TOPICS > Economy

After JPMorgan’s Huge Loss, Is More Regulation Needed?

May 11, 2012 at 12:00 AM EDT
Shares in JPMorgan Chase fell 9 percent Friday on news that the bank lost $2 billion over six weeks due to "self-inflicted" mistakes. Jeffrey Brown, The Wall Street Journal's Liz Rappaport, Michael Greenberger of the University of Maryland School of Law and consultant Bert Ely discuss the details and calls for more regulation.
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TRANSCRIPT

JUDY WOODRUFF: It was a day for digesting the enormous losses reported by J.P. Morgan Chase. And, as the news spread, so did word that the banking giant will face a federal investigation.

The stunning disclosure from the nation’s largest bank rippled across Wall Street and Washington today. It came from CEO Jamie Dimon late Thursday in a surprise conference call with analysts and reporters. The bank had lost $2 billion in just six weeks.

JAMIE DIMON, J.P. Morgan Chase: These were egregious mistakes. They were self-inflicted. We are accountable, and what happened violates our own standards and principles by how we want to operate the company.

JUDY WOODRUFF: Without giving details, Dimon said the mistakes involved so-called derivatives or trading bets in the credit market. He maintained the bank had been trying to guard against risks, but ended up heavily exposed.

JAMIE DIMON: 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.

JUDY WOODRUFF: Dimon also warned there could be additional losses of $1 billion or more. That sent shares in J.P. Morgan Chase plunging more than 9 percent today.

The admission was all the more surprising because J.P. Morgan Chase came through the 2008 financial crisis without reporting a loss. The announcement also triggered new calls for tighter government regulation.

Democratic Sen. Carl Levin spoke on CNBC.

SEN. CARL LEVIN, D-Mich.: What you cannot do is bet on a general direction of the economy, because that’s the kind of bet which can lead to a bank getting in big trouble. And if it’s a big, big bank, if it’s too big to fail, and would, if it did fail, drag the entire economy down with it, then we end up bailing out these banks.

JUDY WOODRUFF: Levin pointed at the need for the new Volcker rule, named after former Federal Reserve Chairman Paul Volcker. It takes effect in July, and will ban so-called proprietary trading, effectively barring big banks from trading with their own money. J.P. Morgan’s Dimon insisted yesterday that’s not what his bank was doing.

In the meantime, it was widely reported that the Federal Securities and Exchange Commission has opened an investigation into exactly what did happen.

JEFFREY BROWN: And to help flesh out more about this story, we turn first to Liz Rappaport of The Wall Street Journal.

So, Liz, in layman’s terms, what was J.P. Morgan doing, what kind of trading? And how could it lose so much money so fast?

LIZ RAPPAPORT, The Wall Street Journal: Hi.

Well, J.P. Morgan was trading in the credit default swap market, which is a derivatives market that is linked to the health of U.S. corporations. So, if a company’s debt gets — if a company viewed as more likely to pay off its debt — its debt, you know, the value of these contracts, these derivatives go up or down.

So J.P. Morgan was effectively taking a very large position in securities that would pay off for the bank if the U.S. economy and these — and American corporations got healthier.

JEFFREY BROWN: Now, one of the questions, of course, here is whether this trade activity was intended as a form of guarding against risk or actually bets that created even more risk.

What is known and not known at this point?

LIZ RAPPAPORT: Well, I think, you know, we heard Jamie Dimon say that these — that this office and that this position was intended as an economic hedge.

I think that’s a really unclear thing to say. You know, usually, hedges in banks are tied very closely to a certain position or a certain activity. If you make a loan, you buy this type of insurance contract, that protects against that company not being able to pay it back. So exactly what kind of hedge and what he — what this group actually hedges against is unclear.

And, you know, the fact that this was such a large and outsized position in one direction, and they got caught sort of flat-footed with it also doesn’t sound like a hedge. It sounds like a bet.

JEFFREY BROWN: Now, you refer to this group — and the character at the center with the colorful name the London Whale, the person at the center of this, tell us about him, the group. And, I gather, it wasn’t the sort of classic rogue trader type of situation that we’ve heard about before, so what was it?

LIZ RAPPAPORT: Well, the London Whale was named Bruno Iksil.

