This is about the $2 billion JP Morgan Chase trade that went bad.
Everyone who reads me, you understand banks, right? Banks take in deposits on one side (the liability side) of the balance sheet, and they make loans on the other side. When you deposit money in a bank, they don’t just stick it the vault. It goes out for a loan, which becomes an asset of the bank.
A very small portion on the liability side is the bank’s capital. The government regulates this, because if this disappears, there really is no “bank” left to the bank. All the deposit money is out on loan, and if you show up to claim your cash, the bank doesn’t have it to hand back to you. The bank is insolvent and the Federal Reserve is called in, because it insured your deposit up to $250,000.
If you go around the corner to a plain vanilla bank, like Ephrata National Bank here in Lancaster, this is the business model. The bank stays well-capitalized, and does not do screwy things. Your deposit money will go out into people’s mortgages, or some business lending. Maybe, even, it will go to agricultural lending. If there is no handy lending business to be done, then the bank will buy U.S. treasury notes and lend to the government.
What is going on at a JP Morgan Chase is a lot different. Chase is doing a lot of transactions for its own account; meaning, it is using the firm’s capital to trade with other participants in the market. They say they are doing this to “hedge risk”. They mean that if they are holding some loan that my go down in value because of a change in market conditions, or a specific change in interest rates, they have another investment that should go up to offset the loss.
They say they have to do this, and that they are better off for doing this. But, it really sounds like they are just making bets with other players in the market, and such a big bank knows that the federal government will come in and help them out, like what happened in 2008, if they get way in over their heads.
I don’t know much about Ina Drew, and there seems to be a lot coming out now, that she wasn’t some wild-eyed trader, or even one of these overly self-assured people like former New Jersey governor Jon Corzine. She is a very competent person, who, because she was making $14 million a year, ignored the fact that the risks she was “managing” were really activities that put more risk on JP Morgan Chase’s balance sheet.
Contemporary risk management on Wall Street is like the casino player on a win streak. They keep winning, and they think it’s their method that is cleaning out the house each time. But, in fact, it’s that they’re playing with financial fire and getting lucky more times than not. They start making or tolerating even bigger trades (even bigger bets, right?)
Finally, one day the trade is too big, and it’s: you lose.
This happens in the casino, and this also happens in the risk management end of Wall Street. Arguably, because the banks themselves are too big, such that no one has a handle on all the moving parts. They really don’t know what the risks are. They just know that they are smart. And, they make a lot of money and no one really questions them.
From what I read, JP Morgan Chase was buying a kind of corporate default insurance, where they would collect in the event that the spread between the terms of two tranches of corporate debt were either to widen or shrink. The problem is they have too much of whatever they are carrying, and now it will cost them money to sell whichever position they need to exit out of. Hedge funds are busy guessing what Chase has and what they might sell (or need to buy to offset!) the bad position.
When a well run bank, that did a great job of surviving the 2008 Financial Crisis, gets into a bind like that, it shows you that commercial banking should be smaller and more regulated. There are enough risks just in the yield curve, and lending to something that is less safe than the U.S. government. Yield curve problems were enough to bring down the savings & loan industry in America during the 1980’s. I believe the yield curve wrecked First Pennsylvania Bank, too, around 1979 and again in 1990, when it sold to CoreStates.
The fact that you are taking in people’s deposits and sending the money out the door, in loans, is sufficient risk to worry about. The idea that you can then do other trades that will somehow offset the bread-and-butter business is foolish. It’s casino gambling.
How could somebody like Jamie Dimon not understand that?
[Update: what’s wrong in this paragraph, below?
In February, Ms. Drew traveled to Washington with other JPMorgan executives, including Barry Zubrow, who oversees regulatory affairs, to explain why strategies like the one that later soured could offset risk within the bank. It was Ms. Drew’s first such trip to Washington, and she was called upon as an expert to discuss how to manage the gap between assets and liabilities for big banks, specifically how to handle the capital risks posed by having more in deposits than in loans.
What would be a risk to capital, if you have more deposits than you do loans? What this means is you have been given cash by your depositors. You do not have opportunities to make profitable loans. So your alternative is to lend it to the federal government, which, the last I checked was borrowing about $1 trillion just for this year.
In fact, this is why the National Banking Act was passed in 1862. The National Banks collected deposits, and lent that money to the federal government, in order to fight the Civil War.
There is always some place to lend deposits to. The question is, whether you will be happy with receiving 0.25%. But how do Japanese banks survive, since it’s been that way there since the early 2000’s?]