May 12, 2012 in Nation/World

JPMorgan’s $2 billion loss draws fire, rattles investors

Bernard Condon Associated Press
 
On Wall Street

JPMorgan’s 9.3 percent decline was responsible for most of the 34-point drop in the Dow Jones industrial average, with a little help from Bank of America, Cisco, and Hewlett-Packard.

NEW YORK – How can a bank lose $2 billion in six weeks?

That’s just one of the mysteries surrounding the news that JPMorgan Chase, widely thought one of the safest U.S. banks, is gushing red ink from bad trading bets. As details slowly emerged Friday, the shares of the nation’s largest bank fell hard, as did those of several rivals.

JPMorgan faced intense criticism for claiming that the $2 billion loss was the result of a sloppy but well-intentioned strategy to manage financial risk.

More than three years after the financial industry almost collapsed, the colossal misfire was cited as proof that big banks still do not understand the threats posed by their own speculation.

“It just shows they can’t manage risk – and if JPMorgan can’t, no one can,” said Simon Johnson, the former chief economist for the International Monetary Fund.

JPMorgan CEO Jamie Dimon told NBC News, for an interview airing Sunday on “Meet the Press,” that he did not know whether JPMorgan had broken any laws or regulatory rules. He said the bank was “totally open” to regulators.

The story behind the loss is complex, and rich in irony. How it’s viewed could influence how regulators implement a financial overhaul law called Dodd-Frank. How hard regulators crack down on the bank could have a big impact on the stability of the financial system.

Here are answers to some questions about the loss:

Q. How exactly did the bank lose so much so fast?

A. First, start with the irony. JPMorgan says the losses came from a trading portfolio designed to offset losses in the bank’s lending business. Instead of offsetting losses, these so-called “hedges” added to them.

JPMorgan extends money to companies through loans and by buying bonds. The bank was worried that it might not get all its money back, so it bought protection. Though it didn’t detail how it did this, banks typically buy credit default swaps, essentially insurance contracts that pay out when companies stiff their lenders.

It gets more complex. In the often dizzying, Alice-in-Wonderland world of banking, these hedges are themselves sometimes hedged, and that’s what JPMorgan did. The bank apparently thought it had bought too much protection, so it hedged its hedge.

It’s that second hedge, basically a bet that companies would pay back their loans, that led to the losses.

Q. Why are other bank stocks falling on the news?

A. It’s not just the size of the bet that’s scaring investors but its complexity. The fact is, not even experts know how precisely big banks make money and occasionally lose it. Their wagers are largely hidden. The opaqueness, which investors normally shrug off, is spooking them now.

Investors are uneasy also because JPMorgan has a reputation of managing risks better than almost anyone in the business. Investors seem to be asking: If this bank can lose $2 billion in six weeks, can others too?

Finally, there’s the regulatory threat. The loss comes amid heated debate in Washington over just how tightly to regulate banks. “The timing of the JPMorgan announcement couldn’t be worse,” said Whitney Tilson, head of hedge fund T2 Partners, speaking at an industry gathering in Las Vegas.

Investors fear that bank profits could be pinched by the so-called Volcker Rule restricting trading that banks do with their own money, as opposed to clients’ funds. Dimon has been an outspoken critic of the rule.

Now that Dimon has been pushed off his pedestal, investors are worried that regulators will be tougher in enforcing the new rule.

Q. Isn’t the trading that led to the loss banned already?

A. No. The rule doesn’t take effect until July, and even then regulators are suggesting banks will have another two years to comply.

In any case, it’s not clear that the trades in question were subject to the rule. In the conference call Thursday, Dimon said the trades that backfired were hedges, not bets for profit, so they wouldn’t have fallen under the rule.

But some experts have doubts. Nancy Bush, a banking analyst at NAB Research, says it’s not always clear what is hedging and what is gambling. The size of JPMorgan’s loss makes her suspicious.

“So they made money on hedges and then they hedged some more,” she said. “At some point it goes from being a hedge to being a moneymaker. They crossed the line here somewhere and it’s going to cost them.”

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