derivatives are the solution. The entire role of derivatives in driving the ongoing U.S. crisis – including the massive growth in fraudulent mortgage loans designed to feed the fraudulent CDOs – disappears. The Volcker rule is made to sound irrational. The axiom is as clever as it is false. It assumes the answer. Derivatives speculation by banks is not hedging. It does not reduce risk. It can massively increase losses. Indeed, there are few things more dangerous than believing that a position is a hedge when it actually operates to increase losses. The false belief that a risk exposure is hedged leads to complacency that can allow losses to grow dramatically.
But none of this captures the greater risk of fraud through derivatives. JPMorgan speculates in derivatives through, for example, the sale of CDS protection. Selling CDS protection (like purchasing a CDO) involves the bank taking on a credit risk that can be exceptionally large. The banks’ officers have perverse incentives to engage in behavior that Dimon’s dictum on control fraud describes. “Low-quality revenue is easy to produce, particularly in financial services. Poorly underwritten loans represent income today and losses tomorrow.” Poorly underwritten derivatives operate in the same fashion, but with accounting rules that are even more fraud-friendly than deliberately making bad loans and with far less transparency than is true of loans. The fact that Dimon refused to tell the Congress the nature of JPMorgan’s derivatives position is a vivid demonstration of how much more opaque derivatives remain than loans.