Regulate the Regulators

On May 11, shares of J.P. Morgan Chase (NYSE: JPM) declined 9% after CEO Jamie Dimon disclosed a massive loss. They have since fallen 19% to $33.10.

At the time, Dimon expected the loss, which stemmed from a botched derivative trade, to be $2 billion(some estimate it could be $5.7 billion when all is said and done). The loss on the trade is reprehensible and heads have and will roll at the bank.

But who is holding the regulators responsible?

Government officials spent the past four years building regulations to avoid making the same mistakes that caused the biggest credit collapse since the Great Depression. Yet bankers from J.P. Morgan were able to skirt those laws and manufacture a $2 billion blunder.

In 2008, Fed Chairman Ben Bernanke declared J.P. Morgan and a slew of other banks too big to fail. Bernanke deemed that the collapse of those banks posed a systemic risk to the U.S. economy, meaning that a failure of one bank would have a cascading effect that would eventually cause the system to fail. In the years following the madness, policy makers revamped regulations to reduce systemic risk in the system.

Despite heightened regulation, J.P. Morgan was able to take the same lame-brained derivative trade that caused the crisis four years ago. And by looking at the chain of evidence in the months that led to the big loss, it should have been obvious to regulators and bank management that risk was not being managed well on the floor.

Back on April 6, both The Wall Street Journal and Bloomberg reported unusual activity coming from J.P. Morgan. The rumors spoke of a London trader, who floor traders dubbed “the London whale,” making unusual movements in credit markets.

Bruno Iksil, “the London whale,” was rumored to be taking large positions – large enough that he was driving a $10 trillion market. Traders speculated that he was selling large amounts of protection on an index of companies with the use of credit default swaps.

With that trade, Iksil was betting that credit would improve for those companies. However, the bet had distorted the price of the CDX NA IG 9 index (the alleged synthetic index that caused losses) to a point where buying protection on the index was cheaper than what it would cost to protect the companies in the index individually. This is exactly the type of activity that regulations should prevent.

The bank had no business taking such a big risk. Also, based on the early warnings from reputable financial sources like WSJ and Bloomberg, regulators should have contacted the bank because J.P. Morgan was clearly doing something incredibly risky.

The bank would argue that it was hedging, but that’s untrue. A hedge reduces risk in a portfolio; this alleged strategy increased it.

A hedge is taken to limit a portfolio’s losses by placing a trade that is opposite to investments within the portfolio. J.P. Morgan’s traders didn’t do that.

J.P. Morgan is already incredibly exposed to corporate debt.  After all, it’s a bank. Banks accumulate massive amounts of corporate debt through normal business operations. Therefore, the alleged hedge wasn’t a hedge at all since it replicated banking functions that would profit from improving credit conditions. In the process, a huge levered bank was built instead of a hedge. The bank could have accomplished the same thing by lending to consumers or small businesses.

Weeks before the loss was made public, Jamie Dimon knew the situation was out of control. That is probably what prompted him to gather a group the New York Times dubbed the “Navy Seals.”  John Hogan, who led the eight person team of risk strategists tasked to solve the mess, simply called his group “the A-Team.”

At this stage, details of the $2 billion gamble (as well as the unwind) are murky, although it does appear the rumors from over one month ago will prove to be true. The Justice Department announced that it would look into the loss. The Commodities Futures Trading Commission (CFTC) and SEC may bring civil charges against the bank.

J.P. Morgan will have a tarnished reputation. It may even face fines. Yet the writing was on the wall over one month ago that excessive risk was taken and big losses were possible.

Regulations must be properly enforced before big losses occur, or else we will repeat the same big mistakes of the past. It appears that we are no more protected now than we were four years ago, despite years of rigorous debate on financial regulation.

Who is investigating the regulators?