By know you should have heard that after the market closed yesterday, JP Morgan Chase (JPM) announced that the company lost about $2 billion on synthetic credit security investment trades taken on by its chief investment office in its London branch. Supposedly the loss was taken on poorly designed hedges in its credit risk portfolio. Let us accept that fact at face value. However, we need to dig a bit deeper. That digging needs to be done outside of JP Morgan Chase. Here is why.
Over-the-counter derivatives are a zero sum game. I should know, I ran the Global Equity Swap business at Merrill Lynch for most of the 1990s and have taught courses in derivatives at Seton Hall University’s Stillman School of Business on and off since 2002. In the unregulated over-the-counter derivative market, for every winner there is an equal and offsetting loser. The problem driving the 2007-2009 Credit Crisis was that the losers were insolvent and could not pay the winners. Thus, the US Treasury had to step in with TARP and other government programs to balance the books, so to speak. This time around, JP Morgan Chase is the loser. While $2 billion is not a drop in the bucket, it certainly won’t move the needle for JP Morgan, a company that earned $17.6 billion after tax in 2011.
So what we need to ask now is: Who is on the other side? I can think of many potential winners on the other side of JP Morgan Chase’s “mistake” as Jamie Dimon called it. Here is a non-exhaustive list: Citigroup (C), Bank of America (BAC), Goldman Sachs (GS), Barclays (BCS), Deutsche Bank (DB), Credit Suisse (CS), UBS (UBS), HSBC (HSB), Credit Agricole, Societe General, BNP Paribas, Royal Bank of Canada (RY) or Royal Bank of Scotland (RBS), to name a few in banking. Then there are hedge funds, pension funds and sovereign wealth funds that could also be on the right side of the trade. Of course, none of these winners will release a press statement pounding their chests as to their victory. Some of these gains might trickle in during the reporting of second quarter results.
Also looking beyond JP Morgan Chase, we have to ask about the “Volker Rule.” There will be politicians and critics of banks who will point to the Volker Rule as not being strong enough with the JP Morgan Chase loss being prima facie evidence to support their opinion. However, the JP Morgan loss was recorded in London, where the new financial regulations and the Volker Rule are beyond the reach of US regulators. I would argue that the Volker Rule might have been a contributory cause to the JP Morgan loss, albeit indirectly and inadvertently. By driving these proprietary trading activities offshore, the Volker Rule in essence has lost any potency that it was intended to have. Thus, just like Nathan Detroit’s Oldest Established Permanent Floating Crap Game, the risk taking activities in banking have just been moved beyond the reaches of the local authorities to London. Along with that go all the gains that collectively the banks make in proprietary trading and the resultant taxes that will be paid. Thus, I would argue that the Volker Rule went too far and not far enough.
Over on Wall Street All-Stars we are conducting a poll through 9AM Monday May 14. The question being asked is: Is the JP Morgan Trading Loss Bombshell an Isolated One Day Event? Please cast your vote and check back for the results.
Disclosure: At the time of this commentary Scott Rothbort, his family and/or clients of LakeView AssetManagement, LLC was long BAC stock — although positions can change at any time.
Scott Rothbort is also the publisher of the LakeView Restaurant & Food Chain Report, a newsletter focusing in on food, restaurant and agricultural stocks. You can subscribe at www.restaurantstox.com
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Posted By Scott Rothbort at May 11, 2012