The disclosure by once future Treasury Secretary and current JP Morgan CEO Jamie Dimon of a sudden and previously undisclosed $2 billion dollar derivative loss should be a wake up call. It unwittingly reveals much about the present state of finance:
• The inherent tension between traders using leveraged risk with Other People’s Money in the pursuit of enormous bonuses is still weighed heavily towards excess risk taking;
• There is no bank in the United States that has demonstrated the ability to manage proprietary trading risks — if they use derivatives and/or leverage;
• It took less than 3 years after the financial crisis peaked for traders to engage in the same sorts of highly leveraged reckless speculative bets that helped crash the economy last time. Imagine the sorts of risks these mis-incentivized desks will be doing when the memories of the crisis fade 10 years after.
• Trades that are so enormous as to be “credit index distorting” are not hedges, but pure speculation. Within banks, apparently the word “Hedging” loosely translates as “speculation.” Actual hedging of existing positions appears to be nonexistent.
• VaR remains a mostly useless concept as applied by banks today. It is a false model of reality whose deviations have devastating consequences. (Call it physics envy)
• At these size trades, the asymmetrical preference for bonuses over risk management is such that even clawbacks won’t work;
• Jamie Dimon, formerly praised as the Capo di tutti capi of bank CEOs, apparently has been more lucky than brilliant. This quarter, his luck ran out.
• Derivatives, because of their enormous built in leverage, are inherently dangerous. They are still financial weapons of mass destruction;
• Too big to fail banks remain a threat to the stability of the global economy.
While this was “only” a $2 billion loss it easily could have been much greater. That banks such as JPM are still putting on trades that distort indices is quite bluntly, astonishing.
The solution to this risk is very very simple: The USA should reinstate Glass Steagall, and repeal the Commodity Futures Modernization Act.
Until that occurs, the risk of catastrophic failure remains present in the financial system.
Disclosure: Long JPM