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What We Can (Re)Learn From JP Morgan's $2B Trading Loss

May 16, 2012

(Reprinted from the June 2012 edition of Bath Country Journal.)

Large banks and brokerage firms are in the news again, with word that J.P. Morgan Chase suffered a $2 billion loss while trading for its own investment portfolio. If you're inclined to be amused by such things, word had apparently leaked out weeks before the losses were spotted that a mysterious individual dubbed "The London Whale,” who we now know is Bruno Michel Iksil, was taking strangely large positions in credit default swaps linked to corporate bonds. The London Whale was the head of JP Morgan’s Chief Investment Office—a group that was supposed to be in charge of hedging the bank’s credit exposure.

Other traders described the unusual market activities to the Wall Street Journal who then reported on April 6th that the London Whale was rattling debt markets with these large positions. The WSJ reported on April 10th that the London Whale and his associated group at JP Morgan had stopped trading the positions.

On April 13th, JP Morgan CEO Jamie Dimon described the issue as a “tempest in a teapot” when responding to a question if JP Morgan’s trading operation posed significant risks to the bank. The bank’s CFO went on to say that JP Morgan was very comfortable with the positions they have and that the operations were merely “protecting the balance sheet.”

During a hastily arranged conference call on May 11th, Jamie Dimon announced the firm’s $2B trading losses and said, “In hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed, and poorly monitored. The portfolio has proven to be riskier, more volatile, and less effective as an economic hedge than we thought.”

These stories prompted some to speculate that the firm's risk management department stayed diligently on top of the firm's speculative trading activities by carefully reading the newspaper.

Volcker Comeuppance

When the 2008 meltdown swept through the financial world, former Federal Reserve Chairman Paul Volcker proposed that brokerage firms and lending institutions be banned from trading in their own accounts, and the so-called "Volcker Rule" bounced around Congress for a full year. Industry lobbyists convinced elected representatives that it was passé to simply require banks to lend their money to businesses and consumers instead of making wild bets with it. While that may keep the banks solvent (a novel idea for sure), it would make US Banks less competitive in the modernized world of global banking. What resulted was a watered-down version of the Volcker Rule set to go into effect on July 21, 2012 and passed as part of the broader Dodd-Frank Wall Street Reform and Consumer Protection Act.

But what if the trading losses weren’t $2B but $200B? What then? Is JP Morgan bailed out by the Federal Reserve and US Taxpayers? The Dodd-Frank Act supposedly provides for orderly liquidation of big banks but critics, including President of Federal Reserve Bank of Dallas Richard Fisher, say the legislation does not give regulators the power and authority to liquidate big banks that threaten the economy. The simple truth is we don’t know if too big to fail has been solved.

Yet, with yet another episode of trading losses piling up at a global bank as a result of its trading operations, it difficult to argue that trading operations such as these belong within a systemic economic institution. What may be considered passé by industry lobbyists is prudent for our socioeconomic stability.

O’ Partnership Where Art Thou?

Michael Lewis, author of the “The Big Short” and “Money Ball” wrote of his experience at Solomon Brothers in the 1980s in his first book “Liar’s Poker”. At that time deposit-based banks like JP Morgan were not allowed to have London-Whale-type trading operations and these were instead reserved to Wall Street investment banks like Solomon Brothers. These investment banks were organized as private partnerships for decades and within the partnership, partners retained the financial risk inherent in their trading operations.

Solomon Brothers became the first of many investment banks to transition from a partnership to a public corporation in the 1980s. This changed who bore the risk. Instead of the partners retaining this risk it was now ultimately born by the shareholders and as we learned in 2008 the US Taxpayer in the direst of circumstances.

Lewis describes in an article entitled “The End of Wall Street’s Boom” how the movement to public corporation was the moment when the Wall Street firm became a black box. The shareholders who financed the risks had no real understanding of what the risk takers were doing. As risk-taking grew ever more complex, understanding continually diminished. After JP Morgan’s trading loss, one can easily argue that even those within the corporation charged to manage these risks lack understanding.

Lewis interviewed John Gutfreund who took Solomon Brothers public. Gutfreund agreed that the main effect of turning a partnership into a corporation was to transfer the financial risk to the shareholder. He said, “When things go wrong, it’s their problem. It’s laissez-fair until you get in deep.”

If 2008 wasn’t the tipping point to effect change in the regulation of these systemic institutions, it’s scary to think what it will take. As consumers, it is important to note that we can vote with our feet and choose to work with institutions that serve their clients first and foremost. While this won’t solve too big to fail, it can send a message and help protect your own balance sheet.


Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent investment advisory and financial planning firm that assists individuals and businesses with their overall wealth management, including retirement planning, tax planning and investment management needs. Kevin can be reached via email at kkroskey@truewealthdesign.com or by phone at 330-777-0688.

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