JPMorgan’s risky business costs big

Courtesy of theatlanticwire.com

During the recent financial crisis, Jamie Dimon was considered one of the smartest CEO’s on Wall Street. He had prudently steered JPMorgan away from the wave of subprime mortgage waste that was bearing down on much of Wall Street. He was Wall Street’s golden boy and shareholders’ savior, but that was 2008. Fast forward to 2012, and Dimon finds himself embroiled in a derivatives mess that has tarnished his reputation and called into question whether or not big banks learned anything from 2008. But this recent fiasco proves banks haven’t learned anything, and it’s business as usual on Wall Street.

According to a recent piece by the Wall Street Journal, the problems began on April 30 during a meeting with senior executives. It was revealed to Dimon that the bank had made some bad bets on derivatives, financial products used to curb risk, and that it was going cost them. The estimated loss could be well above $2 billion—enough to leave Dimon breathless. For a man who is considered a prudent, risk-averse CEO, the loss was too much to handle.  It showcased the hubris of Dimon’s belief that banks can regulate themselves when it comes to risk when, in reality, they can’t; risk is part of the culture, and making profit is the name of the game.  Believing in self-regulation is as naïve as believing in Santa Claus. The complexity of the trades and the size of the banks make it impossible for one person to oversee everything that happens, and eventually something somewhere goes wrong and the true nature of the current banking system is revealed.

The causes of the giant loss were tied to credit default swaps, opaque financial instruments that are supposed to hedge big bets to prevent further losses, though in this case a trader used them to make big bets that went south in the end. A credit default swap, or CDS, is essentially an insurance policy to protect a party from negative exposure to assets. Basically, I sell you an insurance policy on an asset—if the asset performs, you pay me a premium for insuring the asset, and if the value of the asset falls I pay you the full value of the asset.

The trader who had sold those swaps was nicknamed the London Whale by the Wall Street Journal—he had previously bet heavily against a financial index based on the credit worthiness of companies and won. So how did it work? The Whale initially felt that the index was going to tank and decided to buy a large amount of CDS’s, and hedge funds were only too happy to oblige, betting the index would hold. His bet paid off when a couple companies in the index filed for bankruptcy protection, sending the index into a nosedive and forcing hedge funds to pony up the cash. He then decided to go for broke and reversed his initial position, betting the index would perform, and hedge funds, hoping to exact some revenge, bought the CDS’s he was selling. It turned out he was wrong, and the bets failed.

The story of the whale is a prime example of how broken the culture of banking is—it’s no longer about serving clients or financing bold projects, it’s about who can make big bets and claim big bonuses. It’s Vegas: the players on a hot streak feel they can’t lose, so they bet bigger, hoping they will hit payday, but eventually the house always wins.  In this case, the market always wins.

The loss and article about the London Whale have renewed calls for further regulations on risky bets banks can make and questions as to whether or not JPMorgan violated the Volcker Rule, a rule meant to prevent overt risk-taking as demonstrated by JPMorgan.  The Volcker Rule prevents banks from using bank deposits to trade on their own behalf, and, while this recent trade may seem like it violated the rule, the reality is that regulators aren’t sure.

Generally, I am opposed to most government regulations, but the Volcker Rule is necessary to the implementation of real financial reform. The culture of Wall Street has become completely unhinged, driven purely by overt greed—it’s the Wild West without a sheriff.  Derivatives like CDSs were originally created to curb risk and help banks finance more projects, but now they are used in complex trades involving highly leveraged bets that increase risk.  It’s no wonder that Warren Buffet has referred to them as “weapons of mass destruction.”

Wall Street was once a place where companies or startups went to obtain funding. Now it is a place to bet the house and have someone else pick up the check. The culture of greed runs rampant throughout the system and when left unchecked leads to disasters like the one in 2008 and more disasters down the line. We cannot allow big banks that exert such pressure on the financial system to partake in risky ventures that can backfire and bring down the entire financial system. While the JPMorgan loss is only small fraction of their total assets and the firm is projected to still earn a profit at the end of the quarter, risky bets by large financial institutions for shareholder gain aren’t worth the health of the entire system.

Banks should have learned from Lehman Brothers that too much risk and too little oversight make a recipe for disaster. And Jamie Dimon should have learned from Dick Fuld, former CEO of Lehman Brothers, that hubris is better left to gods than mere mortals.

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