JPMorgan’s $2 Billion blow-up

For the better part of the past four years, Jamie Dimon has been known as the “King of Wall Street.” The company he leads, JPMorgan Chase, emerged from the carnage of the 2008 financial crisis with two new acquisitions: Bear Stearns and Washington Mutual. It is the largest bank holding company by total assets in the world. According to Ezra Klein, Dimon has been using the political capital he built up during the crisis to fight against the Volcker Rule, part of recent financial regulation efforts:  “Paul Volcker by his own admission has said he doesn’t understand capital markets,” Dimon told Fox Business earlier this year. “He has proven that to me.”

And then, last night, Dimon announced that JPMorgan Chase had lost $2 Billion so far this quarter on some very big hedges. I find this story to be a very illuminating case-study in the volatility of the American economy at the present moment, so I want to highlight some important aspects of it in this post.

First, is the incredible history of Jamie Dimon and his company. Upon graduating from Harvard Business School, Dimon took a job at American Express as the personal assistant to AmEx President, Sanford I. Weill. Weill (and Dimon) left AmEx in a power struggle in 1985, convincing Minneapolis-based super-computing firm Control Data Corporation to spin-off one of their smaller subsidiaries for $7 million, and turning it into “Commercial Credit,” a consumer finance company. In 1988, Commercial Credit acquired “Primerica,” a former tin-canning company that had by that time become a holding company for Smith Barney (securities-trading service provider) and A.L. Williams (life insurance underwriter).

What I find most interesting about this early part of the story is the nature of the businesses that companies are moving out of, in order to get into the banking/finance space. “Primerica” was founded as the American Can Company in 1901 to manufacture tin cans on its 150-acre factory in Connecticut. In 1986, the packaging arm of Primerica was sold, and the company shut down its factory in Greenwich to move to Manhattan. On the other hand, Control Data Corporation was one of IBMs major competitors in super-computing throughout the middle of the 20th century. They diversified into a number of businesses in the 60s and 70s, and were bought by the British telecom holding company BT Group and split up in the early 1990s. The stories of these two companies are indicative of the growing “financialization” of the U.S. economy, and the decline of manufacturing in the latter part of the last century. Whereas these companies used to be involved in producing machines and packaging, now they have moved into a different sort of business. One that, as we will see, is very complex and very hard to regulate.

From 1989 to 1998, Commercial Credit added more insurance and investment banking companies to its portfolio, including Travelers Insurance, Shearson Lehman, Aetna Life & Casualty, and Salomon Brothers. This massive financial services conglomerate now went by the name “Travelers Group.” In April 1998 Weill announced his intent to undertake a $76 billion merger between Travelers Group and Citibank, the largest bank in the U.S. and the largest issuer of credit cards in the world, at the time.

There was a problem, however. Ever since the Glass-Stegall Act, commercial banks (the banks regular consumers use to open accounts and take out loans, like Citi) and investment banks (the banks involved in trading in capital markets) had to be kept separate by law. So, Weill recruited ex-President Gerald Ford (Republican) and former Treasury Secretary Robert Rubin (Democrat) to his Board of Directors and began a full lobbying push to change the law. In November of 1999, the Gramm-Leach-Bliley Act was passed, meaning that Weill’s merger which created Citigroup, the largest merger in history at that time, was indeed legal.

I posted my thoughts on the fundamental economic changes signaled by Gramm-Leach-Bliley last week. I think affiliations between commercial banks and investment banks are the most disastrous aspect of our economy at present, and will surely lead to further financial crises and (probably) federal bailouts in the future.

Dimon left Citigroup, after playing a key role in the merger, in November 1998.  In March 2000, he became CEO of Bank One. When JPMorgan Chase purchased Bank One in 2004, Dimon became President and COO of the combined company. In March of 2008, he became CEO. Then the financial crisis happened, and with Dimon’s leadership, JPMorgan Chase emerged as the leading US bank. (Exactly how this happened deserves a closer look–someone needs to look into the New York Federal Reserve bank in mid-late 2008, which was directed by current U.S. Treasury Secretary Timothy Geithner and included Dimon on its Board.)

The second important aspect of this story, besides what the history of it can tell us about what has happened to the U.S. economy in the past 50 years, is what the story tells us about the key parts of the financial regulation that is being debated right now. In the wake of the financial crisis of 2008, Congress introduced the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law by President Obama in July 2010. This is a massive bill, and I don’t have the time to dive into all of it. But there is one section of the bill that is particularly important to this issue, called the Volcker Rule. The rule is often glossed as a ban on “proprietary trading” (prop trading) by commercial banks.

