Maybe the Senate hearing into JPMorgan Chase's London Whale derivatives trades will be a "modern Pecora moment" that will eventually lead to tough, effective financial reforms. More immediately, even while JPMorgan's witnesses were testifying with practiced humility, lobbyists for derivatives-trading banks were working to gut the reforms of derivatives trading enacted less than three years ago as part of the Dodd-Frank Act.
The picture that emerged from the hearing and the committee report was ugly. JPMorgan's reputation for mastery of the universe in general and risk control in particular survived the financial crisis better than any other bank's. They looked pretty clueless about the derivatives trades.
Here was the trader's stated strategy:
- Sell the forward spread and buy protection on the tightening move
- Use indices and add to existing position
- Go long risk on some belly tranches especially where defaults may realize
- Buy protection on HY and Xover in rallies and turn the position over to monetize volatility
The trader probably intended that to be indecipherable gobbledygook. The higher-ups at the bank had no idea what it meant. A JPMorgan witness described the strategy this way: "basically, it's a strategy of buying low and selling high." The strategy really was to move so much money in and out of positions that the trader could control a relatively small market. Other market participants figured out what was happening, and the result was similar to all the third graders on a playground ganging up on a fifth-grade bully.
So the trader bought high and sold low, costing the bank at least $6.2 billion in trading losses.
As losses mounted, the head of the investment office sent a subordinate an email that was the equivalent of saying, "Will no one rid me of this meddlesome accounting valuation?" The bank adopted new accounting and risk models that understated the losses and risk exposure. Executives assured regulators that risk controls were adequate, while the trades repeatedly violated risk controls. They assured investors that the bank's top risk managers approved the trades, which was also a departure from the truth. They simply did not provide troubling information about the trades to the bank's principal regulator, the Office of Comptroller of the Currency. And the bank's CEO, Jamie Dimon, told investors and analysts that it was all just a "tempest in a teapot."
In short, the bank's executives misled regulators, investors and the public.
The hearing and the committee report raised obvious questions about JPMorgan's competence and honesty, and about the rigor of OCC's oversight, but there is a more basic question: What was the point?
The bank's "synthetic credit portfolio" had nothing to do with real credit. The derivatives trades did not make it possible for more businesses to buy equipment, pay overtime or hire new employees; no household was able to buy a new car or replace their furnace. Instead, the trades were "synthetic" credit, a bet on whether a borrower would default on debt to someone else. The bank was playing the derivatives casino and lost.
Real credit is vital to the economy. Synthetic credit, on the other hand, appears to have approximately the same economic value that plastic fruit has nutritional value.
Within days of the Senate hearing, the House Agriculture Committee passed the banks' wish list of bills to free the banks from the derivatives regulation in the Dodd-Frank Act.
The "Swaps Regulatory Improvement Act" would effectively repeal the "push-out rule" that requires banks to trade derivatives in a separately-capitalized subsidiary, not the taxpayer-insured "depository institution." The purpose of the "push-out" rule is to make banks' derivatives trading small enough and separate enough to fail without bringing down every subsidiary in a heap.
The "Inter-Affiliate Swaps Clarification Act" would let the banks slosh derivatives around between subsidiaries (they all have thousands) to avoid regulation. The bill would also let banks move souring derivative positions like the London Whale trades from subsidiaries with lower credit ratings to the depository institution to avoid collateral demands from counterparties. Instead of quarantining risk as the push-out rule intends, the bill would let a desperate bank spread contagion from one failing subsidiary to the bank's depository institution, creating far more risk of economic disruption. That is not a hypothetical.
Predictably, Scott Garrett, a senior Republican on the House Financial Services Committee, said the legislation was needed because "Our job creators – millions being crushed by overly burdensome Washington rules and regulations – deserve to be on a fair, level playing field with the international community."
It is hard to see how unregulated, taxpayer-subsidized synthetic credit creates real jobs, but the risk it creates is very real.
Brad Miller is a former U.S. congressman.