When a Bank Loses Billions, Who Wins?

BY Paul Solman  August 8, 2012 at 9:53 AM EDT

President and CEO of JPMorgan Chase Co. Jamie Dimon testifies before a Senate Banking Committee hearing in June. The committee was hearing testimony from Dimon on how JPMorgan Chase lost billions in stock market trades. Photo by Mark Wilson/Getty Images.

Paul Solman frequently answers questions from the NewsHour audience on business and economic news on his Making Sen$e page. Here is Wednesday’s query:

Name: Hill Kemp

Question: When Morgan Stanley loses $7 billion, does that money just disappear into the ether or does some other party(s) make $7 billion?

Making Sense

Paul Solman: I’m not sure if you mean JPMorgan Chase instead of Morgan Stanley. Before the 1930s, they were the same firm, but the Banking Act of 1933, often referred to as “Glass-Steagall” after its congressional sponsors, effectively hived off investment banking from commercial — deposit — banking in order to limit risk. Thus the two “Morgans.”

Moreover, if you mean JPMorgan/Chase, then the total amount of its recent loss is reported to be $5.8 billion and
I’d give the same answer if the amount were $70 billion and the losing entity was named Morgan Frank (after the actor who played the Wizard of Oz): There are two sides to every trade and what one party loses, the other party gains. That’s why those who make trades in the market are known as counter-parties. For every loss, there is an equal and opposite gain.

“So what’s the big deal?” you may well ask. The answer is that the Morgans — and all the other major players in the markets — make their trades with borrowed money. This is called leverage because you’re using the lever of borrowed money to use only a little of your own to control or lift a lot more.

It’s like buying a house with only a small down payment — say, for the sake of example, $10,000 on a $330,000 home, a leverage ratio of 32:1. The beauty of leverage is that if the house rises in value by a mere $10,000, you’ve doubled your money. The danger, of course, is that if drops by $10,000, your equity — your ownership stake — is wiped out.

The same thing happens with financial institutions and indeed, they do sometimes make trades in which their own stake is as little as 3 percent: a 32:1 leverage ratio. So if a trade goes bad, yes, a counterparty gains just as much as the loser loses, but the loser may be busted. If that loser is one of the Morgans and a major player in the global economy — a counterparty to trades with lots of other players, that is — than the whole system can freeze. That’s what happened in 2008. See our explanation of the same, complete with falling dominoes.

As usual, look for a second post early Wednesday afternoon. And please don’t blame us if events or technology overtake us. This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions