Why JPMorgan’s $3 Billion Loss Is Sparking Fears of Another Crisis

Libby Kane
Posted

Last week, JPMorgan Chase disclosed that it lost at least $2 billion as a result of speculative trades that went wrong … and then revised the number up to $3 billion this week.

CEO Jamie Dimon has issued multiple apologies for the bank’s actions and four top-ranking JPMorgan officials will likely step down. One is Chief Investment Officer Ina Drew, a top woman on Wall Street and the company’s fourth-highest earning officer, who took home $14 million last year.

Drew isn’t the person who made the trades–it was actually London trader Bruno Iksil who made bets so big that they distorted the market. For that reason, he was nicknamed “The London Whale” and “Voldemort,” which—if you’re familiar with the plot of Harry Potter—was rather prescient.

But while the big financial news might feel like it’s a world away from you, the truth is, similar risky financial behavior has, in the past, had very real effects on all of us. (See Crisis, Financial.) Read on to find out what happened and how it could affect you.

What Happened, Exactly?

Banking activities include the mundane (lending) and the nearly incomprehensible (i.e. derivatives trading), and many of the latter are pursued as a means to improve a bank’s profits.

JPMorgan’s fiasco stemmed from one of the riskier trading practices called “hedging,” which in broad terms means reducing risk by making bets mixing securities (such as stocks, derivatives and futures). Ostensibly, this should reduce risk when the trader is unsure of what the market will do … but others say that these “hedges” are actually big bets that can backfire when the market doesn’t move as expected. Which is what happened to JPMorgan.

Rumors of the risky hedging practices coming through the London office came to the attention of both the press and Dimon months ago, but when asked if he was concerned, the CEO called the issue “a complete tempest in a teapot.” Now, he admits that the mistakes were “sloppy” and “stupid,” and that they had made “a terrible, egregious mistake.”

Keep in mind that $3 billion isn’t a devastating monetary loss for JPMorgan, which made $19 billion last year (although its stock market value did drop nearly $13 billion the day after the trading loss was announced). The problems are with public relations and shareholders, who filed two lawsuits against JPMorgan Chase for misleading investors about the company’s risk exposure and the potential losses on those bets.

The loss also has implications for recently proposed financial regulations. After all, JPMorgan’s “egregious mistake” was caused by exactly the kind of bet that was common in the run-up to the financial crisis.

Could It Have Been Prevented?

Much of the speculation surrounding the company’s loss focuses on whether it could have been avoided through stricter financial regulations or improved incentives.

The Volcker Rule

At the forefront of the discussion is a proposal called the Volcker Rule, which would prohibit federally insured banks from using money to trade for their own profit. If it became law, it would be added to the Dodd-Frank bill, which became law in 2010 and was intended to prevent another financial crisis.

Many members of the financial industry, including Dimon even post-debacle, vehemently oppose the Volcker Rule, which would limit a bank’s autonomy when it comes to making speculative investments. If Volcker were made law, violations like the one JPMorgan is accused of would most likely be subject to SEC regulation. But as with any legislation, deciding deceptively simple things like which trades are OK and which are not defies easy answers. Even old-fashioned banks that focus on lending still make trades for profit.

Clawback Pay

Another issue at hand is compensation. Part of the Dodd-Frank Act is the institution of “clawback policies,” which demand personal compensation be returned to the company when an individual hasn’t exercised proper judgment and the bank has suffered.

The policy was meant to ensure that employees act in the company’s best interest instead of solely pursuing deals for guts and glory, but JPMorgan’s policy rescinds the past year’s compensation from only a certain pool of high-ranking employees who are judged to have neglected the company’s interests.

You can probably see that there’s a lot of gray area in that definition. For that reason, the verdict on whether CIO Drew will keep last year’s earnings is greatly anticipated. Again with the loopholes: Clawback pay makes sense in theory, but the company-specific policies and judgment on a case-by-case basis means it may not play out as intended.

Current Law

While the recent bad trade could not be prevented by current law, it could still be punished. Companies are not allowed to make false or misleading statements about their activities and are required to be upfront with the Securities and Exchange Commission.

As far as anyone can tell, JPMorgan was never dishonest. Yes, the CEO downplayed the trades when asked, but he never actually lied. Because of that, any potential SEC investigation would have to focus on who knew what and when, and how it was communicated to investors, which is no easy task. (As of Thursday afternoon, the FBI, SEC and Federal Reserve have all opened inquiries into the trade.)

How Will This Affect You?

As we said above, the issues surrounding JPMorgan’s mistake aren’t so much about cash as they are about how banks should be regulated so that their activities don’t harm the overall economy and our own wallets.

And granted, we’re no SEC, but from our end it seems like this story has already been told. The Dodd-Frank Act was instituted in the wake of past “terrible, egregious mistakes” that caused a major financial crisis and shaped an entire generation.

But even with the laws on the books, these mistakes are still happening. What will it take for regulations to make a difference?

  • Guest

    this article neither answers why the loss is “sparking fears of another crisis” nor “how it will affect you”.