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$2 Billion Chump Change

A finance professor specializing in derivatives lays out the implications of J.P. Morgan’s $2 billion bum bet.

Robert Brooks, professor of financial management at the University of Alabama

Robert Brooks, professor of financial management at the University of Alabama

News in May that J.P. Morgan dropped more than $2 billion in a derivatives trade made headlines, stirred Congressional committee hearings—Harrumph! Harrumph!—and was a really revolting development for the bank giant’s CEO, Jamie Dimon, a leading critic of derivatives regulation.

The blunder was committed within the supposedly conservative treasury department of the commercial bank, not the freewheeling investment bank—all the more cause for puffed feathers among the pols.

It’s rare for these obscure financial instruments to grab headlines, but the sheer size of the derivatives expansion seems to cry for attention. In a five-year run up to the 2008 crash, there was a five-fold growth in derivatives, reaching $596 trillion. It puts $2 billion into chump-change perspective.

We talked about JPM’s financial gaffe with Robert Brooks, the state’s leading academic expert on derivatives, professor of financial management at the University of Alabama. Brooks continues to be an enthusiast for derivatives and financial engineering, but not so much giant banks and giant bank bailouts.

There are a lot of things that go on in a financial company that are referred to as hedges that really are not. In these global, complex organizations, almost any trade can be asserted to be a hedge for something that organization has. To me, it’s a misuse of the term “hedging,” and that’s a very serious concern. What does that word mean? It is often used for transactions that most common folk would call speculating. But in a strict, regulatory compliance argument, it’s going to be a hedge. If you can label it a hedge, it is allowed. All kinds of things are allowed if you can slap that label on it.

If you listen carefully to some of the comments with regard to this trade and others, you hear people talking about correlation between one variable and another variable. We live in a day of empiricism, in which you don’t know anything unless you have the data. But finance is not a physical science. It’s a social science. And in a social science like finance, the data has an unruly capacity to fool rather than rule.

What the average person might observe as common sense, the treasury department of J.P. Morgan may have long forgotten. The degree to which we know things in finance is never going to be at the same level as physics. Only a foolish corporate executive would think otherwise.

The definition of “hedging” in Dodd-Frank is vacuous. Every time there is a crisis, there’s a new round of regulation, just layer on layer. Now we have regulations that are ambiguous, a high level of ambiguity. A good analogy is if I were to drive out onto I-59 to Birmingham and notice a speed limit sign that said, “Drive at a reasonable speed.” That’s what Dodd-Frank says. That kind of thing makes the state trooper or the regulator a tyrant. They now have infinite power.

We do need regulations, but a few and crystal clear, and let’s have it so that violations of those are extremely punitive. What we can’t have are firms like J.P. Morgan making economic calculations that drive an Alabama municipality into bankruptcy because it’s more profitable doing that and paying the penalties for getting caught.

The only reason that regulators have an interest is the “social put.” The social put means that if J.P. Morgan executives take on huge gambles hoping for a massive payoff, if they lose, you and I as taxpayers have to bail them out.

In my opinion, the bank bailout was a great mistake. Any bank that received bailout money should have had to fire top management and have salaries clawed back for the previous five years. There should have been direct consequences to them, the management team. A lot of really good bankers understand what it means to be a fiduciary. But a lot have long since lost the high calling of being a fiduciary, and I have no problem with those banks going out of business. But since we live in an environment with a social put, we as taxpaying citizens have an economic interest in J.P. Morgan. So we should just withdraw FDIC insurance, unless they want to carve out their commercial bank side and go back to the Glass Steagall days.

Markets are extremely effective in sorting out who knows and who doesn’t know what he is doing. One of the serious risks is that regulators would try to teach corporate executives what risk is and how to measure it and manage it. Risk is a very elusive concept, and you don’t want each bank thinking about risk in the same way. If a regulator on the outside defines and measures risk in the wrong way, he sends every single bank over the cliff at the same time. I’d much rather have hundreds of banks grappling with the question on their own and lose five or 10 banks each year.

What you have now is that the regulators have taken over the risk management function of these banks, and that is a serious mistake. An example is when the Federal Reserve Board of Governors had the banks go through stress tests. That exercise alone had unintended consequences. It tells those commercial banks that that is how they should be thinking about their risks. There are an infinite number of tests you could run, but the regulators pick a few, and now everybody’s managing to regulators’ stress test and not the actual risk out there.

There is a massive weight of regulations, but that’s not new. What is new is the arrogance of people who think they can see the future and the greed of a banker to bet the bank on the chance of pocketing millions and, when he loses, passes it on to the U.S. taxpayer. And exactly how J.P. Morgan’s back office can take a speculative bet and call it a hedge: That’s new.

If these bankers want to speculate, they will. But you’ve got to allow them to fail. And the government should be concerned over the high level of concentration of these large banks. If it becomes apparent that at the highest level of a company like J.P. Morgan if they’ve forgotten what “fiduciary” means, and don’t have an ethical compass and transgress with abandon, they ought to be shot down.

Chris McFadyen is the editorial director of Business Alabama

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