And he — you know, he is a trader in London in this synthetic credit market, you know, credit default swap market. He’s from Paris. He commutes to London. Apparently, he wears black jeans all the time. But he basically was called the Whale because in this market — which sounds very big, you’re talking about trillions of dollars in numbers, but it’s actually often very illiquid — he amassed his position in one index called — I actually forget what it is called, but like an index that references 121 kind of corporate debt names.

And, you know, he took such a large position, he was so known in the market for being — amassing that portion, you know, he was like a whale in the ocean. He was sort of obvious and noticeable. So, hedge funds and other types of traders that operate in this market noticed what he was doing, which was driving down the price of protection on these types of companies.

And they took offsetting bets. So that why he was a whale.

(LAUGHTER)

JEFFREY BROWN: Okay, but not a rogue trader, as we often use the term. I mean, he wasn’t operating off on his own.

LIZ RAPPAPORT: No, I think that’s still somewhat unclear.

But, apparently, the bank has said that — you know, I mean Dimon said it was poorly monitored. But the bank has also said that, you know, it knew well — it well knew exactly what this office was doing and the trades that it was making.

And, you know, permission to make such big bets and trades were kind of run up the flagpole to high levels and senior executives at the bank. You know, I don’t know Mr. Dimon knew exactly about what this guy was doing, specifically. But, yes, I don’t think we have a rogue trader situation.

JEFFREY BROWN: And, finally, before this, Jamie Dimon and the firm, they quite good reputations, right, through the financial crisis, in fact.

LIZ RAPPAPORT: Oh, definitely. J.P. Morgan is a bank that survived the financial crisis better than most of its peers.

The CEO was considered kind of a very plainspoken and very sort of true representative of kind of Main Street’s, you know, need for safe banking. I mean, J.P. Morgan itself was considered a very, very, you know, skillful risk manager, having gotten out of some of the riskier types of mortgage securities that other banks were doing well into the crisis.

So, yes, I think this is a big reputational hit for J.P. Morgan, which — you know, and it creates a lot of uncertainty in the marketplace about banks. The big question about banks was, can we ever really understand was’s going on there? And if J.P. Morgan had a unit that was ill-understood and ill-monitored, you know, even by him, then I think that, you know, the marketplace gets scared all over again.

JEFFREY BROWN: All right, Liz Rappaport of The Wall Street Journal, thanks so much.

And that nicely leads to our continuation. We continue with a question. What, if anything, does this case say about the need for increased financial regulation of the banking system?

We pick that up with Michael Greenberger, professor at the University of Maryland School of Law and a former federal financial regulator. And Bert Ely heads his own consulting firm specializing in banking, monetary policy and financial regulation.

Well, Michael Greenberger, I will start with you. So that is the question. Was this just a bad mistake or does this say something about a more systemic problem?

MICHAEL GREENBERGER, University of Maryland: Well, this is not, thank goodness, appearing to be a systemic problem.

In other words, we’re not going to, hopefully, bail J.P. Morgan out. But, as Liz Rappaport said, these were supposed to be the brightest guys in the room. And if you listen to Jamie Dimon explain this thing, and call it egregious, sloppy, et cetera, et cetera, that is the signal that is being sent. It’s at a minimum a canary in the mine saying that these complex instruments are not even well-understood by the people who create them and trade them.

JEFFREY BROWN: And, therefore, we need more regulation?

MICHAEL GREENBERGER: Well, we don’t need more regulation, because actually the Dodd-Frank statute, which was signed into law in July of 2010, if it is ever allowed to go into effect — and the banks have been very tough in keeping it from going into effect — would have, six ways from Sunday, stopped this kind of trading.

And there is legislation pouring through the House right now to undo Dodd-Frank. Presidential candidate to be Mr. Romney, one of his pledges is to repeal Dodd-Frank. And so he’s asking the American public to go back to a situation where the profits that are made on these, and they can only be called bets in my book, are kept by the bet. The losses, if they are extreme, must be made up by the taxpayer.

JEFFREY BROWN: All right, Bert Ely, what do you see? Does this suggest the need for Dodd-Frank?

BERT ELY, Banking Consultant: Well, I think the real issue here is with regard to the so-called Volcker rule in Dodd-Frank. Dodd-Frank is a very complex piece of legislation.

So I think it’s important to focus in on what is at issue here. And that is the so-called Volcker rule, which is intended to provide a basis for more closely regulating the derivatives activities and other trading, financial trading activities of the banking companies.

