Major banks hoping to thwart calls for tighter banking restrictions were dealt a blow by news that JPMorgan Chase lost $2 billion in a trading blunder that proponents of new rules say more stringent regulation would curtail.
The spectacular trading meltdown came despite assurances from bankers that existing layers of regulations, internal safeguards and proper oversight are adequate to prevent such disasters. Those critical mechanisms failed to surface a sprawling series of bad bets that reverberated through the global financial markets.
JPMorgan's shares were slammed Friday after Jamie Dimon, CEO of the largest bank in the U.S., said in a conference call late Thursday that his bank's trading losses resulted from a 'flawed' hedging strategy that was "poorly constructed, poorly reviewed, poorly executed, and poorly monitored."
Dimon has been a vocal opponent of a regulation that would restrict certain types of risk-taking by banks, aka the Volcker rule, proposed in the aftermath of the financial crisis by former Federal Reserve Board Chairman Paul Volcker.
"This may not have violated the Volcker Rule, but it violates the Dimon Principle," Dimon said in the conference call.
The losses apparently originated in the bank's London-based Chief Investment Office, where a trader named Bruno Michael Iksil, nicknamed the 'London Whale,' reportedly accumulated a large holding of investments that hedge funds began betting against.
The full scope of the financial meltdown is unknown. Unlike a loss on a single trade, JPMorgan is holding investments that could continue to shed value. Until the web of interconnected hedges is fully unwound, the $2 billion figure could rise, perhaps by $1 billion more this quarter or next, according to Dimon. Some analysts suggest that investors could line up on the other side of JPMorgan's bad bets and widen the bank's losses.
The bank is well-positioned to sustain the loss. Before the news broke, analysts were estimating the company would earn more than $4 billion in the current quarter alone. At the end of last year, JPMorgan had more than $2 trillion worth of assets on its books, including $380 billion in cash.
But the loss has already amplified calls for tighter regulation on risky banking, more than three years after a wave of losses from bad mortgage bets swamped the global financial system and brought about the worst recession
JPMorgan's losses are "the latest evidence that what banks call 'hedges' are often risky bets that so-called 'too big to fail' banks have no business making," said Sen. Carl Levin, D-Mich., chairman of the Senate Permanent Subcommittee on Investigations and an author of the "Volcker Rule."
The final version of the Volcker Rule, included in the sweeping 2009 package of bank regulations known as Dodd-Frank, has yet to be implemented. Last week, Dimon and leaders of other large banks met Federal Reserve Governor Daniel Tarullo in New York to argue against trading restrictions, which bankers have suggested would burden them with costs that will eventually have to be passed to customers.
But on Friday, the co-author of the law, Rep. Barney Frank, D-Mass., noted that, at $2 billlion, JPMorgan's losses from risky hedging would amount to "five times the amount they claim financial regulation is costing them."
"The argument that financial institutions do not need the new rules to help them avoid the irresponsible actions that led to the crisis of 2008 is at least $2 billion harder to make today," Frank said.
The Securities and Exchange Commission said Friday it was looking into JPMorgan's $2 billion botch for potential civil violations, the New York Times reported, citing people briefed on the matter.
JPMorgan's multibillion-dollar losses were apparently self-inflicted by a sprawling web of interconnected investments designed to benefit from an improving U.S. economy, which would reduce the odds of defaults on corporate bonds. Those investments were described as "synthetic credit" because they were designed to mimic the performance of those bonds.
Opponents of tougher regulations argue that tighter restrictions on this type of hedging would make it harder for companies to manage risk. That, in turn, would cause them to be more cautious, slowing economic growth and employment and making U.S. companies less competitive globally.
"That's what these banks do; you can't regulate them away from taking risk without making banks go away," said Jeff Harte, a banking analyst at Sandler O'Neill. "And if you make banks go away, we're going to be bartering cows and eggs with our neighbors and the economy is going to be kind of destroyed."
But proponents of tighter restrictions argue that allowing banks to make unrestricted bets simply concentrates risk in a just a few of large institutions.
"We've got to have real controls and real regulation so this doesn't happen," said Jacob Zamansky, a New York securities lawyer. "When I invest in JPMorgan, I'm not assuming I'm taking this kind of a risk. I think I'm taking a modest risk and that the firm is under control. This shows that Dimon doesn't really know what's going on in the coal mine."
After announcing the spectacular losses, Dimon conceded that the bank's massive hedging failure adds weight to the argument in favor of tighter regulations.
"It plays into the hands of a bunch of pundits, but you have to deal with that and that's life," Dimon said in the conference call with analysts.
The scope of the doomed trading scheme raised wider questions about whether the bank's internal controls were adequate to prevent future disastrous bets that could cause wide financial and economic damage.
"What concerns me is risk management, size, scope," said Dallas Federal Reserve Bank President Richard Fisher, who has called for the breakup of the top five U.S. banks.
"At what point do you get to the point that you don't know what's going on underneath you? That's the point where you've got too big," he told a Texas Bankers Association meeting Friday.
Bankers shouldn't appear on the front page of a newspaper, he added, unless it's for Rotary Club or other community work.