Friday, May 11, 2012

Too big to fail bank loses $2 billion (so far) in bad trades

Bloomberg reports this morning
JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon said the firm suffered a $2 billion trading loss after an “egregious” failure in a unit managing risks, jeopardizing Wall Street banks’ efforts to loosen a federal ban on bets with their own money.

The firm’s chief investment office, run by Ina Drew, 55, took flawed positions on synthetic credit securities that remain volatile and may cost an additional $1 billion this quarter or next, Dimon told analysts yesterday. Losses mounted as JPMorgan tried to mitigate transactions designed to hedge credit exposure. 
There are several stunning concerns here.

First, these colossal losses occurred within a unit that had initially been set up to manage risk but in recent years had been given the go ahead to expand into other markets to generate profits. This suggests that the bank's risk management strategy has been compromised.

Second, the episode exposes a potential counter-strategy by the big banks to restrictions on proprietary trading. Banks argue that those restrictions inhibit their ability to hedge and manage risk. However, if the banks are going to use their risk-management units as profit centers, any hedging exceptions in the proprietary trading rules would allow the banks to play a shell game where they simply move the same trading from one unit to another but call it "risk management."

Third, while the losses are huge, the underlying trades are larger still. Again from the same Bloomberg report
Bloomberg News first reported April 5 that London-based JPMorgan trader Bruno Iksil had amassed positions linked to the financial health of corporations that were so large he was driving price moves in the $10 trillion market.
Here we have a single unit within a single bank influencing prices in a $10 trillion market. It's anti-competitive--the bank has moved from a price taker to a possible price maker. Worse, the bank's actions have introduced a systemic risk. Indeed, one of the problems for JPMorgan right now is that its unit's position in the market is so large that it can't be immediately unwound.
JPMorgan risks losing more money now because other market participants will figure out what the bank has to do to unload its position, said Charles Peabody, an analyst with Portales Partners LLC in New York. Costs from the trades may affect earnings through the end of the year, he said.

“When there’s blood in the water, the sharks are going to attack that animal,” said Peabody, who downgraded his recommendation on the stock in March to sector perform. “It could make it very difficult for them to unwind a trade.”
Republicans are already attempting to eliminate the restrictions on proprietary trading and gut other provisions of the Dodd-Frank financial reform legislation.

This latest episode shows that, if anything, tougher regulations are needed and that the biggest banks need to be split up.

Too big to manage? Too big to trade competitively? Too big to fail? Too big period.