Normally I keep my work and the rest of my life separated, and therefore blog little about financial industry matters. There are lots of people out there better mentally equipped, and with more time, to do that. But the JP Morgan $2 billion trading loss story is too good to pass up, for any number of reasons. For one thing, it’s fun to see Morgan CEO Jamie Dimon with some egg on his face. Karma is usually a good thing. For another, it will almost certainly derail the impact of the massive lobbying effort the banks over the past several years have put into fighting any further regulation of what we call the financial services industry. I say “almost” because who would have thought three years ago that banks would still be free to put on ridiculous trades that have the capacity to lose billions, three years after similar cavalier actions nearly sank the global financial system?
Actually, this is a bit unfair, because as far as I can tell, it wasn’t a ridiculous trade. For details about what actually happened, if you care deeply, Lisa Pollock over at The Financial Times has probably the best summary and analysis of the logic of the trades themselves, and what most likely went wrong with them. Felix Salmon has a good take too, and Simon Johnson, Barry Ritholtz and Yves Smith have good discussions of what this tells us about the overall state of the financial system these days, and how pitiful the attempts to devise and enforce the Volker Rule have been. The problem wasn’t so much with the logic of the initial trade, which actually is a trade I would have agreed with—given what was known at the time, it made sense. The problem with the trade itself appears to be that when it became clear it wasn’t working, the trader doubled down, rather than cutting his losses. Well, that’s sort of human nature, we all do that sort of thing. Except banks are supposed to have systems in place to prevent the vagaries of human nature from winning out over actual risk management. And the broader JPMorgan failure here is one of risk management, which will be attended to, by both Morgan and by the regulators.
The broader issue for financial markets and the world they operate in, however, may not be. What issue is that? The fact that Morgan was able to pass off what is clearly some proprietary trading as a trade whose ostensible purpose was hedging risk. It’s a subtle but important difference, and it goes to the heart of many of the ills of the global financial system these days—that the banks are still one step ahead of the regulators in many areas. JPMorgan got a clean bill of health only a month ago when it passed its current round of Federal Reserve-mandated stress tests with flying colors. Johnson asks the appropriate question here—how could this possibly have happened, when the trade existed at the time—and it’s a trade that produced a $2 billion loss to the bank? The Obama administration has tried to deal with this issue by hiring a bunch of ex-bankers to deal with these sorts of issues. Well, that didn’t work out so well, except for the bankers themselves, who generally tend to return to the banks. We’re still not dealing with the critical issue that, as Morgan has just demonstrated, these are institutions that not only are too big to fail, they’re too big to manage. What this suggests is that JPMorgan and Jamie Dimon, who emerged from 2008 relatively unscathed, may have been as lucky as they were smart.
Politically, if the Obama administration were smart, which in financial matters it does not appear to be, they would seize the opportunity just presented and run with it. We already know, courtesy of the estimable Kevin Williamson, that Wall Street, which generally supported Obama in 2008, now can’t give Mitt Romney money fast enough. So Obama should just say “screw these guys, they’ve been fighting me every step of the way after I saved their butts,” and start developing a stronger attack on the current bank model, which clearly will sink us at some point unless it is brought under control. And this means bringing back Glass-Steagall to separate investment banking from other financial institutions, specifically commercial banks and asset managers. The push for this here in Europe is serious—even the coalition government here in the UK is pushing it. The banks have been fighting it, of course, but the optics have just moved against them pretty significantly, and, one hopes, permanently.
Oh, and that $2 billion loss that JPMorgan just took? Look, this was a series of trades. The people on the other side of these trades just made $2 billion. So in some respects the system worked the way it’s supposed to. And, you know, JPMorgan is good for it. The problem in 2008 was that it wasn’t clear if the person on the other side of your trade would be good for it at the end of the day. We’re not dealing with that issue now, at least—well, perhaps in the case of Bank of America we are, but other banks are probably ok. But it would be nice to think that this gives regulators a bit of a push towards moving to a global financial system that won’t crash and burn the next time, taking us all with it.