How Does a Bank Lose $5.8 Billion?

The BU School of Management’s Mark T. Williams calls it “hedge-u-lation”—speculative binges like those that earned global banking giant JPMorgan Chase worldwide headlines after its bet on a European recovery ate $5.8 billion… and counting. The magnitude of the losses has experts and consumers scratching their heads and renewing calls for banking reform legislation.

To help us sort through the confusion, BU Today recently spoke with Williams, an SMG executive-in-residence and master lecturer in Finance. A frequent op-ed contributor to The Boston Globe and other publications, Williams (SMG’93) has worked as a senior trading floor executive, a bank trust officer, and as a bank examiner for the Federal Reserve Bank in Boston and San Francisco.

BU Today: How did JPMorgan Chase get into such risky trades?

Williams: The risky trading was done at JPMorgan’s Chief Investment Office (CIO) located in London. This office traditionally focused on investing the bank’s excess cash at a corporate-wide level—a relatively low-risk activity. Excess capital was invested in liquid, low-risk bonds and money market instruments. Basically boring stuff.

About six years ago, JPMorgan CEO Jamie Dimon changed the mandate of the CIO function to seek profit. High-risk-taking trader types were hired. Incentive systems were also modified. Those that could generate big profits made big bonuses. In the three years leading up to 2011, CIO made bets that earned about $5 billion. To make billions, JPMorgan decided it was now willing to risk billions.

How did these trades lead to such huge losses?

Trades involved credit default swaps, the same derivatives that helped trigger the financial crisis of 2008. This time, the derivatives were linked to credit default indexes of corporate bonds and not home mortgages.

Derivatives are used by banks to either hedge or speculate. As a global bank, JPMorgan made a lot of loans to European corporations. As the global economy deteriorated, the bank became worried about its loan exposure and decided to hedge against this risk. One way to mitigate default risk is to buy credit default swaps. Theoretically, if a bank made a million dollar loan and owned the equivalent in credit default protection, the risk would be perfectly hedged. However, if the bank buys or sells swaps greater than its loan portfolio, it is speculating. If you are 50 percent hedged, you are speculating.

Leading up to 2011, JPMorgan bought billions worth of derivatives to protect against credit default. By early 2011, the prospect of a European corporate credit meltdown declined. The sudden improvement in market outlook reduced the value of owning credit default swaps. JPMorgan quickly lost over $1 billion on the hedge side of the trade. In response, the CIO decided to reverse its position and sell credit default swaps. This was an aggressive bet. The link between risk and hedge was crumbling. JPMorgan was no longer hedging. It was speculating. The timing of this trade was also poor. No sooner did they sell credit default protection, the European economy plunged back into deep financial crisis. The bank lost even more money. By the first week of May, JPMorgan announced it could lose up to $2 billion. In July the number increased to $5 billion. Some experts predict the losses could top $9 billion.

And this is what you call hedge-u-lation?

Yes. This department was supposed to hedge or reduce this risk and not increase the overall risk. A large international bank like JPMorgan has to aggregate risks on a corporate-wide basis. But this department, with Ina Drew as head, decided to do something different, they placed billions in ill-conceived bets. So they moved from hedging to speculation. This is called hedge-u-lation. I use the term in the classroom to describe the point when hedging activities morph into speculative trading. The bank was saying, I’m smarter than the market and the billions earned in previous years is living proof. What JPMorgan failed to acknowledge is that a trading strategy that worked last year might not work this year.

How did the bank try to stem the damage?

The bank attempted to reduce the market fallout, but it was too late. Dimon underestimated the level of losses and telegraphed to the market that they were having a fire sale. Many speculators waited on the sidelines to make money off of JP’s bad trade. Dimon did the equivalent of announcing he had to sell his home in thirty days. Losses continued to grow, and have more than doubled the initial estimate provided in May. And the bank’s credibility with investors and regulators has declined.

JPMorgan insists its actions hurt no consumers.

Yes, JPMorgan is quick to say no taxpayer dollars were lost in this trading debacle. However, shareholders’ money was lost. Since trading losses were first disclosed, the value of JPMorgan stock has dropped by $30 billion. The potential risk to taxpayers remains. Here’s a bank that benefits from a cheap form of funding through FDIC insurance. The fact that it is behaving more like a risk-taking hedge fund than a traditional commercial bank is disturbing. JPMorgan is the largest bank in the United States and is too big to fail. Excessive trading loss causes bank failures. If trading losses grew to the size where JPMorgan was rescued, it would cost taxpayers.

As the biggest commercial bank, what message is JPMorgan Chase sending to the industry?

One clear negative message is that this large FDIC-insured bank thinks it can take a lot of risk, regardless of the consequences. As a former bank regulator, I’m concerned that the largest bank in the land would, number one, take such outsized bets, and number two, lose such large amounts. If less-capitalized banks followed a similar strategy, it could be devastating. By definition, a commercial bank takes in deposits and makes loans. However, JP went one step further and gambled big.