Here’s where it gets tricky. All banks (as companies that assist other companies in raising money; exchanging foreign currency; and managing financial risks) trade. This is because they must make a market to facilitate the services they provide. For example, if my company issued stock, whoever first bought it would have a hard time selling because I haven’t made a name for myself and my company yet. So banks agree to “underwrite” the stock issuance, buying up the shares I sell and looking for a buyer for me. This is an essential service, providing liquidity to the market.

In the course of this “market-making,” some individual traders begin to find different strategies to earn more profit for the bank. When these profits are over-and-above providing liquidity to the market, the trades become known as “proprietary.” Over the past 30 or so years, proprietary trading has evolved considerably and at a break-neck pace. Before the Volcker Rule, to prevent front-running–when knowledge of a client’s move (e.g. an impending merger) can influence profits for the bank–banks were supposed to keep their prop trading and market-making businesses separate. But it is easy to see how proprietary  positions by commercials banks (when market-makers make more profit) can be easily confused with proprietary trades (made by a separate division of the company, entirely). It’s also easy to see how this gets confusing for regulators to sort out when commercial banks and investment banks (the big guns with the really sophisticated types of prop trading) are now combined into the same company.

Now that the Volcker Rule has become law and “banned” all prop trading for commercial banks, we shouldn’t be seeing these risky moves from them any more, right? Well, if you weren’t sure of the answer to that question, JPMorgan’s $2 Billion loss yesterday should have cleared it up for you: prop trading has not disappeared.

In their amazing 325-page letter, Occupy the SEC–the “policy” arm of Occupy Wall Street–went through the Volcker Rule meticulously, explaining where it falls short and where it can and should be improved. The biggest problem they find is in the “market-making loophole.” Under the law as it is, commercial banks are still allowed to engage in market-making as a business. This business is broadly defined, so that banks can claim to be “making a market” in stocks when they are only on one side (buying and not selling or selling and not buying), or even if they’re unwilling to provide executable bids or offers at all. Under the guise of “making a market,” then, commercial banks can continue engaging in risky positions to reap profits.

The $2 Billion loss we saw at JPMorgan this week was the result of exactly the same kind of risky arbitrage that this Occupy the SEC letter warns is still possible under current law. It came from a single London trader named Bruno Iksil. Iksil took JPMorgan into an arbitrage between the credit spreads market (where the yield on a corporate issuer’s bonds is compared to the risk-free rate) and the credit-default swaps (CDS) spreads market (where the future yield on the corporate bond is securitized and traded as a derivative). Usually, CDS spreads and cash spreads are closely-related, but not always. Iksil had moved JPMorgan into a massive long position on CDS (betting that the difference between the CDS spreads and the cash spreads would go down as the economy recovered). The position was meant to be a hedge, although it is still unclear what Iksil was hedging against. CDS spreads went up, cash spreads didn’t, and boom: goodbye $2 Billion.

The past 48 hours, Jamie Dimon has been holding press conferences and getting on CNBC, swearing that Iksil’s position was consistent with the Volcker Rule. It is clear that the spirit of the law, which was to keep commercial banks from engaging in risky prop-trading, was violated. But Dimon may still be correct. If Iksil’s position falls under market-making or another one of the many loopholes of the rule, then the rule simply is not strong enough. With an election season approaching, Congress is not going to take on such a controversial issue. But maybe the SEC will pay attention to Occupy’s letter. I will end this post with a selection from that letter, because authors Akshat Tewary, Alexis Goldstein, Corley Miller, George Bailey, Caitlin Kline, Elizabeth Friedrich, and Eric Taylor put it better than I could ever hope to:

Market making is an indispensable component of liquid, efficient markets. This service, however, simply does not belong in banks…

The bank lobbying effort is certainly understandable: market making is a profitable business and one that banking entities certainly do not want to lose. It is well-known that the major dealers have always fiercely guarded their dominance of market making, particularly in the less regulated OTC markets. Firms that attempt to enter this business are regularly strong-armed through anti-competitive arrangements with inter-broker dealers… Despite the banks’ desire to continue reaping such profits, their contention— that banking entities alone are able and willing to provide this valuable service to the market, and that regulation will cause irreparable damage to the financial system at large—is unfounded and nonsensical.

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