Clarification: The second paragraph of this column uses the word "offset" in the vernacular sense. Gains on the sale of unrelated securities (the "assets" mentioned in the passage) mitigated the bottom-line impact of losses on the JPMorgan Chase chief investment office’s derivatives. But as stated later in the column, the derivative positions did not qualify for hedge accounting treatment, and so were not "offset" in the strict accounting definition.
Accountants hate to be ignored, but we're used to it.
Accounting standards allowed Jamie Dimon to offset seemingly sudden, multibillion-dollar mark-to-market declines (on trades which were supposedly designed to mitigate losses) with unrealized gains on the sale of $1 billion of unrelated assets. Unfortunately, the proposed Volcker Rule ignores accounting standards for derivatives and hedges when judging what constitutes bank proprietary trading.
Dodd-Frank's Volcker Rule restricts a Fed-supervised bank from engaging in proprietary trading. To receive an exemption for "permitted risk-mitigating hedging" activities, a bank would have to meet seven criteria – all seven, not just one – under the implementation rules proposed by the OCC, the Federal Reserve Board, SEC, and the FDIC.
Would the Volcker Rule have prohibited JPMorgan Chase's losing "whale" trades? According to the most recent quarterly and annual filings, JPMorgan's positions in credit default swaps did not qualify for hedge accounting treatment under accounting rules. I believe they should be considered proprietary trading on that basis alone. The Volcker Rule hasn't been finalized yet, but the implementation proposal, published in the Federal Register in November, describes an approach that does not consider hedge accounting rules for deciding which trades are proprietary. That leaves plenty of opportunity for banks to arbitrage the possibilities.
The blog Economics of Contempt explains that it's been misguided for pundits to use the rule's portfolio hedging criteria to argue that JPMorgan's trades would be allowed by Volcker. "Even if JPMorgan's failed trades qualified as portfolio hedges, they would still have to meet other, more stringent requirements in order to qualify for the Volcker Rule's hedging exemption."
The other, more stringent, requirements of the proposed rule include an internal compliance program, such as reasonably designed written policies and procedures, internal controls, and independent testing. The transaction under the hedging exemption must be constructed in compliance those written policies, procedures and internal controls. The proposed rules also require that any transaction expecting a hedging exemption be continuously reviewed, monitored and managed.
Dimon has admitted that the losing trades were "poorly constructed, poorly reviewed, poorly executed, and poorly monitored." If policies and procedures to cover these activities exist at JPMorgan, they surely weren't followed.
The proposed implementation of the Volcker Rule also requires that the transaction be designed to hedge one or more specific risks, including market risk, counterparty or other credit risk, currency or foreign exchange risk, interest rate risk, basis risk, or similar risks, related to individual or aggregated positions.
Dimon has yet to identify the specific positions, or the portfolio that was hedged. Nor has he demonstrated that the hedging transaction that's losing billions was intended to be reducing risk in the aggregate, as measured by appropriate risk management tools. In fact, Dimon admitted that risk management tools like Value at Risk failed and that the trade was not designed to be profit-neutral.
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