Opinion

David Cay Johnston

JP Morgan’s $2 billion experiment with truthiness

By David Cay Johnston
June 11, 2012

JPMorgan Chase & Co blames its $2 billion, and maybe much larger, trading loss on mistakes made in hedging the market. Bill Black, a finance criminologist, calls this “hedginess.”

“Hedginess” riffs on “truthiness,” the word the comedian Stephen Colbert invented in 2005. Truthiness means favoring versions of events that one wishes to be true, and acting as if they were true, while ignoring facts to the contrary that are staring you in the face. Fake hedges are to real hedges as “truthiness” is to truth. Hence “hedginess.” JPMorgan’s trades got around the Volcker rule, which tries to prevent banks from speculating in financial derivatives, by labeling as “hedges” bets that were clearly not hedges.

As Black puts it, JPMorgan is now defining as a hedge “something that performs in exactly the opposite fashion of a hedge.” A hedge is supposed to reduce risk, but according to Black, the losses came from deals that “dramatically increased risk by placing a second bet in the same direction, which compounded the risk.”

Actually, it isn’t quite as simple as Black says. While JPMorgan did not respond to my questions on its strategy, Reuters and others have reported that the trade began as a standard hedge. Subsequently, the reports say, it morphed into speculation as the bank layered bet on top of bet.

Such doubling down is why Black says JPMorgan indulged in hedginess.

Who is Black to pronounce on such things? As a senior regulator at the Federal Savings and Loan Insurance Corp, he, more than anyone else, was responsible for the more than 3,000 felony convictions in the savings-and-loan crisis. Black now talks his walk as a law and economics professor at the University of Missouri-Kansas City.

WEAPONS OF MASS WEALTH DESTRUCTION

The S&L crisis of the late 1980s was a mere grenade compared to the weapons of mass wealth destruction that went off on Wall Street four years ago and the others that remain primed and ready to explode. But instead of facing indictments, JPMorgan and others face impunity. “It’s clear that JPMorgan has absolutely no fear that this might have consequences,” Black said. “And why should they?”

As Black is quite right to note, there are exactly zero reasons that Wall Street should fear the consequences of its compulsive gambling, be it with the money of shareholders or the deposits of its clients.  Chief Executive Officer Jamie Dimon is scheduled to testify before two congressional panels this week, where I hope he is asked pointed, nuanced questions that break through the veneer of his and the bank’s public remarks to date.

Too Big To Fail banks like JPMorgan enjoy an implicit federal guarantee in the event a manageable $2 billion loss becomes an unmanageable $20 billion loss. These banks have also delayed implementation of the Volcker rule, which bars some speculative trades, and other provisions of the Dodd-Frank law as they work to make it more loophole than law. Most disturbing is Wall Street’s success in blocking any move to restore Glass-Steagall, which required commercial banks to take deposits and make loans, not speculate like JPMorgan did. With Glass-Steagall restored we would not be talking about bailing out banks that speculate.

Headlines blare that the FBI is investigating the JPMorgan trades for evidence of crimes. But down in the fine print the bureau calls this routine. It’s show, not substance, our own Captain Renault rounding up the usual suspects in Casablanca.

Says Black: “There has not been a single investigation by the Justice Department worthy of the word investigation of any of the major entities whose frauds caused the financial crisis.”

STATUTE OF LIMITATIONS

Criminal investigations now hardly matter, because most of the frauds took place before 2008. Under the five-year statute of limitations for most federal frauds, governments let the crooks run out the clock. They keep their riches, their reputations, their jobs and, absent real reform and real regulation, plunder on. Both the George W. Bush and Obama administrations have let the crooks escape. The challenger who wants to replace President Obama would be even worse. Mitt Romney wants to repeal Dodd-Frank. Unless some determined and creative prosecutor finds a way to pursue the wrongdoers, there will be no justice, just more gambling with taxpayers on the hook to pay off the markers. Only Eric Schneiderman, the New York state attorney general, offers any hope, but his staff is tiny and the crimes are mighty. Keep in mind that in 2004 the FBI and the Mortgage Bankers Association in 2004 said there were only two kinds of mortgage fraud, both of them perpetrated by unqualified borrowers who could not repay their loans. The FBI said nothing about banks profiting off huge fees for issuing fraudulent “liar loans,” nor about why banks lacked standards and practices to turn away unqualified borrowers. I’ll call that “investigativeness.”