The problem is that the regulators are having an extremely difficult time figuring out exactly how to write the rules to implement the Volcker rule. And I would contend — I think Michael might disagree with me on this — that I don’t think an implemented Volcker rule — and it will be implemented eventually — would have prevented this type of situation, because, at least on the surface, these derivatives that the London Whale entered into were meant not to be — were really meant to basically protect the bank against losses on loans and securities, and, as I understand, the Volcker rule would have been outside the focus of that rule.

JEFFREY BROWN: Well, does anyone understand this? Because, as I read it, so much seems to rely on the terms hedging and proprietary trading.

MICHAEL GREENBERGER: If that question can’t be answered, you have got a real problem. If you ask me am I hedging in my life, yes. I buy automobile insurance to protect my car being totalled.

JEFFREY BROWN: So you say, this case, it’s clear that. . .

MICHAEL GREENBERGER: If Jamie Dimon or J.P. Morgan can’t clearly explain how they were hedging — they would like to say they were hedging because that makes it more forgivable.

If there are doubts, if you can’t clearly say I have got a credit default swap to protect me against the failure of a company I have lent money to, that is a hedge. Trying to bet on a 121-company index, the Volcker rule will go into effect, and when it goes into effect, if you can’t explain that you are making a market clearly, if there are doubts, if there are questions, if the PBS NewsHour is confused, that is going to be found to be in violation of the Volcker rule.

(LAUGHTER)

JEFFREY BROWN: I don’t know about the PBS NewsHour, but you don’t see seem to be clear that this case would have been different if the Volcker rule was in place.

BERT ELY: I don’t think it would have been different.

One of the things — and Michael has really kind of touched on — is there are differences of opinion, legitimate differences of opinion about the purpose a particular hedge is serving.

And I think what happened in this situation is that, an idea that was good in concept and good up to a point was taken to extreme. And Liz touched about how he was dealing in particular instruments and the market became very illiquid.

He became too big a player in the market. That is in effect why he was the Whale. And this reminds me of another situation back in 1998, when a company called Long-Term Capital Management blew up. The big difference there is that there was great concern at that time when Long-Term Capital Management had its problems that it might shake and rattle the whole financial system.

The good news about this situation is that, as big as that loss is, it was one that J.P. Morgan Chase could handle internally and bear all of the loss.

JEFFREY BROWN: All right, but in layman’s terms, there is still this too big to fail question. And we heard it in the setup from Sen. Levin.

JEFFREY BROWN: Is this a case that suggests to you that. . .

MICHAEL GREENBERGER: Yes.

The purpose of the Volcker rule is to get bank holding companies that have our deposits, that are insured by the FDIC or the American people, and who have the ability to turn to the Fed in a crisis and get themselves bailed out, what the Volcker rule says, we don’t want you engaging in reckless transactions, egregious, sloppy transactions, to use Jamie Dimon’s word, because you are using the taxpayers’ money.

So we’re going to take you and say, you can’t do this kind of trading. If you can’t clearly explain to me this is a hedge, you’re out. Now, by the way, it’s not just the Volcker rule. There’s something called the Lincoln rule which would have prevented this trade, because it was an unclear credit default swap, therefore unsafe.

And, also, there’s a whole measure of clearing, transparency, capitalization, collateralization. None of these things were present. If this were transparent, the regulators would have known about this when The Wall Street Journal was reporting about the London Whale weeks ago, and they would have put a stop to it before it was a crisis.

JEFFREY BROWN: What about my question about the — are the banks too big? Does this tell us anything about whether something more needs to be done about the too big to fail idea?

BERT ELY: I am not as concerned about the so-called too big to fail problem as many others are.

One of the things that becomes a problem is, they say, well, break up the big banks. Well, the question is exactly how do you break up the big banks? I have yet to hear a credible explanation on that.

But here’s what also concerns me. The more you try to zero regulation in on the banks, number one, you raise the question, are the regulators up to the job? But to the extent that you try to squeeze in on the banks, it’s like squeezing a balloon. What’ll happen is a lot of these transactions will move out into what is called shadow banking, into a less regulated world.

And if they blow up there, they might in fact blow up the whole financial system.

JEFFREY BROWN: Well, that’s a horrible place to stop, but I have to stop there.

(LAUGHTER)

JEFFREY BROWN: Bert Ely and Michael Greenberger, without blowing up the whole financial system, thanks so much.

(LAUGHTER)