The second message that should be heeded is that over-reliance on trading models is dangerous. JP thought the market would continue to behave like their models told them it would. These models were flawed and understated the probability of market loss. As market dynamics in Europe changed, extreme losses previously thought improbable occurred—not once but many times. Bank models turned out to be precisely wrong.

How do these practices affect the image of bankers?

I was a banker in the eighties and later a Federal Reserve Bank regulator. Banking used to be boring but a very respected profession. Bankers were pillars of the community. They were also conservative in their level of risk-taking. But over the last two decades, bankers have forgotten their important role as stewards of the economy.

When you think of the US economy, it’s two-thirds driven by consumption: bankers lend, consumers spend, and the economy grows. But if banks engage in dangerous trading, they increase the chance of financial instability. The persistent global recession is endemic of what happens when enough banks take too much risk. An economy can only be as strong or weak as its banks are collectively. Many bankers have lost their way and have forgotten they are in the business to lend and help corporations grow profits and jobs.

What parallels can you draw between JPMorgan Chase losses and the mortgage crisis of 2008?

Credit derivatives were at the center of both events. The level of risk-taking was excessive, not well understood, and lax internal controls were evident. In 2008, weak lending standards triggered the mortgage crisis; here it’s excessive trading risk. Regulators also appear to have been slow to uncover the festering problem leading up to the 2008 crisis and the events that caused JPMorgan to lose over $5 billion. Similar to 2008, JPMorgan’s latest announcements suggest that trader fraud might have also come into play.

The New York Times quoted the bank as saying it will be solidly profitable for the quarter, despite the loss. How is that possible?

Per month, they generate about $2 billion of revenue, so they’re saying they’ll be profitable for the quarter. This is overly optimistic. In the earnings release last week, they actually surprised the market and reported a 9 percent drop in quarterly earnings. Trading losses continue to grow and are beginning to take their toll. This behavior undermines trust, and depositors must be thinking, why should I invest in this bank? My bet is that Jamie Dimon will be forced out in the next thirty days.

Would the trades be permitted under the still evolving Dodd-Frank Act that President Obama signed into law in 2010?

One camp says yes, one says no. I believe that the Dodd-Frank Act prohibits the type of trading JP engaged in. However, the Dodd-Frank Act is over 2,300 pages long and the specific Volcker provision is over 80 pages. As written, the law has a lot of loopholes, many created by lobbyists hired, in part, by JP. Banks have to become fully compliant with the Volcker provision within the next 24 months. A critical aspect to all of this is how regulators interpret the law. If the Fed and Office of the Comptroller [of the Currency] take a hard stance, banks will be prohibited from entering into higher risk proprietary trading. However, if regulators decided to take a relaxed stance, the large banks will continue to engage in these trading practices.

The so-called Volcker rule prohibits speculative investments that don’t benefit bank customers. That sounds very subjective.

It is an important distinction and raises the question of what activities FDIC-insured banks should be allowed to engage in. The Volcker provision is broad enough that it allows for interpretation. It’s like the Supreme Court in that famous obscenity case: They’ll know it when they see it. Regulators should have the ability to interpret. Importantly, regulators need to take a hard stance on proprietary trading by FDIC-insured banks.

So how speculative is too speculative?

It is true that a bank with larger capital can take larger risk, but it needs to be controlled. The fact that a bank could lose $1 billion, $2 billion, and now it looks like $5 billion in a single trading strategy is disturbing. If banks want to take bets like hedge funds, they should not be FDIC insured. JPMorgan should not be able to have it both ways—benefit from government subsidized funding and also profit by putting the bank at significant risk. Banking should not be about gambling.

Can we assume other banks are engaging in this level of speculation as well?

If the largest bank in America is doing this, there’s a good chance that other big banks are to. So the real question is to what extent. Regulators are also obsessing over this question. These banks are unwinding their own positions. I suspect no one took the level of risk that JPMorgan did. Of the over 6,000 banks in America, there are only a handful that would have the trading capacity to trade at such large dollar levels. The majority of banks don’t permit such large risk-taking or trading floor bravado to exist.

Is the bank regulation system a healthy adversarial one, or do the banks have the upper hand?

There’s a sophistication gap between bankers and regulators. The reason for that is, in part, the compensation system. Higher Wall Street salaries, four to ten times larger, are attractive and can pull the brightest from pursuing a career as a regulator. Regulator budgets are oftentimes constrained and their systems are not keeping pace with those of the banks being regulated. Some argue it’s a cozy relationship between regulators and banks, but it’s more the sophistication gap. Many times the regulators really don’t have the tools or human capital. They’re at a big disadvantage.