The Too Big To Fail banks’ triple play of lobbying, campaign donations and lucrative jobs for family and friends of Washington officials, elected and appointed, blocks real regulation.  Budget cuts and rules in fine print have declawed the SEC and the Comptroller while filing the IRS’s audit teeth down to nubs.  Washington regulators are looking for problems in all the wrong places, when they are looking at all.

That’s “regulationiness.” The JPMorgan derivatives debacle reveals how the appearance of banking regulation and reform, rather than actual regulation and reform, threatens the financial health of the entire nation. That’s what comes of “hedginess.”

Comments
11 comments so far | RSS Comments RSS

On the button as usual David. What ‘too big to fail’ really means is that politicians of all stripes are so dependent on Big Money for constant electioneering, they will never pass any tough laws to rein in this vast casino. At every attempt, Big Money screams that they are being unfairly targeted and harassed. They would actually like a world where there was no regulation. Part of the solution is to remove the political incentive to turn a blind eye to what is going on. To do this we need to 1) stop electing the same kind of people we have always elected, and 2) start looking at the real truth of what is going on, rather than listen to the ‘truthiness’. Your column and many others expose the ugly underbelly of what is really happening, but Americans, more or less, refuse to see and deal with these facts. For some reason, they much prefer ideology, believing that the label ‘conservative’ or ‘liberal’ is the answer to the problem despite all evidence to the contrary. In fact, these ‘beliefs’ in political mythology may result in the ultimate decline of America. Someone once said ‘Experience keeps a dear school, but fools will learn in no other’. Our countrymen apparently will not learn even from terrible experiences.

Posted by steve778936 | Report as abusive
 

David, have you learned what kinds of loans JPM was purportedly hedging? I am confused about the very notion that hedging has any place in the business of collateralized loans. I mean, doesn’t the collateral plus the amortization schedule constitute a hedge? In my view, the very fact that huge banks with highly diverse collateralized loan portfolios supposedly need a hedge indicates that they are well aware that their loan portfolio is crap. Have they ever been asked to explain this practice, and what justification have they given?

Posted by Sanity-Monger | Report as abusive
 

Outstanding article!

I’d like to add that the “truthiness” of what is hedging vs. speculating is manifest throughout financial market regulation.

Look at FASB 133, banking and brokerage law, rules and regulation, and in particular, the Volcker Rule, and the thousands of comment letters about that. The “truth” between hedging and speculating is fraught with “truthiness”.

On Wed at banking.senate.gov you are going to see
Truthiness in all its glory. Built on a foundation that was never very good in the first place each eye is free to see what it only wants to see.

…Yes oddly the legions of regulators are looking to JPM to help them FINALLY determine exactly where the truth lies? Is that going to be the best guiding light?

More at wiki pedia article:
2012 JPMorgan Chase trading loss

Posted by RickL | Report as abusive
 

There is no loss to JP Morgan, presently. Ina Drew, a JPM Manhattan Office chief investment officer overseeing a JPM London Office, moved financial instruments (assets) from a banking division to another division of JP Morgan that manages securities. For good reason, JPM CEO, James Dimon characterized the following outcry as “a complete tempest in a teapot” since no harm came to JPM (but to some clients, e.g. Jefferson County Alabama). Although, CIO Drew has resigned, and given the increasing risks in investments, she did what was best for a banking division of JPM since the Dodd-Frank Act limits [a bank's investments in proprietary trading] “aggregate investment in any and all hedge funds and private equity funds to no more than three percent of its Tier 1 capital.” That is, as of fiscal 2011, 3% of JPM’s proprietary trading would have been approximately $67,973,760,000. $2B is only about 9/10,000ths of JPM’s fiscal 2011 revenues.

Posted by awayneramsey | Report as abusive
 

In the same way Wall Street does not fear the regulators so the regulators do not fear the public.

The power is with the 1%: the 99% are in the main uninterested and uneducated. Why should anyone worry when you are leading a mule to slaughter?

America is about money, greed and power, therefore, why should those that display a surfeit of those qualities, bankers and politicians, be thought of as anything other than ideal leaders? One suspects even the election success of the very pinnacle of greed will be seen as true a triumph by many. Then the mules will know the real meaning of “up yours”!

