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JPMorgan’s $2 Billion Loss Shows Impotence of the Volcker Rule

I spent most of yesterday afternoon laughing my ass off about Jamie Dimon’s London Whale loss, but it’s actually not all that funny. JPMorgan Chase revealed a $2 billion loss on a bad bet they made on a credit default swap index trade. They described it as an egregious, self-inflicted mistake. I think Felix Salmon has the best explanation of just what happened here.

The basis trade is an arbitrage, basically. There are two different ways the market measures credit risk: by looking at credit spreads — the yield on a certain issuer’s bonds, relative to the risk-free rate — or by looking at CDS spreads, which are basically the same thing but set in the derivatives market rather than the cash bond market. Most of the time, CDS spreads and cash spreads are tightly coupled. But sometimes they’re not. And at Merrill, a huge part of that $16 billion loss was reportedly due to a bad basis bet: the basis on many credits became very large and very negative during the financial crisis.

This time around, the basis-trade disaster has happened at JP Morgan, where the famous London Whale seems to have contrived to lose $2 billion on what was meant to be a hedging operation. And once again, although the details are still very murky, the culprit seems to be the CDS-cash basis.

The type of trade exploits very small movements in indexes that are meant to track a certain market. But in this case, the spread got a little too large, and JPMorgan Chase was left on the bad side of the bet.

Notice the presence of the word “bet.” Dimon insisted in his hastily arranged press call yesterday that the trades were compliant with the Volcker rule, which was supposed to ban proprietary trading. Dimon claims that the CDS index trades were for the purposes of hedging. But the initial Volcker rule, the one that passed out of Congress, prevented this type of portfolio hedging. On pages 29-30 on this letter, from the writers of the Volcker rule, Jeff Merkley and Carl Levin, they lay that out specifically.

One major weakness in this part of the Proposed Rule is allowing hedging
on a portfolio basis. Hedging on a portfolio basis essentially allows banks to view an investment portfolio as a whole and take actions to offset a particular type of risk that appears in the portfolio. This contrasts sharply to professional traders who have told us that hedges are, by far, most effectively utilized as actual hedges when matched on a position by position basis, and not on a portfolio basis […]

There is no statutory basis to support the proposed portfolio hedging language, nor is there
anything in the legislative history to suggest that it should be allowed. To the contrary, the
legislative history of this provision clearly rebuts any assertion that such a broad allowance
should be made. We introduced the first draft of what later became the Merkley-Levin
Provisions as S.3098 on March 10, 2010. In that legislation, the permitted activity was worded only as risk-mitigating hedging activities. During the legislative process, this language was significantly revised to remove the possibility for portfolio hedging.

But the Volcker rule that passed Congress bears little resemblance to the Volcker rule that is slowly taking effect. All kinds of loopholes, particularly for hedging, have been blown into it. And the JPM case is a textbook example of why that, for this reason, the Volcker rule has been rendered useless. If you allow loopholes like this, hedges and actual bets for the purposes of speculation tend to look pretty much the same. Maybe at this point JPM can cover the $2 billion loss. But there’s going to be a time where somebody can’t, and they’re going to come hat in hand to the government looking for help. Basically nothing has changed on Wall Street as far as mindset, and now we learn that very little has constrained them after Dodd-Frank. The casino remains open.

The other darkly amusing part of this is that Dimon has spent the past several months saying that Dodd-Frank forces his bank to hold too much capital and limits his bank on making risky trades. Because if we were in a situation where JPM had less capital and more credit risk right now, things would be dandy.

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David Dayen

David Dayen