Thanks to Jamie Dimon JPMorgan Scandal, Expect More Financial Reform in Washington

A recent New York Times story provides more insight into what JPMorgan was doing when it incurred a large loss from derivative trades, and whether its actions violated the intent of the Volker Rule. It should be noted that the article is somewhat diminished by its skepticism, but it is worth reading for those interested in learning more about derivatives.

There are three issues addressed in the article that warrant consideration.

The motivation of JPMorgan

Using clearinghouses for derivative trades

Increasing reserve requirements for derivative trades

What was JP Morgan's motivation? Was it trying to legitimately hedge risk, or create risk that would generate profits if certain asset groups declined in value?

Jamie Dimon, JPMorgan CEO, has stated publicly that the bank and its “whale” (the trader who affected the trades) “amassed large positions in credit derivatives  . . . that eventually soured.” The article states that the motivations of the bank were unclear even though “the bank says [the derivatives] were intended to offset other risks on the books [of the bank] . . .” Basically, the author is implying that Dimon is not being truthful, or he did not know what his people were doing. Neither of these options is acceptable.

The crux of the controversy is whether JPMorgan speculated or hedged. If it speculated, it violated the Volker Rule. If it attempted to hedge and made an error, it was managerial incompetence creating another concern for regulators.

The Volker Rule is supposed to prevent banks from speculating, not hedging. The latter is transacted to eliminate risk from bank portfolios. The art in drafting the regulation will be to effectively define what constitutes hedging and what constitutes speculation.

The bank “wanted to hedge the large amount of loans and bonds on its balance sheet.” To accomplish this, it purchased “bearish” derivatives “that would rise in value as the creditworthiness of large companies deteriorated.” This would effectively protect the bank from losses from the corresponding assets. At a later date, JPMorgan’s perspective about the risk of these assets changed, and it “[tempered] [its] bearish bet- essentially, a hedge against a hedge.” It was this latter bet that seems to be the culprit; the bank was wrong about credit conditions improving, became “unhedged” and lost money from the second derivative, a lot of money.

The balance of the article discusses the effect of trading derivatives through a clearinghouse and affiliated margin requirements; basically, the transactions would cost more and might discourage the use of derivatives. Additionally, the author outlined another proposal to increase capital requirements on derivative transactions, which would also increase costs to the banks and discourage their use. 

The aforementioned two tactics are inane if banks are truly using derivatives to decrease risk on their balance sheets. Why make it more expensive for the banks to take action that makes the market safer?

The regulatory drumbeat will continue, and the Volker Rule will likely be made more restrictive. This is an effective way to deal with the situation if you believe banks will cheat or stretch the rules. Otherwise, increased regulations and costs will be an impediment to legitimately hedging risk.