JP Morgan Shocks Markets: Whither Dodd-Frank?

JP Morgan’s disclosure of $2 billion in trading losses in its Chief Investment Office portfolio, which has now prompted an SEC investigation, is more proof that political rhetoric is rarely based on an actual understanding of the conditions the rhetoric addresses. 

This was clear in the last gasps of the Democratic controlled Congress, before the House was cleansed in the 2010 election, with the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Act, signed into law by President Obama on July 21, 2010, was intended to identify and manage threats to the stability of the nation’s financial system. JP Morgan’s loss could easily have been such a threat.

While a $2 billion trading loss is a big number, a little perspective is important. JP Morgan had net earnings in 2011 of $18.9 billion on $97 billion in revenue. The shock to the market was not the magnitude of the loss but came from JP Morgan Chief Executive Jamie Dimon’s disclosure that the loss was “unexpected” and the result of “bad execution” and “faulty monitoring.” 

The immediate reaction of a nervous market — worried about the financial struggles in Europe and the sluggish economy here at home — was to panic in electronic after-hours trading and pull 6.5% of value from the giant bank’s stock price. JP Morgan and large banks including Goldman Sachs, Bank of America, Citibank and others experienced mass after-hours shares selling. The reality is this is more of an embarrassment for Mr. Dimon and his industry-leading management team than it is a real threat to the bank or the banking system.   

However, the loss could as easily been ten times larger or could also have been a problem replicated across the industry and therefore a true threat to the stability on the U.S. banking system. Nicely done, Dodd-Frank! Even with 800 pages of regulation the politicians completely missed this aspect of risk management, essentially rendering Dodd-Frank useless.

The trading done by JP Morgan’s Chief Investment Office is highly complex and a necessary part of managing asset liability risk, because JP Morgan has over $2.3 trillion in assets and over $1.8 trillion in liabilities, of which $1.1 trillion are deposits. All those assets and liabilities have interest rates and maturities associated with them. Small movements in interest rates over the life of those maturities could result in significant swings in the bank’s net interest margin, which is the effective difference of what it earns on assets and what it pays for liabilities. 

When assets and liability balances are as large as they are at JP Morgan, sophisticated hedge trades are necessary to manage the risk of those interest rate movements. Those hedges need to be carefully structured and closely monitored, with traders quick to unwind the hedges if conditions warrant. It is highly unlikely that the authors of Dodd-Frank even considered this aspect of risk management and it is even more unlikely that they would have understood it. There will be those who will immediately point to the Volcker Rule written into Dodd-Frank and proclaim that this was the type of trading it would isolate and limit. Well, not really. The Volcker Rule provides broad exemptions based on several factors.

The real concern here that taxpayers should pay attention to is the relentless issue of “too big to fail.” When a bank’s balance sheet grows in size and complexity, the risk management techniques necessary to effectively manage the enormous mix of assets and liabilities become equally complex. 

The issue does not stop there. Since large banks manage risk by trading with other large banks, exposure to those trades spreads across the entire banking system. As long as the trading goes well, the banks and their shareholders win. If a weak link poorly executes or fails in its monitoring, large losses may result and those losses – if large enough – could create a ripple effect across the entire banking system. Guess who will be called on to save the situation? Yes, the taxpayers.  

A simple example is to consider that a complex risk management trade is structured by Bank A, which then trades with Bank B, which in turn trades with Bank C. If Bank B makes a mistake, it could default to both Bank A and Bank C, creating losses across the chain. While the facts seem to indicate that JP Morgan’s loss is fully contained at JP Morgan, it could just as easily have created a systemic problem across all the banks it traded with, the banks that traded with those banks and ultimately the entire industry.

JP Morgan’s Dimon is considered to be a superstar executive with an equally talented management team. History and track record proves this point to be true. This problem is likely no more than an earnings opportunity lost, and it will not be surprising to see JP Morgan report a nice profit for the full second quarter in a few months. That said, it does bring the issue of “too big to fail” back into focus. This time the issue should be heavily debated. As for Dodd-Frank and other politically convenient legislation, voters need to let representatives know that regulation for political gain is theater that our economy can no longer tolerate.