What Can We Learn from JPMorgan’s $2 Billion Loss?

Yesterday superbank JPMorgan announced that it had lost more than $2 billion in a massive hedge trade made by its London office, highlighting the ongoing debate over financial regulations currently being written and spurring an SEC investigation into the firm’s accounting practices and public disclosures.

JPMorgan’s chief executive Jamie Dimon, pictured above, said “errors, sloppiness and bad judgement” were to blame for the losses incurred by a trader nicknamed “the London whale”; DealBook explained the losses this way:

The $2 billion loss came from a complicated trading strategy that involved derivatives, financial instruments that derive their value from the prices of securities and other assets. JPMorgan said the derivatives trades were part of a hedge, meaning they were set up to offset potential losses on the bank’s large holdings of bonds and loans. But, in the sort of nightmare situation that bankers dread, the ostensible hedge backfired, producing losses of its own.

Dimon is known for his fierce opposition to many of the regulations in the 2010 Dodd-Frank financial reform bill, including derivatives reforms and the Volcker Rule, which would bar banks from making trades for their own benefit using customer funds, and he maintained his position yesterday. “This trading may not violate the Volcker rule, but it violates the Dimon principle,” he said on a conference call. The loss, he cautioned, ”plays right into the hands of a whole bunch of pundits out there” who support more strict financial regulation.

Financial experts and pundits have been quick to point at the lessons to take away from the $2 billion blunder; we’ve highlighted key analysis below.

JP Morgan: When Basis Trades Blow Up – Reuters’ Felix Salmon says JPMorgan’s problems came from “a basis trade blowup” involving credit default swaps (CDS) and argues that the provisions in the Volcker Rule probably would not have prevented the bank’s loss. “This loss only goes to show how weak the Volcker Rule is,” he writes. “Dimon is adamant, and probably correct, in saying that Iksil’s [the London trader] bets were Volcker-compliant, despite the fact that they clearly violate the spirit of the rule.”

JPMorgan Debacle Reveals Fatal Flaw In Federal Reserve Thinking — Baseline Scenario‘s Simon Johnson argues the “real losers in this turn of events are the Board of Governors of the Federal Reserve System and the New York Fed, whose approach to bank capital is now demonstrated to be deeply flawed.” Noting that JPMorgan passed recent Fed stress tests “with flying colors,” he writes: “We need much higher capital requirements and much simpler rules – focus on limiting leverage. Big banks should be forced to become smaller – small enough and simple enough to fail.”

The Lesson of JP Morgan’s $2 Billion Loss: Break Up the Big Banks –  Reuters’ David Rohde argues that the JPMorgan loss is only the latest example of how the nation’s biggest banks are only getting bigger, and should be broken up before their collapse cripples the U.S. economy and forces another bailout. “The sheer size of the banks – and the theoretical government backing that they enjoy – make it impossible for the country’s roughly 20 regional banks and 7,000 community banks to challenge them,” he writes. “Smaller banks will be easier to regulate – and foster more competition.”

JPMorgan Loss Bomb Confirms That It’s Time to Kill VaR – Naked Capitalism‘s Yves Smith argues that JPMorgan’s loss further illustrates that the widely-used risk management tool coined by JPMorgan known as “value at risk” (VaR) — a measure of the maximum possible daily loss — is an unreliable and “lousy” metric. ”There is a tremendous bias towards scientism, towards undue faith in quantification and statistics which leads to overconfidence,” she writes. “And when people are paid bonuses annually, with no clawbacks for losses, and banks show profits a fair bit of the time, who is going to question bad metrics when the insiders come out big winners regardless?”