By Nick Massey
CNHI News Service
Well I hate to say I told you so, but I can’t help myself.
In case you have not heard, JP Morgan bank had a little trading problem recently that resulted in a $2 billion loss. Oops!
At least they say the problem is “contained.” Oh wait, isn’t that what Fed Chairman Ben Bernanke said in 2007 about the subprime mortgage problem before it blew up? And wasn’t that what every bank and investment bank said in early 2008 before they finally confessed to having a problem? And isn’t that what they said after Bear Sterns collapsed and just before the sushi hit the fan at Lehman Brothers?
But this time is different because we know better now. Yeah right! The inmates are still running the asylum and putting us all at risk again.
Perhaps JP Morgan just gave us a glimpse of the next financial crisis. A surprise, hidden $2 billion trading loss in a bunch of exotic financial instruments at an offshore branch of one of our premier banks was certainly not what the markets wanted to hear right now.
But it begs the question that if one of the most sophisticated banks in the world can screw up this badly and get caught on the wrong side of a trade, what else is out there among institutions of lesser abilities? Mark my words; this is just the first of many revelations to come in this area of trading by major financial institutions. There is never just one cockroach.
I don’t want to beat up on JP Morgan. Plenty of other people are doing that. The problem is much bigger than just them. This is precisely why I have argued since 2008 that we need to bring back some version of the 1933 Glass–Steagall Act, which separated commercial banking from investment banking. These two businesses have completely different risk characteristics and capital requirements.
Prior to the late 1980s, most investment banks were private partnerships and not publicly traded corporations like they are today. That meant when they worked on any kind of deal, or engaged in any kind of speculative trading, they were risking the partners’ own money. You can be quite certain that they considered risk very carefully then. As publicly traded corporation today, they are risking shareholder money, only some of which is theirs. That’s a different ballgame.
Traditional commercial banking is fairly tame and predictable. You pay interest on deposits, which are FDIC insured, and then loan the money out at a higher rate. The difference, i.e. the spread, is your potential profit. It’s not very exciting or sexy, but as long as you don’t do anything too stupid and you closely manage the credit risk, there is not a lot to go wrong. Of course, that is way over simplified, but you get the idea.
Investment banking and trading, on the other hand, can be quite exciting, glamorous and highly profitable if you do it right. It is also a lot more risky and even the best and brightest sometimes get caught going the wrong way and can suffer serious losses. That’s why capital requirements are so different and risk management so important.
Prior to the Great Depression, commercial banks and investment banks were usually one and the same. After the financial crisis of the depression, the 1933 Glass-Steagall Act directed that commercial banks and investment banks be separate. You could be one or the other, but not both. The act was repealed in 1999 under great pressure from financial institutions.
The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law in 2010. It was supposed to prevent a lot of the problems that led up to the recent great recession. Actually what it ended up doing, among other things, was pass a lot of very unnecessary and costly regulations onto local and regional banks, which were mostly not part of the problem in the first place.
The so-called Volker Rule, as proposed by former Fed Chairman Paul Volker, was to prohibit banks from speculating for their own account with depositor money. Wall Street is fighting that one with all they can and JP Morgan has led the fight.
Dodd-Frank was a thin coat of paint over a cracked and broken banking system.
So what did JPMorgan actually do? As far as we can tell, it used the market for derivatives - complex financial instruments - to make a huge bet on the safety of corporate debt, something like the bets that the insurer A.I.G. made on housing debt a few years ago.
The key point is not that the bet went bad; it is that institutions playing a key role in the financial system have no business making such bets, least of all when those institutions are backed by taxpayer guarantees. Here we go again.
Nick Massey is a financial columnist for The Edmond (Okla.) Sun.