Posted by johnrxx99 | Report as abusive
 

The unregulated Hedge Fund Industry calls it risk management..trading our deposits with FDIC institutions. Yes hedging is important with regards to currency, yet all the rest is creating instruments that only serve “the trade” This is not capitalism … it is gambling. Capital formation that is provided to Corporations to create products and services create jobs to the local communities which is what brought prosperity throughout the United States over the last several decades. That capitalism. The capital is all overseas and no longer serves the US. And the chatter you hear is that the Government is the problem.

It was the formation of the newfangled financial product called swaps. This is a $62 Trillion trading platform where tens of trillions of dollars are done in the dark, and we only find out later… oops, bad call. You have to separate Banks from Wall St… they should not have access to our deposits to play tidily winks … paper flipping is not capitalism.

Posted by mmcg | Report as abusive
 

Do these people have no sense of personal honor or responsibility?

Posted by TimWarren | Report as abusive
 

It’s ironic that a journalist writing about truthiness is guilty of the same crimes he is imposing on others.

First of all, Glass-Steagall was not created to prevent commercial banks from engaging in trading activities, but to seperate the supposed conflict of interest that Congress believed was a result of a combination of banks that provided retail and underwriting services. At the time, US politicians were convinced that companies that operated both lines of business were engaged in ‘predatory selling’ by dumping junky stocks from the underwriting side to overly entusiastic retail investors. Subsequent empirical research actually refuted this claim and was a contributing factor to the repeal of Glass-Steagall with the Gramm-Leach-Bliley act. It had absolutely NOTHING to do with institutional/proprietary tading.

Second, I am suspicious of your ability to determine what exactly is a hedge in a bank as complex as JP Morgan. Do you know the exact loan portfolio of JPM and how they hedge it? The fact of the matter is that JPM has a 2 TRILLION dollar loan portfolio on its book that needs to be hedged. The media is currently turning a blind eye to the fact that lending in itself is a risky activity, and arguably inherently riskier than trading or underwriting. The CDS tranche trades JPM’s CIO office undertook were effectively a hedge against short-term credit deteroriation that would have a negative impact on their loan book.

However, buying large enough amounts of the CDS contracts JPM decided to hedge their loan portfolio with costs a lot of money and eats into a banks profits. As a result, JPM decided to offset their expected hedging losses of buying CDS tranches by simultaneously writing CDS contracts on a longer dated CDS tranche. The hedge in sum was protection against negative short-term credit conditions which was paid for by expectations of positive long-term credit improvement.

In short, JPM was conducting a necessary and extremely prudent activity by protecting themselves against the large losses that could potentially from lending activities and paid for it with an offsetting position. What really needs to be taken away from all this is that a $2 billion mark-to-market (non-cash) loss in relation to a $360 billion Chief Investment Office portfolio and a $2 trillion loan portfolio is absolute peanuts in the broad scheme of things.

Posted by JMayhew | Report as abusive
 

We will have problems until Glass-Steagall is fully restored. Measures such as Dodd-Frank are too dependent on regulators stepping up to the plate and doing their job. Remember Glass-Steagall worked pretty well.

The notion of deposit institutions being allowed to gamble with other peoples money is absurd.

Posted by QuietThinker | Report as abusive
 

JP Morgan Chase admitted over two weeks ago that the “losses were over THREE Billion and could be much more”.

As any banker knows who has worked around these operations, the amounts of gains and losses on such transactions are tracked to the penny and accurately recorded within seconds. So, to believe that they don’t know EXACTLY how much they lost is an exercise in gullibility at best and shear lies at worst – and very insulting. It’s well known that Jamie Dimon personally gave the okay on these transactions, so why does he get a pass? Then, they scapegoated Sallie who had the gall to say she still didn’t know the extent of the losses.

Of course, these transactions were entirely legal and represented typical gains and losses for the week. So, what’s the big deal?

Posted by ptiffany | Report as abusive
 

Ah, what is three billion anymore. Seems like it is play money. The F35 fighter now runs $480 million a copy, only six have to go into the drink and we have thrown away the equivalent of Mr. Dimon’s gambling debts. I saw that many jets go down during my time in the Navy for stupid reasons. Two because they ran out of gas.

There seems to be zero connection between the little money we humans work for and the Big Money the various ‘security’ industries squander. None.

Posted by TheOldSodbuster | Report as abusive
 

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